Guided by Greed

SAR investors are in a no-man's land when it comes to financial planning, writes Daniel Hilken

"Hong Kong is perceived as a cutting-edge international financial center with remarkable infrastructure and entrepreneurial flair."

So far, so good. Just the kind of thing that Hong Kong likes to hear. But, hang on - what comes next is not calculated to flatter the regulatory elite.

"This could not be further from the truth with regard to the personal financial advisory industry."

The speaker is a financial adviser himself. To avoid accusations of self-promotion, he prefers that his name not be used, but he is increasingly worried about cases of "mis-selling" and their impact on the industry's reputation.

The common denominator of most of these cases is that people who wanted low-risk, conservative investment plans wound up with high-risk schemes that involved considerable leveraging, or borrowing.

He says most so-called independent financial advisers, or IFAs, are just brokers with a vested interest in touting plans that pay them maximum commission for minimum effort.

The speaker - let's call him Mr IFA - belongs to a small minority in the financial advisory business, those who resist the tyranny of commissions by charging clients for their advice.

Mr IFA says the most glaring proof of Hong Kong's backwardness in the personal financial products area is the depressingly predictable way that IFAs foist long-term contractual savings plans on their clients.

Notorious for high management fees, punishing early-exit penalties and colossal commissions, these plans have all but disappeared from most advanced jurisdictions - including Britain, the place Hong Kong traditionally has turned to for regulatory inspiration.

"The weapon of choice for advisers is the contractual savings plan - the most profitable of products for life insurance companies and a generator of huge commissions for advisers," says Mr IFA.

"For example, a 25-year savings plan with a HK$35,000 monthly premium generates an initial commission of HK$441,000 and total renewal commissions of almost HK$200,000. Not bad for a couple of hours' work."

Disclosure of commissions is not mandatory for advisers in Hong Kong, though it is in Britain and Australia.

If the Securities and Futures Commission, which licenses advisers, is not comfortable requiring disclosure of plans' commissions and costs, wonders Mr IFA, "what are they doing authorizing them in the first place?"

Once an investor is locked in, getting out is tough. One lawyer described the "horrendous" lock-in terms of a typical fixed-term contractual savings scheme.

It stipulated that if the investor withdrew within 12 months, he would lose his entire investment; if he left after two years, he would lose 87 percent of what was invested during the first 18 months, and so on, on a sliding scale.

Such plans may be appropriate for long-term savers confident of keeping up their contributions, but the lawyer's experience indicates that advisers are not always honest with their clients about exit penalties.

One adviser told him a plan was so flexible that after 18 months, he could withdraw his money. "Just like a bank account?" he asked. "Yes," she replied, without breathing a word about the high cost of early redemption.

While contractual savings plans are all but dead in Britain, they are the product most often recommended by salespeople in Hong Kong.

Mr IFA says they make no sense: "Why pay surrender charges to access your own money? In such circumstances, you simply have to ask who's benefiting from such arrangements, because it certainly isn't you."

He adds: "A good adviser will develop a truly flexible plan that should be suitable for years to come, but which can be changed at a moment's notice without undue effort or expense."

Eagerness to maximize commissions also seems to be behind another trend in financial advice - encouraging investors to borrow extra money to invest. This is called leveraging or gearing, and it adds greatly to the investor's risk.

As an example, Mr IFA cites "with-profit" funds, where the investor is paid out of the fund's earnings. Such products have been available in Hong Kong for years, and advisers used to dismiss them as boring.

"But as soon as it was discovered that with-profit funds could be geared and be capable of generating up to 21 percent commission, they suddenly became the greatest investment ever."

Mr IFA says Hong Kong is years behind Britain and Australia in terms of regulation. "The regulatory framework is almost non-existent and thus heavily weighted in favour of the salesperson."

In better-supervised markets, expensive, restrictive products like the ones major insurers tend to sell in Hong Kong have been phased out or radically redesigned, he says.

In Britain, tighter rules have created a market for good products from discount brokers, fund supermarkets and online share dealers. But there is little incentive to offer them in Hong Kong.

"Why spend a fortune advertising the virtues of a cost-effective, transparent product when brokers can easily hide the charges on high-paying products?" Investment products sold on commission generally underperform the market because of the drag from the commission and the hefty fees paid to the investment managers.

With most contractual plans, management charges continue to be assessed at the same rate even if the investor reduces or suspends his contribution.

Says Mr IFA: "An already expensive plan suddenly becomes extortionate and unlikely to ever produce a positive return for the investor."

As charges usually apply up front, the threat of a pullout by the client is of scant concern to the investment manager. "In fact, investment managers prefer plans to be stopped early," says Mr IFA. "The last thing they want is to have to administer a savings plan for 20 years."

Advisers, many of them expatriates, don't worry much either about clients who withdraw. "Hong Kong is an excellent place to come for a few years, earn a small fortune selling high-premium, long-term plans and depart, leaving clients to fend for themselves."

All too often, what clients are left with is not just a poorly performing investment, but a disastrous one.

Take Susan Field, who last year sued financial intermediary Barber Asia after she lost nearly HK$3 million - almost all her savings - in a high-risk leveraged scheme.

