Bob's Blog

“I was right 70% of the time, but I was wrong 30% of the time” – Alan Greenspan responding to the Financial Crisis Inquiry Commission back in 2010. Greenspan’s response left many people shocked as to his arrogance, let alone his legacy. He presided at the Federal Reserve at a time when subprime mortgages were seen as ‘solutions’ for many. In reality they were nothing other than toxic debts which would bring down an entire global financial system and leave many people homeless.

The crisis was sparked off with the collapse of Lehman Brothers back in 2008. Since then we have witnessed the loss of over 30 million jobs in the US and looked on as trillions of dollars of wealth has been wiped out while millions have lost their homes. The interdependence of financial markets has been well documented in recent times. However, regulation is not always connected by policy makers as being the route cause to many macroeconomic issues. This short-sightedness has inevitably led the global financial markets to disastrous outcomes which are still some time away from being properly addressed.

Typically, financial regulators are charged with a number of main tasks such as authorising market entrants, ensuring transparency, enforcing regulatory guidelines and prosecuting transgressors. Regulators tend to look at the market as the sum of the parts, whereas, in reality the very companies authorised and regulated usually have a contagion-like effect when things go wrong. This can lead to systemic issues as we saw with the collapse of Lehman Brothers back in 2008. This company was so intertwined in the financial markets that it sent a shockwave through the entire system. Not alone was the Fed left reeling from the effects, but every other financial regulator throughout the globe felt the jitters coming from Wall Street.

This crisis has reopened the debate about integrated international financial regulation. While an argument can be made for national governments surrendering some regulatory sovereignty for the greater good, one cannot ignore the considerable challenges that exist through differences in national legal systems, structures of corporate governance and financial custom and practice. These types of difficulties are further reinforced by a letter dated 7^th December 2010 from the Central Bank of Ireland to the Directorate General of General Internal Markets of the European Commission. That letter states:

“The Central Bank does not oppose the creation of a European Market for auditors. However, cross border audits may be problematic, at least in the short term, due to the varying nature of company law requirements in the difference jurisdictions and the logistics of undertaking audits in different jurisdictions etc”.

International audits, as a component part of the international regulatory framework demonstrates the difficulties in creating an international agenda. While this does not suggest that enhanced international financial regulation should not be pursued, it is a telling tale that there are many challenges to overcome if it is to incorporate local legal systems, corporate governance functions and financial customs into a regulatory system. This regulatory system must have the authority and flexibility required to fulfil the premise of an effective international regulatory system if it is to be successful.

Thomas Oatley, in The Dilemmas of International Financial Regulation, emphasises the point that the role of international regulation may move towards that of international coordination as an acceptable alternative. If international financial regulation is unattainable, then the focus should shift towards non-binding agreements at a national level. National governments may be responsible for regulating domestic banks. However this international coordination may seek agree on how multinational institutions are regulated. As stated earlier, it is rare that institutions act in isolation and if national governments want to protect their consumers and balance sheets, it may be the lesser of two evils to share regulatory responsibility in this regard.

As I see it, the biggest issue facing the financial planning business in Ireland is that of trust. This is an issue difficult to quantify which can rarely be legislated for. Every week we read of how “trusted advisers” took gambles, acted fraudulently or misrepresented clients. Just recently a High Court report stated about Custom House Capital that:

“There was a systematic and deliberate misuse of assets and cash…The misuse was deliberately disguised by Custom House through the use of false accounting entries and misleading statements to clients”.

This in itself makes a mockery of the entire regulatory system. At the same time, if a company authorised to act by the Central Bank of Ireland can ridicule the system and fail in such a spectacular fashion, then we must also question what exactly the regulator was doing in the lead up to this. Additionally, of the eight principles put forward by the Financial Planning Standards Board, only two; competence and confidentiality were adhered to; and even at that, at a push. It appears at face value that the other principles, namely, best interest of the client, integrity, objectivity, fairness, professionalism and diligence were all ignored or sidestepped. Is it possible therefore, through a combination of common law, statute and regulation, to protect consumers and enhance the duty of care by the adviser in the pursuit of financial planning?

 

Irish Context

 

There are a number of routes and protections available in the pursuit of a properly functioning financial services industry. All of these elements combined should result in negating any negative impact of mistrust, suspicion and perceived shortcomings of the financial services industry. However, for various reasons either singularly or combined, the rule of law and regulation has failed in this regard.

1. Common Law

Through common law, there are decades of judgements which can be used in settling disputes which may arise under tort law and contract law. While there are many differences between the two areas of common law, disputes can nevertheless be pursued under both aspects. Common law relates to disputes that arise from the frustration of a contract whereas tort relates to a civil wrong. The principles of tort, while not specified in a contract, are established by the courts whereas contract law, relates to the provisions specified in a contract. In the case of Finlay v Murtagh (1979), the plaintiff sought to bring a professional negligence case in tort against the defendant even though a contract existed.

