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Advisers and investors in the dark on LITs and LICs

(This article was updated on 28 January 2020 to reflect developments subsequent to the original publication. Other articles on this subject are published here and here).

A record amount of over $4 billion was invested in new Listed Investment Trusts (LITs) and Listed Investment Companies (LICs) during 2019, up from $3.3 billion the previous year. Fixed interest LITs were one of the success stories of the year, with $2.2 billion raised in four issues.

The overall sector now holds $52 billion across 114 issues, and while the fixed income LITs are trading close to the value of their Net Tangible Assets (NTAs) value, most equity LICs are struggling at price discounts to NTA. 

But suddenly, there is also a cloud hanging over all new issuance, with financial advisers and stockbrokers unsure whether they can accept selling fees under the Financial Planners and Advisers Code of Ethics 2019 Guidance (it is a guide, not legislature). Amid the uncertainty, well-known global managers such as PIMCO, Neuberger Berman and Guggenheim are hoping to issue in early 2020.

Will advisers participate? Prominent columnist and fund manager, Christopher Joye, opened his Australian Financial Review article on 13 December 2019 in no uncertain terms:

“From January 1 commissions on listed investment companies and trusts will be banned, opening the way to huge compensation claims for losses incurred by any clients other than sophisticated institutional investors.”

The Financial Adviser Standards and Ethics Authority (FASEA) has advised me that Chris Joye's interpretation is incorrect, and this article will explain why. However, a high level of confusion over the proposed Code remains.

Are financial advisers caught in another trap?

In the worst position of all, financial advisers are unsure whether they will breach their Code of Ethics from 1 January 2020. The selling fee for placing clients into new LITs was one of their few bright spots in a tough 2019. The uncertainty arises just when it seemed there was little more that could be thrown at advisers already reeling from:

  • the Royal Commission identifying conflicts of interest and not acting in the best interests of clients
  • a mountain of compliance and paperwork at every client interaction
  • the early removal of grandfathered commissions
  • the exit of the major banks which were once big supporters, and
  • new education standards pushing thousands out of the profession.

FASEA has produced detailed obligations “that go above the requirements in the law”. It includes five values and 12 standards, and they are imposed on financial advisers personally:

“You have a fundamental, personal, professional obligation to understand and to adhere to your ethical obligations under the Code. You cannot outsource this responsibility … You will need to keep appropriate records to demonstrate, if called upon, your compliance with your obligations under the Code.”

With responsibilities that are almost impossible to quantify and judge, the five values are Trustworthiness, Competence, Honesty, Fairness and Diligence, followed by pages of definitions. Advisers will not be able to pick up the phone to a client without worrying if they have met all potential requirements. The concern is that costs are rising so much that financial advice will increasingly become the domain of the wealthy.

Where do LICs and LITs come into it?

The impact of FoFA on funds and listed vehicles

The Future of Financial Advice (FoFA) regulations prohibit payments from product manufacturers to financial advisers. However, in 2014, the Coalition granted an exemption from FoFA for financial advisers and brokers to continue to receive commissions in the form of ‘stamping fees’. Under Corporations Regulations 7.7A.12B:

“A monetary benefit is not conflicted remuneration if it is a stamping fee given to facilitate an approved capital raising.”

And an 'approved capital raising' includes:

“interests in a managed investment scheme that are, or are proposed to be, quoted on a prescribed financial market.”

In addition, on 27 January 2020, Treasurer Josh Frydenberg issued a media release:

"The Morrison Government is today announcing that Treasury will undertake a four week targeted public consultation process on the merits of the current stamping fee exemption in relation to listed investment entities.

Stamping fees are an upfront one-off commission paid to financial services licensees for their role in capital raisings associated with the initial public offerings of shares.

Public consultation will allow the Government to make an informed decision on whether to retain, remove or modify the stamping fee exemption in order to ensure that the interests of investors are protected and capital markets remain efficient and globally competitive."

Does the Code apply to both financial advisers and brokers?

