By Simon McArley
Friday 21st March 2003
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With New Zealand law moving closer to Australia, the obvious pick would seem to be some form of compulsory licensing regime.
However, licensing may be full of hidden costs and problems and could end up doing more harm than good.
The position of investment intermediaries has become more central to our capital markets. Over the past 20 years, the investment advisory market has grown and reshaped.
We have come a long way from an industry dominated by share brokers and tied life insurance agents.
With a vast amount of savings being channelled through unit trusts and other collective investor schemes the importance of the networks by which those products are distributed has increased.
And as the industry gains importance, the need to ensure the quality, honesty and transparency of the service grows.
Until now we have relied on 1980s light-handed regulation, using disclosure, self-regulation and investor enforcement. This approach has put us at odds with international experience. A quick look at the IOSCO's "Objectives and Principles of Security Regulation" shows that the international standard calls for regulation of minimum entry standards for market intermediaries. The IMF and World Bank are currently undertaking a review of New Zealand's regulatory environment and the failure to meet IOSCO standards will undoubtedly be raised again.
All this may explain why intermediary adviser regulation has become an important topic.
The Securities Commission highlighted the need for change in its February 2002 recommendations to the minister. While it stopped short of recommending investment adviser licensing, it recommended amendments to the existing disclosure regime and extension of the commission's regulatory powers.
The suggestion of licensing arose as a result of general harmonisation with Australia We have seen competition laws, securities markets laws and now insolvency laws adopt Australian models, so it seems a fair bet that a licensing regime, fairly closely modelled on the Australian experience, if not the Australian system itself, is on the cards.
However, before looking at a licensing regime, we need to define the problem. Is it the need to exclude the dishonest and the hopeless? If so, a licensing regime can do the trick. But then the same can be achieved with a simple negative licensing system, banning the cowboys from the market.
But if we want to act before the damage occurs, we need to raise the standard of the industry. If this is the aim, a poorly done licensing regime could be counterproductive. It creates false hopes and over inflated expectations.
To be effective, licensing must be supported by merit qualification, professional development and supervision. And that comes at a fairly significant price. And while it's easy to shout "user pays" and throw the costs back on the investment advisers, the cost will ultimately be borne by the public, in the form of increased commissions and increased product management fees.
Until recently, the standard solution would have been self-regulation. The usual model is to pick a brand, such as "registered investment adviser," set up some rules around using the brand and then promote the brand to the public as a mark of quality. But these schemes inevitably serve the interests of the industry, not the consumer. While participants are happy to pay to develop the brand, they are less willing to pay for development of realistic standards or enforcement. Initial entry standards are set low to get industry coverage, and all the existing cowboys have a home for life. These schemes can also be seriously anti-competitive. Set the entry standards too high, and the cowboys are safe from competition.
Of course, the risk of legitimising suspect players is not unique to self-regulatory schemes. Automatic acceptance of existing "qualifications" is equally a risk for statutory schemes.
Not an easy decision for the minister. What are the alternatives? We rely on a buyer beware system, supported by the Fair Trading Act and Consumer Guarantees Act. While this addresses out and out dishonesty and deception, the standards required by the CGA are not high. Should we be looking at enhancing the standards required by the CGA or creating some specialised guarantee regime for investor advisers?
Can we continue to rely on our current disclosure based model? The Securities Commission's solution is mainly to ask for more disclosure.
The problem is that disclosure often goes over the head of consumers. They just don't know what to look for. Disclosure also has difficult questions as to how we deal with commissions and advisor remuneration. Some jurisdictions ban payment of soft remuneration such as gifts, volume-based rewards and access to discounted services. Are we prepared to go that far here?
What about enforcement? So far we have relied on investors enforcing their own rights.
This is pure economic theory.
The reality is that those most in need of protection are those least able to pay for it. So will enhanced public enforcement be the way to go? We have seen this appear in the proposed consumer credit legislation.
Compulsory negligence insurance, guarantee or fidelity systems have also been suggested. However, they produce more questions than the answer.
Clearly, a large number of challenges are still to be faced in formulating a comprehensive response.
High-profile investment failures and generally poor returns have put great focus on performance of investment advisers and there is now some urgency to produce a solution.
Simon McArley is a partner in the financial services group of KPMG Legal and convener of the Law Society's commercial and business law committee. The views expressed are however personal and do not reflect the views of KPMG Legal or the Law Society
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