17 June 2011

Introduction

A recent High Court decision has a number of implications for the financial advisory industry.

The case was brought by a retired Wellington public servant against his financial adviser, who had 20 years of experience.

The adviser assessed the client's tolerance for risk as being at least "at the high end of balanced" and directed most of his money towards a series of managed funds, some of which were later frozen, and a number of finance companies including Bridgecorp.

Whilst the judgment resulted in a finding against the adviser, the manner in which the judge reached a number of conclusions, including that about the amount of damages payable by the adviser, provide a useful benchmark for financial advisers and their obligations sunder the Financial Advisers Act 2008.

Background

The client had retired from a career in the civil service with a portfolio of investment properties. In December 2005 he approached the adviser for advice regarding the investment of approximately $350,000 expected after the sale of one of the properties. Completion of a risk profile questionnaire saw him ranked as a "conservative fund" investor. As a result he was recommended investments in a number of fixed interest securities in the form of a mortgage trust, a managed fund and four finance companies. All four of the finance companies subsequently failed.

In 2006 he again approached the adviser for further advice in anticipation of realising a further $640,000 from the sale of his remaining investment property. A further risk profile questionnaire was completed in respect of both:

• himself – "balanced/growth"; and
• his family trust – "balanced/moderately aggressive".

As a result, further investments were made in managed funds which were subsequently frozen.

The client claimed losses of $292,000, saying that the adviser had breached a duty of care in the spread and risk level of his portfolio and that of his family trust.

Findings

In his judgment, Justice Robert Dobson dismissed part of the claim which was based on the assumption that the client did not fully understand the relationship between risk and return (in the form of high interest).

However, he said the adviser should have treated the newly-retired client more conservatively and recommended a much wider range of fixed interest options – referring to an “imprudent concentration” of investments in finance companies because the adviser failed to offer any alternatives that would have created options for less risky fixed interest investments.

In this regard, expert evidence was given that the narrow range of investments recommended which have the effect of exacerbating the risk in the client's portfolio. Specifically, the client ended up holding 67% of his investments in three managed funds and his family trust had 24% of its portfolio exposed to four finance companies, a further 27% on a fixed interest managed fund and the balance of nearly 47% in a number of other managed funds. .

The failure to make recommendations about a wider range of fixed interest investments, such as quality corporate bonds or those issued by central or local government, was also held to be negligent. In this regard, the Judge found that a competent financial adviser would not have completely ignored the market for listed bonds and similar fixed interest products.

He also found fault with recommending one managed fund (the ING COF) fund as a component of the fixed interest part of the portfolio – agreeing with expert advice that it was not appropriate for a conservative or balanced investor and should have been treated as a growth asset.

However, he also found that the balance of the adviser's advice was not negligent, and that she could not be held liable for the client's cash flow crisis.

Contributing factors

The Judge also found fault with the client, who pulled his money out of some of his managed fund investments before investors were paid out.

He also concluded from the evidence that the client might not have been inclined to always follow the adviser's advice, and apportioned costs accordingly, awarding the client just over $148,000.

Findings

In the judgment, it was held that over $200,000 of the capital losses incurred by the client were suffered because of the adviser’s advice. However, the damages award was reduced by 27% because the client was held to have been contributed to his loss because he had pressed for higher paying fixed interest investments out of kilter with his risk portfolio. This revised figure for damages was reduced again by a further 40% because of evidence that the client may not have followed more prudent advice even if it was given. For example, evidence was given that the client continued to place funds with finance companies despite his initial losses with Bridgecorp.

The Judge also ruled that the adviser was not negligent in respect of advice about future cash flows. Specifically she was not responsible for the cash flow deficiency suffered by the client. In large part this seems to have arisen because of the evidence that the client prepared his own cash flow budgets which did not fully recognise the periodic manner in which the payments would be received or that withholding tax would be deducted prior to receipt. In addition, the client had chosen to retain bank borrowings after the sale of his investment properties for reinvestment in fixed interest securities. This cost also contributed to his cash flow difficulties despite the fact that the adviser had questioned the wisdom of not repaying those borrowings.

Concluding comments

One of the most immediate practical points arising from the decision is that it is unlikely to be sufficient for a financial adviser to simply have a client complete a risk profile questionnaire. Specifically, financial advisers are clearly obligated to recommend investments suitable for the client's risk profile and to ensure that the client's (clear) cash flow requirements are met. From the ruling, it is apparent that where clients are recommended investments that are inappropriately risky, they are entitled to recover losses arising at the time the investment was intended to be realised.

It is understood that the High Court decision is to be appealed on the grounds that the adviser met industry standards of the time.

For further information about matters affecting the financial advisory sector, please contact Stephen Layburn or any member of Hesketh Henry's Corporate & Commercial team.