At first glance, as the Code Guidance addresses ‘Financial Planners and Advisers’, it looks like another attack only on financial advisers. At the Royal Commission, the stockbroking industry barely rated a mention while advisers were hammered.

But the examples in the Code Guidance, discussed below, also apply to stockbrokers and every other Australian Financial Services (AFS) licensee. I checked this point with FASEA, who replied:

“The Code of Ethics is a compulsory Code for all relevant providers (as defined in the Corporations Act) when providing personal financial advice or services to retail clients on relevant financial products. Stockbrokers fall within the definition of a relevant provider and therefore must comply with the Code when providing personal financial advice or services to retail clients on relevant financial products.”

Brokers have become major supporters of LICs and LITs in recent years as they receive fees similar to the rewards of floating a new company. When a new LIT or LIC comes to market, the issuer (manager) selects a syndicate of brokers with the ability to market and sell this type of transaction. A welcome development in recent deals is that the managers cover the up-front costs, enhancing the potential for the issue to trade around its issue price. The manager pays a selling fee, as noted in the recent KKR offer (the largest of 2019 raising $925 million) document:

“the Manager will pay to each Broker a selling fee of 1.25% (exclusive of GST) of the amount equal to the total number of Units for which the relevant Broker procured valid Applications.”

KKR also states that:

The Responsible Entity does not intend to pay commissions to financial advisers in relation to an investor’s investment in the Trust under this Offer.”

There is nothing to stop brokers paying fees to financial advisers who place their clients into the funds. In some cases, the commission may be refunded to the clients. In the case of KKR, half the transaction was placed by brokers and half by financial advisers, with the adviser receiving most of the selling fee from the broker.

What does the Code of Ethics say about fees and commissions?

The FASEA Code of Ethics Guidance addresses ethical issues facing financial advisers, and is also relevant to investors want to know what happens to the selling fee.

Christopher Joye sees FASEA’s position as clear:

“In one of the biggest shake-ups of the financial advice industry in years, the government’s Financial Adviser Standards and Ethics Authority has blanket-banned conflicted sales commissions, including previously acceptable “stamping fees”, for advisers recommending listed investment funds to both retail and wholesale clients ... The ban on stamping fees for LICs and LITs for all advisers is therefore black and white (my bolding).

Joye quotes from Examples 6 and 9 of Standard 3, including from page 17:

“The option to keep the stamping fee creates a conflict between [the adviser's] interest in receiving the fee and his client’s interests. Standard 3 requires [the adviser] to avoid the conflict of interest. It is not sufficient for him to decline the benefit as it may be retained by his principal. Either the firm must decline the stamping fee altogether, or [the adviser] must rebate it in full to his clients.”

Joye says there’s “no room for confusion” there. In fact, there is plenty.

There’s no outright ban on ‘stamping fees’ to advisers

Example 6 concerns a stockbroker, Yasmin, who is motivated to do the transaction because she needs the extra brokerage income to meet her monthly target and earn a bonus. FASEA says:

“the actual reason for advising the clients was to earn an increased proportion of total brokerage by ‘churning’ client accounts.”

The Code does not say she cannot accept the commission (stamping fee), it says it cannot be her primary reason for the deal. In fact, FASEA says the usual practice is:

“Her firm takes advantage of the carve out from the conflicted remuneration provisions introduced by the Future of Financial Advice reforms”.

Example 9 is the same. This is headed, ‘Selling IPOs’. It starts: Scott works for a securities dealer which specialises in advising in small cap stocks.” Again, it’s not a financial adviser, it’s a broker. Scott’s firm allows its advisers to either keep the stamping fee or rebate it to the client. However, on this occasion, Scott keeps the stamping fee to pay for school fees whereas he usually rebates to the client. This is how the conflict of interest arises, as it is a change of behaviour. It’s not that keeping the stamping fee is prohibited.

From 1 January, investors who pay an annual fee to their adviser should ask what happened to the stamping fee on new LIT and LIC transactions as a check on potential conflicts of interest.