Field testified that she asked the firm for a "conservative investment strategy." Instead, she ended up in a scheme leveraged 2.5 times with borrowings in yen, leaving her disproportionately exposed to fluctuations in stock prices and the yen exchange rate.

And she had to find more money to meet margin calls when the value of her plan's investments declined.

Barber Asia stood to earn a commission of up to £40,000 (HK$558,060) over five years - more than 20 percent of Field's £187,000 up-front investment - thanks in good part to the leveraging.

Sales of unauthorized funds are another problem. The SFC has found instances where brokers skirted the rules by having their clients declare in writing that they wanted to buy unauthorized funds or else be recognized as professional investors.

Yet the SFC concluded that in some cases the investors had neither enough assets nor enough knowledge and experience to qualify as professionals.

Many are tempted to dismiss these issues, arguing that people with large sums to invest should be smart enough to know when they're being had.

But Mr IFA is not surprised that a woman like Field, who runs her own marketing and communications business, can be fooled. After all, "financial principles are not taught in school or university," he says. Even financial sophisticates get taken.

One leading accountant says he could walk up Des Voeux Road Central almost any day of the week and bump into half a dozen senior figures in the financial community who sank money into the CSA Absolute Return Fund, a hedge "fund of funds" whose founder awaits trial on allegations that he faked its underlying assets.

A lot of dodgy investment plans are sold to members of the legal profession too. "They are too embarrassed to come out and say 'I've been done'," admits a senior lawyer.

The salespeople "are very good at what they do," he says. "Sometimes you sign up just to get them off your back." But for him it's "the end of the conversation" when an adviser offers him an insurance-based product.

"There are good sides to savings plans: one of the good aspects is that because it is so painful to stop contributing, it is quite a good discipline and it forces you to keep saving through the term of the plan because you are going to get pummeled if you don't.

"But it would be better if people went into it with their eyes completely open," says the lawyer.

He thinks the light regulatory burdens placed on advisers in Hong Kong may be the result of indecision over how to regulate them.

Because they have arrangements with fund houses, one could argue that they ought to be licensed for dealing in securities. And where they promote insurance products, the insurance authority ought to be concerned. But "in terms of sales practices, it's really an SFC issue," says the lawyer.

Britain, which experienced a spate of scandals over mis-selling of investment products in the 1980s, finally got a handle on the issue by dispensing with artificial regulatory distinctions.

Since the creation of a single regulatory agency, the Financial Services Authority, most of the bad apples have been removed from the British financial advisory industry.

"What we have in Hong Kong is based on what was there in the UK prior to the 1980s in terms of licensing," says the lawyer.

Investors who feel themselves wronged can always sue, of course, but even when they win, they aren't guaranteed financial redress.

Though the Court of Appeal in September ordered Barber Asia to reimburse her losses, Field has yet to see a penny of compensation. In March this year, company founder Andrew Barber failed to appear in court to explain why he had not coughed up. To account for his absence, he left a message - it was my mother's birthday, he said.

After the Barber Asia case and that of Towry Law (Asia) HK - which last year partly compensated investors over allegations it directed them into fraudulent hedge funds - the SFC launched an investigation into mis-selling.

It is also looking into complaints from investors who lost big money from leveraging their investments in funds operated by Clerical Medical Insurance, a British-run firm.

So far, it has done little more than issue a report on the sales practices of a few licensed advisers, accompanied by a reminder that advisers should comply with their official code of conduct.

The code, which has been drawn up by the SFC, is of little effect, argues Mr IFA. The examinations advisers must pass to be licensed are not considered difficult, and no previous formal training is required.

For those who plan to sell insurance-based products too, there is a simple multiple-choice exam set by the Confederation of Insurance Brokers.

"Alarmingly," says Mr IFA, "many financial advisers are educational underachievers who lack the cognitive reasoning to grasp the ramifications of their recommendations."

Within the advisory profession, awareness of the law is often lacking. After Field successfully sued his company, Andrew Barber told The Standard that the decision signaled the end of the contractual principle caveat emptor (let the buyer beware).

Actually, that principle has never applied in the financial advisory industry, which operates on a fiduciary legal basis and is therefore governed by the rules of tort, not contract. There was no contract between Barber Asia and Field, only between her and the fund house. So Barber Asia had responsibility for the consequences of any advice it gave which Field relied on.

The SFC's investigation looked at what it called a "good mix" of 15 investment advisers.

It found a host of deviations from regulatory requirements, including unauthorized investment products being offered and failure to give clients enough information to make proper decisions. In one case, a 90-year-old client was urged to invest in a product with a long lock-in period.

Observers of the advisory industry welcomed the report's revelations, but accused it in the final analysis of offering pieties in the place of remedies.

Lawyer Ian De Witt, who acted for Field against Barber Asia, commends the report - "in fact, it's quite depressing reading" - but is disturbed by the SFC's failure to follow up with action.

A primary objective of the report, according to the SFC, is to "remind [investment advisers] to adhere closely to regulatory requirements."

De Witt reacts with sarcasm: "Well, that's alright then. We can all rest at ease now." He also scoffs at the statement that "the SFC draws no inference that these findings would be found in the remaining 90 percent of [investment advisers]."

The obvious solution, which the report acknowledges, he says, is that brokers should be required to disclose their remuneration.

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