The courts have responded to the area of negligence by developing more robust guidelines in establishing that a duty of care has been breached. These guidelines are:

-          There was a duty of care

-          There was a breach of that duty

-          Damage has ensued as a result

However, in order to establish that a duty of care exists, the courts also look at the areas of foreseeability, proximity and the extension of liability beyond manufacturers.

-          Foreseeability

 

In the case of Donoghue v Stevenson (1932), Lord Atkin established the ‘reasonable man’ test, that is, whether a reasonable man would have foreseen the potential for injury. In addition, there must also be proximity between the parties. This is necessary as the defendant in these cases must be able to identify who the end users are.

-          Proximity

 

The ‘reasonable man’ test is once again used to establish what relationship exists. If there is a breach in the duty of care, can the hypothetical ‘reasonable man’ identify who may suffer as a result of that breach.

 

-          Extension of Liability

 

Under the revised Consumer Protection Code which is due to come into effect from 1^st January 2012, product producers are required to give detailed information to intermediaries in relation to the investments they sell on their behalf. We will cover the impact of regulation shortly, but it is worth noting a potential exposure that intermediaries face under this provision. This may, in actual fact, be an unintended consequence of the revised code, as it potentially shifts some of the responsibility from the product producer to the intermediary.

In Kubach v Hollands (1937), a schoolgirl lost an eye in a school laboratory accident. The black powder responsible was purchased from a retailer who mistakenly mislabelled the chemical. The manufacturers, however, had given notice of the dangers associated with the chemical. It was held in this case that the duty of care rested with the retailer.

 

While tort law may compensate the injured party for economic loss, a watershed decision was held in the Hedley Byrne Co Ltd v Heller & Partners Ltd (1963) which expanded the duty of care specifically regarding financial loss. The expansion covered two new areas:

-          Liability for negligent misstatements where parties rely on the statements

-          Liability for financial loss caused by negligent acts

Financial planners should also recognise in offering a particular set of skills, clients will come to rely on their trust and expertise. Moreover, any financial planner that claims to be of a certain skill and professional standard can come to expect that their clients will rely on their judgement and expertise. Hedley Byrne exposes financial planners to further action being taken and while this judgement is almost 50 years old, its foundation has yet to be fully explored through the Irish courts. In Glennis v McGougall, the broker in this instance had an interest in the shares which he did not disclose to the client. This was regarded as a breach of duty. Similarly in a modern day setting, brokers who do not divulge their interests in commission’s payable on the sale of investment products are compromised when it comes along to their duty of care. Financial planners must chose – clawback on commission or their duty or care? I suggest that in difficult times, shortcuts will present themselves and some planners may leave their clients exposed through a diminished duty of care.

Financial planners are also expected to deliver a higher standard of care to clients if they masquerade as specialists in their profession. In the case of Duchess of Argyll v Beuselinck (1972) the judge lists the example of a client attending a solicitor who was an expert in a particular area of law. Similarly, the planner should deliver a greater duty of care if they specialise in a chose field. Apart from common law, however, there are few checks in place to ensure this is achieved.

2. Irish Statutes

 

Statutes are laws created by legislators and implemented through various acts. Through these acts, it becomes the responsibility of the various regulatory bodies to ensure the provisions are enforced. Typically the main enforcement bodies in this context are the Financial Regulator, the Office of the Director of Corporate Enforcement, the Financial Services Ombudsman’s Bureau, the Competition Authority and the National Consumer Agency. The main acts in question are:

-          Central Bank Acts, 1942 – 1997

-          Investment Intermediaries Act, 1995

-          Consumer Credit Act, 1995

-          Stock Exchange Act, 1995

-          Insurance Acts, 1909 – 2000

-          Consumer Protection Act, 2007

-          Relevant Statutory Instruments

Legislators and regulators must work towards reconciling national pieces of legislation in a global context. This is currently the greatest shortcoming of the financial regulatory system and the reason there are persistent calls for an international regulatory framework. Subprime mortgages are one such example whereby legislators and regulators failed consumers across international boundaries. These mortgages were regarded as complex loans with hidden terms and oftentimes sold to the least sophisticated buyers. Yet, little was done to restrict their activity in the Irish market. Andrew Mozillo ran Countrywide Homes, one of the largest suppliers of subprime mortgages in the US, at the height of the boom. He viewed these loans in private as toxic products, yet reassured the markets and his investors that all was well in the subprime business. National regulators often take the lead from their international counterparts and this is a fine example of the available statutory instruments being ill equipped for the task at hand. The Irish legislators and regulators failed a nation because they took their lead from the US, and proved to a nation that they were not up to the task. This was a major mistake and one which is currently responsible for the majority of house repossessions through the Irish courts.