The Code of Ethics offers flexibility

Outside of these examples, on page 17, FASEA allows financial advisers to receive “Income derived from ancillary products and services”. It says:

“You will not breach Standard 3 if you share in profits generated by the provision of ancillary products and services to clients providing that:

- the ancillary products and services are merely incidental to the adviser’s dominant purpose in providing advice, and

- the ancillary products and services recommended are in the best interests of your client – conferring on the client value that is equal to or greater than that offered by any other option.”

The reason Examples 6 and 9 breach the Code is because of the change in behaviour, such that:

“You will breach Standard 3 where the dominant purpose of providing advice to clients is to derive profits from selling those clients ancillary products or services from which you personally benefit.”

As a further nod to flexibility, page 6 of the Code says to financial advisers:

“Individual circumstances will differ in practice and, as with every profession, there is allowance for differences of professional opinion on how the ethical rules of the profession should apply in a particular case. Doing what is right will depend on the particular circumstances and requires you to exercise your professional judgement in the best interests of each of your clients.”

The Listed Investment Company and Trusts Association (LICAT) argues in a recent release:

“We note, however, that there are significant gaps and differences between the explanatory wording provided in FASEA’s Code of Ethics Guidance and ASIC’s Regulatory Guide RG 246.

The first significant difference is how conflicts of interest can be avoided in practice while continuing to ensure that investors receive the best possible advice. ASIC’s Guidance recognises that there are practical ways in which conflicts may be eliminated including a client authorising a fee to be paid to their adviser for services that have been provided. At this time, FASEA’s Guidance has not explicitly addressed this important point.”

What would a disinterested person, in possession of the facts, conclude?

At this point, it seems fine for both brokers and financial advisers to accept a selling fee from a fund manager, but what about conflicted remuneration and best interests?

Is there a difference between a fund manager with an unlisted fund paying commissions to an adviser (banned under FoFA), and a fund manager listing a fund and paying a selling fee to a broker, who then shares it with an adviser?

FASEA says there are overarching principles which should dominate decision-making by advisers and licensees, such as on page 17:

“You will breach Standard 3 if a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (e.g. brokerage fees, asset based fees or commissions) could induce an adviser to act in a manner inconsistent with the best interests of the client or the other provisions of the Code.”

We cannot avoid the elephant in the room. How does a relatively unknown fund manager raise nearly a billion dollars in a month when there are plenty of similar managed funds readily available? For example, there are dozens of fixed interest funds on the ASX's mFund service offered by leading global managers (Janus Henderson, Legg Mason, Aberdeen, PIMCO, UBS) which struggle for attention, and there are many fixed income ETFs which are cheaper than LITs.

Have financial advisers and brokers really considered whether these are better for their clients than a new LIT which happens to pay a 1.25% selling fee (and in some cases, invests in non-investment grade securities)?

Consider this: PIMCO has long offered the ‘PIMCO Australian Focus Fund’, a fixed interest fund holding asset types that LIT investors have scrambled into in 2019. Let’s say they offer it in four formats:

  1. A managed fund on various platforms. Commissions are banned under FoFA.
  2. A managed fund accessed using the ASX mFund service. Again, commissions are banned under FoFA. This fund has raised less than $1 million over the years of its availability on the mFund service.
  3. An active ETF listed on the ASX, with no selling fees (ETFs do not pay selling fees).
  4. A new LIT with a selling fee of 1.25%.

It’s the same fund from the same manager with the same strategy, and three of the vehicles can be accessed directly on the ASX. Money would trickle into the first three, but it would flood into the fourth. On the LIT, the brokers would hit the phones to their own clients and financial advisers and generate large inflows for a 'global fund manager specialising in fixed interest securities'.

Can anyone deny that many brokers and advisers are motivated by the selling fee? Some of the advisers rebate the fee but what about the rest? Was a LIT offered in a particular month the best fixed interest fund available, and so much so, it deserved a billion dollars? That’s a stretch.

On FASEA’s test: What would a disinterested person, in possession of all the facts, reasonably conclude?

When I asked a financial adviser how he can justify taking a fee for placing a client into a LIT when he can't on a managed fund, he said it was to offset his risk that the client does not proceed. What about KYC, or Know Your Client?

We will never know how much of the billions placed into fixed interest is motivated by selling fees to brokers and advisers struggling with the loss of commissions elsewhere, and whether they have explained the risks to their most conservative clients.

Wait a minute. Didn’t Magellan recently raise $860 million on a LIT that paid no commissions? Yes, but Magellan is a unique case, having spent a decade developing its own distribution channels and gathering the direct contact details of 200,000 investors.

Furthermore, as Joye points out, it’s not as if most LIC investors have had a wonderful experience. The chart below provided by the ASX shows the majority of LICs are trading at a significant discount to their NTA. While most of the recent LITs have done well (except KKR which has been at a discount to its $2.50 issue price since launch, and as low as $2.41), over 70% of these closed-end funds listed on the ASX are trading at a discount to their NTA value. When a client cannot exit an investment at the market value, there is something wrong with an adviser recommending the product.

What about fees on other listed products?

There’s another elephant in the room. Supporters of LICs and LITs point out that there is no loophole because these products are treated the same way as the initial offerings of structures such as hybrids and real estate trusts (A-REITs) on stamping fees. For example, the recent CBA hybrid paid a 0.75% selling fee. Did the advisers check the dozens of other hybrids for better value?

LICAT argues:

“ASIC’s Guidance (but not FASEA’s Guidance) recognises the practical differences in the capital raising process for coordinated blocks such as listed entities which is done at a single point in time and that of the continuous raising of capital for other investment products such as managed funds and ETFs.”

These examples simply emphasise the problem. Financial advisers and brokers are accepting payments from product manufacturers to place investments with their clients. Every adviser and licensee will have to judge their motivations and whether their actions are a contravention of the Code of Ethics.

It matters little if it’s legal when it’s not ethical

As at the end of January 2020, the Code of Ethics does not ban financial advisers and brokers from receiving commissions on LITs and LICs, but there's another issue. Consider how advisers receiving grandfathered commissions were treated at the Royal Commission, although these commissions were legal. Commissioner Hayne lambasted advisers for their behaviour in retaining the fees five years after the implementation of FoFA that made them legal.

Similarly, the advice industry has reacted with horror at CBA’s recent decision to demand advisers obtain a signed form from fee-paying clients to give trustees comfort that clients are aware of the fees. This is not a legal requirement but was recommended by Hayne. Fees are already disclosed annually and the client has agreed to the fees in the Statement of Advice. Advisers are calling CBA’s decision ‘virtue signalling’, but that’s what the big players are doing under pressure from regulators and the government.

ASIC Commissioner Danielle Press recently wrote an email to industry participants advising:

ASIC does not expect advisers or licensees to change remuneration structures to comply with Standards 3 and 7 (of the Code of Ethics) until there is certainty with respect to these standards and how they impact on remuneration. This applies to existing remuneration streams such as asset-based fees and commissions that might be considered in doubt.”

The review announced by Josh Frydenberg is likely to ban financial advisers (but not brokers) from accepting selling fees on new issues by investment trusts. While new LIC and LIT issuance will continue with broker support, it will reduce demand and probably result in smaller transactions. 

 

Graham Hand is Managing Editor of Firstlinks. FASEA has also released a Preliminary Response to Submissions paper intended to clarify the application of the Code. For the moment, it confirms that financial advisers are allowed to accept selling fees. However, it does not change my opinion that advisers and brokers offered a 1.25% selling fee are incentivised to distribute LICs and LITs to clients which may not be the best available fund at the time. 

11 Comments
Chris
December 31, 2019

Great article, Graham. I hope ASIC reads it. You should push it under their noses. It is a huge conflict the fees brokers earn on LICs/LITs.