However, if the regulators can have independence of thinking and the requisite skill, then there would be more scope in protecting the consumer.

3. Regulation

 

“If the banks continue to act in a way which is do damaging to customers and which appears to take advantage of the current dysfunctional competitive environment, it seems they are courting the risk of public policy response involving powers to impose direct restrictions on their rate setting capacity by the competition or financial regulatory authorities” – Matthew Elderfield, speaking at UCC, October 2011.

The important aspects of Elderfield’s speech covered a number of areas which have been largely absent from the rhetoric of the Regulator’s office:

1. The regulation that exists is sufficient to protect consumers, if the will exists to enforce it.
2. The players in the market may need guidance from the Regulator in interpreting certain aspects of existing regulation.
3. Balance is all important in this industry. Pushing consumers into a more precarious situation is a lose — lose scenario for all involved.
4. If the principles and guidelines set out through regulation are not accommodated in an acceptable manner, the Regulator will reach for a public policy response, sounding the warning bells of increased regulation.
5. This speech can be viewed as the moment when the Irish Financial Regulator signalled a departure from the “no-touch” regulation of this predecessor, Patrick Neary.

Financial regulation is the preferred response in protecting consumers. As we can see from common law and Irish statute responses, both are costly to pursue, have limitations and usually take quite some time to bring to a conclusion (or amend/introduce in the case of statutes). For the majority of consumers, these outlets are usually unattractive as a result.

However, there are many ways in which the Financial Regulator and his agents can promote higher standards throughout the industry. There are too many to mention in this particular context, so I have decided to focus on some of the more obvious avenues that can have a dramatic effect on the industry as a whole.

-          Minimum Competency Code 2011

The Code allows the Regulator to remove the professional designation from an individual who failed to comply with the relevant CPD requirements. This would go a long way to sending out shockwaves to industry colleagues and ensure the CPD is elevated in its standing and reinforce the principles of competence and diligence as stated in bye law number 2 of the Financial Planning Standards Board.

-          Remuneration of Stakeholders

 

As stated by Matthew Elderfield in his speech in UCC, he suggests that: “…the bank’s CEO, CFO and other relevant senior management have specific personal objectives linked to the execution of the strategy” {relating to the mortgage arrears problem}.

This idea that the management of banks and financial houses should have a 360 degree view of their stakeholders is a responsible and sensible view. This train of thought links to David Wise’s article for the Harvard Business Review where he puts forward the notion that “If CEO’s are going to operate for stakeholder value – rather than just for shareholder value – then their pay ought to be structured in a way that supports them doing so.”

-          Guidance from the Top

 

Elderfield’s approach to financial regulation is by creating a psychological contract with the stakeholders in the industry. There are major issues to overcome, but these issues can be overcome nonetheless. Restoring the industry to a footing where regulation is preventative rather than reactive must be welcomed. Whether the culture can change remains to be seen.

As stated by Alan Greenspan, regulators can get it very wrong. In the Irish context, we have witnessed this firsthand and it has been proved to be an abject failure. Unfortunately, there is reluctance by industry professionals to engage with the legislators and regulators in proposing amendments to the existing regulatory system and when regulators get it wrong, the very ones that should be demanding changes, do not. There are a number of ways we can ensure that our regulatory framework is fit for purpose.

-          Term limits for regulators

-          Imposed monetary fines for those who have had a successful case taken to the Financial Services Ombudsman’s office

-          A greater communication between the Financial Services Ombudsman’s office and the Financial Regulator on ways to improve the systems and procedures already in place

-          Oireachtas committees continuously probing regulated firms in the financial services sector ensuring compliance with common law, statutes and regulation

-          I support the Financial Services Ombudsman’s call for powers to “name and shame” offenders

-          The authorisation of new entrants should be much more stringent and new entrants should have a compulsory compliance inspection within the first two years of being established.

-          There must be a major rethink on the role of independent financial advisers in the overall context of financial services

-          Establishment of a whistle blowers avenue to expose rogue elements of the financial services sector

More so than anything else, many of the shortcomings in financial services relates to cultural issues. We each have a role to play in being more vocal in how consumers should be protected, what practices should be outlawed and how we can improve the sector as a whole.

Finally, while I have proposed a number of additions to the existing regulation, it must be emphasised that what we have through common law, statute and regulation at present is sufficient to vastly enhance the financial services industry and offer greater protection to consumers. What we do not have, however, is proper policing of these areas. I, for one, will be vocal in my demands for greater transparency, integrity and consumer protection. If I can deliver it to my clients, I expect the same from my industry participants and the industry as a whole.