George
December 21, 2019

As Paul Keating often says, quoting Jack Lang: ''In the race of life, always back self-interest - at least you know it's trying''. So a fund manager offers an adviser $1,250 to put a client's $100,000 into a new LIT, or nothing to go into an existing managed fund. There's no ducking that it's the way to raise a billion quickly. What's going to change in 2020?

Gerald
December 19, 2019

So whats the current alternative to LIC /LIT?

Graham
December 19, 2019

Hi Gerald, do you mean as an investment? There are thousands of choices. We're not licensed to give personal advice, but generally, you can buy an existing LIC or LIT on the market, you can find a wide range of funds on the ASX mFund service, you can invest in an unlisted managed fund, you can invest in an ETF. If you don't know what these things are, maybe you should see an adviser. Or do you mean as a fund manager?

Daniel
December 19, 2019

Hi Graham,

I don’t agree with the spirit of this article and my opinion is that it will be on the wrong side of history. Some additional thoughts.

'The selling fee for placing clients into new LIT's was one of the few bright spots in a tough 2019.'

This makes it sound like advisers earnings revenue mostly at the expense of client capital is something that should be enshrined and celebrated. The article also gives the impression that the removal of 'grandfathered commissions' and efforts to shine a light on the conflicts embedded in the bank advice business model (a giant distribution funnel) by Hayne is somehow a travesty. How is an adviser earning an annuity-type revenue stream into perpetuity from putting a client into a legacy, high-cost underperforming investment product defendable? On the education front, if you go to see a doctor, lawyer or accountant and found out they only had a diploma from some clown college, would you feel comfortable doing business with them? I think not. I keep hearing the argument that advisers who have ’40 years in the industry’ should be precluded from the education standards. Just because you have worked as an adviser for a long time does not mean you have acquired the necessarily skills, knowledge and training to properly understand the often complex products and strategies being recommended. Much like doctors (who are highly qualified) advisers make recommendations that can have lasting effects (both good and bad). Ensuring a certain standard is met ensures the client’s interests are protected. It’s also the only way that advisers are viewed in the same light as professional services (maybe not lawyers) instead of used car salesmen..

You attempt to use semantics in regards to interpretation of the FASEA Code. I can only assume this is an attempt to muddy the waters regarding whether a conflict exists in regards to the payment of stamping fees. The defence of ‘normal behaviour’ in the broker example used for not banning fees is laughable. If a broker can assert that ‘churning’ (another way to destroy capital) was the primary motivator for participating in an IPO and not the 1.25% fee that is sufficient? Firstly, the broker will make more from the stamping fee versus a round trip on brokerage? So if anything is driving the motivation to cover school fees it will be the stamping fee. This also offers an easily exploitable loophole as there is no easy way to prove the stamping fee was the primary motivator behind the recommendation. Easy way is to scrap it and remove all ambiguity.

Moreover, an easy test to determine whether revenue generated from ‘ancillary products and services is merely incidental to the advisers dominant purpose in providing advice’ would be to place a moratorium on stamping fees. You could then assess the impact this has on level of demand from advisers/brokers for LIC/LIT IPO’s. Again, I will happily bet the house that demand would tank faster than Bernard Tomic at Wimbledon.

‘In some cases the selling fee will be refunded to the client’. I can’t claim to have seen the breakdown, but I would also bet my humble house that almost of all the fees (90%+) would be retained by the adviser/broker.

I don’t think brokers/advisers are nefarious by any means but I’ll quote Munger who I know you are fond of who said: “show me an incentive, I’ll show you an outcome.” LIC’s/LIT’s are, for the most part, a sub-optimal way to invest. The fact that ~80% of the market trades at a perennial discount to NTA should be enough of a reason to eschew them. Investors are also essentially making the difficult job of earning returns even harder by introducing another layer of uncertainty regarding where prices trades relative to its NTA. With ETF’s and unit trust, this is largely nullified.

This is a conflicted commission every day of the week. The fact this is even a debate is worrying..

Graham
December 19, 2019

Hi Daniel, thanks for the comment but we seem closer to saying the same thing than disagreeing. I set out to show that the Code Guidance allows financial advisers to keep a selling fee, and this has been confirmed verbally to me by FASEA since this article was written. So that's me proving a fact, not offering a personal opinion.

BUT, I then go on to say that many advisers and brokers are motivated by the selling fee and that is a conflict. The example of the four different types of funds is my evidence. So my conclusion is that advisers and brokers will find it difficult to defend the ethical position of taking these fees, even if it is legal.

I agree that an adviser taking an annual fee for providing advice should reimburse the fee if a client is put into a LIT or LIC.

The example of the stamping fee is not my example, it is taken from the guidance note. I'm simply explaining what it says, not justifying it.

My other point is that the industry is not sure what to do so it's 'in the dark', stuck between a legal position and an ability to make an ethical judgement. And if 'self-interest' is in a horse race, that's the horse to back.

David
December 19, 2019

I'm bemused by this debate. If you are a financial adviser charging your client on ongoing fee for your services then why would you/ should you get a stamping fee? Your client is already paying you to consider these sorts of things. We've participated in 2 LIC floats a few years back and rebated the fee back to the client.
My view is 90% of advisers and brokers recommend these things for the upfront fee primarily.
If the investment proposition is good enough, it should stand on its own two feet and people will invest and not need it to be 'sold' by an adviser or broker.
We don't bother participating in floats of these now, history shows if you think its good proposition, just wait a few months and you'll pay a lot less than the float price, even with brokerage.

Judith Fox, CEO, Stockbrokers and Financial Advise
December 19, 2019

Graham Hand is right to point out that ASIC is on the public record saying that it does not expect advisers or licensees to change remuneration structures to comply with Standards 3 and 7, given there needs to be certainty with respect to these standards and how they impact on remuneration. That is because there is ongoing concern about the meaning of the FASEA Code of Ethics 2019, in particular Standards 3 and 7.

FASEA has publicly said that it will continue to consult with industry about these two standards. FASEA is also currently working on revised guidance to the Code, because the first version that was issued in late October added to the confusion rather than clearing it up. The guidance contains the examples referred to in the article. For example, the FASEA professional standards regime only applies to retail clients, not to wholesale clients, yet the first version of the guidance muddied the waters by suggesting it covered both.

Another area that needs clearing up, as pointed out by Graham Hand, is the reference in the guidance to stamping fees. The first version of the guidance appears to ban them, despite their being specifically exempted with bipartisan support under FOFA from the conflicted remuneration prohibition. Yet the FASEA CEO has publicly stated that the Code of Ethics does not seek to ban particular forms of remuneration nor articulate that any forms of remuneration are specifically a conflict. As this article illustrates, the confusion this engenders needs addressing in the revised guidance note, which is expected to be issued either just before Christmas or early in the new year.

While ASIC has stated that it expects licensees to take reasonable steps to comply with the Code as of 1 January 2020, it has called out that it will take into account the current dynamic regulatory environment as well as the timing of guidance provided by FASEA about the meaning of the code. So this is very much a 'Watch this space!'.

Graham hand
December 19, 2019

Thanks, Judith, I understand from FASEA that a clarifying document following consultations will issue in the next day or two.

Steve
December 19, 2019

The fund managers & the FSC only have themselves to blame for caving into all of this mess. The only reason the FSC is going along with it, is that many fund managers have sold their souls to the Industry Super funds, who are keeping them in clover. Until the day their mandate is terminated...lol. What everyone needs to realise is what is happening is extremely anti-free market, and is encouraging monolithic control of the funds industry, which is very unhealthy long term. The development of the Industry funds controlling default super is is a total disaster, which will become obvious 10 years down the track. The outcome will become so bad, the Govt will be forced to introduce anti-trust legislation to prevent monopoly control by the Industry Funds. It's a horror nightmare, just starting to unfold - particularly as the Industry funds demand board representation on major public companies.

Donald
December 19, 2019

Confusion. Advisers need to defend ourselves better, we have ourselves to blame because we do not lobby politicians and explain our case. How is the average Australian any better off from all this?

 

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