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Conflicted Interests

November 16, 2010

Conflicted Interests

1 November, 2010

Written by Tim Hunter

Printed by Fairfax Media

Please click here to download a PDF of this article.


It’s standard practice in the broking business. Your investment banking arm creates a financial product for a corporate client, your retail arm sells it to investors, and you get paid on both sides of the deal. Sweet.

Except when it does go wrong, investors – the mums and dads with life savings at stake – are the ones who often end up paying the price.

Allison Guilford is a widow, reliant on income from investments after spending much of her 25-year marriage nursing her husband, who had multiple sclerosis.

In late 2006 the trust they had formed sold a rental property and she asked sharebroker Forsyth Barr to manage the proceeds – about $400,000, enough to generate a modest retirement income.

Today most of the money is gone and Guilford has fired her investment adviser.

The last straw was a phone call after South Canterbury Finance collapsed, telling her she had lost all $50,000 her adviser had put in its preference shares.

Unlike the debentures, preference shares were not covered by the government guarantee.

”I’m surviving on just over $100 a week and I tell you what you don’t survive well on that.

”Really Forsyth Barr has effed up my life.”

Like Guilford, Grant Waterhouse also lost money in investments sold by Forsyth Barr. The retired businessman returned to New Zealand from overseas in 2006 and asked the firm to manage a $2 million retirement fund.

”At that stage I was only 52 so it was important that I invest that wisely, so I took advice from these guys,” he says.

”Two years later I got $1.2m back – $800,000 had gone.”

While the shareholdings could potentially recover some value, much was lost permanently in failed fixed interest investments – $60,000 in South Canterbury preference shares, $40,000 in Strategic Finance preference shares and $150,000 in a complex derivative product called Credit Sails.

In yet another case, Andy Cunningham, a former financial sector marketing executive, hired Forsyth Barr to manage assets for his family trust around the end of 2004. Like Guilford and Waterhouse, he arranged to pay the firm a fee to manage the assets on a discretionary basis – ie, it could make decisions without consulting him first.

It wasn’t until several years later, when the market value of Strategic Finance began reducing, that he began to feel concerned about his investments.

”We had been allocated $55,000 in Strategic – these were perpetual preference shares – and I began to challenge my adviser and say ‘look what’s going on here?’, and I was reassured, rather blandly I thought, that this was a rock solid company¬† there was nothing to worry about.”

But there was.

”It got to the stage where Strategic had gone belly up – and I accept because I’ve been in the finance industry myself that sometimes things go bad and sometimes you win and sometimes you lose – and South Canterbury was trading around 30-40c in the dollar at the time. I went to my adviser and said ‘what should we be doing here?’.”

The response, says Cunningham, was so ambiguous it offered no advice at all.

”That got me thinking, what is the relationship between the investment advisers and the investment bank?”

Wondering whether the firm had other interests which many potentially affect its advice to clients, Cunningham looked more closely at his portfolio.

”I began to ask a number of questions like who was the lead bank in all the issues and what was the credit rating and was there any underwriting commitment and commissions?

”I found the shocking information that whenever Forsyth Barr was lead manager they’d been investing nearly twice as much as when it hadn’t been lead manager.

”And where Forsyth Barr was lead manager we’ve now had 73 per cent of the assets invested in those securities written off.”

The lead management role garners little attention outside the broking community, but to Cunningham it potentially revealed why so much of his trust’s money had been allocated to poor quality stock when there was so much else to choose from.

A lead manager is essentially a salesman for an issuer of stock. A company wanting to raise money hires an investment bank to figure the best way to do it, and the bank uses its best efforts through roadshows and presentations to sell the issue to investors, usually via institutions or financial advisory firms.

Where the investment bank is part of the same firm as the financial adviser, ”Chinese walls” are supposed to ensure the two sides of the deal remain independent.

Forsyth Barr’s investment banking arm has had several lead management roles.

Three in particular drew Cunningham’s attention – Credit Sails, South Canterbury Finance preference shares and Strategic Finance preference shares.

In all three, Forsyth Barr was sole lead manager, paid to sell as much stock to investors as possible.

All three issues produced a total loss for Guilford, Waterhouse and Cunningham.

Forsyth Barr’s head of retail Shane Edmond strongly disputes any suggestion they were victims of conflict of interest.

”The suggestion that any adviser would intentionally invest in any product or security that may diminish in value is nonsense and is totally contrary to the manner that they will be rewarded long term,” he says.

”While unable to discuss the clients individuall,y what I would say is that all are different cases and most importantly what they are victims of, is the failure of some portfolio investments during the recent global financial crisis.”

Advisers have no incentive to sell stock lead managed by Forsyth Barr, he says.

”The simple thing for advisers in our industry is that they don’t get paid any different for doing Craig & Co’s Goodman Fielder issue as for doing Forsyth Barr’s Trustpower issue. The adviser couldn’t care whose issue it is and the adviser is the only person who makes a decision on what goes into client portfolios.”

Traditionally, one reason firms had their own investment banking operation was to ensure a pipeline of good quality product for their retail customers.

As well as commission, the main privilege of a lead manager is to allocate stock among investors, allowing it to favour clients of its retail arm with more of a new issue than anyone else.

Thus most of the big firms have investment banking and retail operations – Forsyth Barr, Craigs, Goldman Sachs, First NZ Capital, Macquarie all work that way.

One sharebroking executive, who asked not to be named, tells BusinessDay: ”Fees on an equity capital markets transaction aren’t the primary driver – the reason is to get lead roles in good quality offerings so we can get stock for our clients.”

Investment adviser Brad Gordon of Macquarie, whose Australian investment banking arm was co-lead manager on Kathmandu’s initial public share offer, says there was no incentive to sell the shares to clients.

”The only benefit from an adviser point of view was the amount of stock we got,” he says. ”There were no other terms or conditions over and above any other broker in town.”

However, regulators clearly recognise the potential for conflict of interest – and if it exists for Forsyth Barr, it also exists for all the other firms with both retail and investment banking businesses. The question is how they deal with it.

”The way it works is the investment bankers are far more dominant inside these firms and far more influential,” says one broker, who also asked not to be named.

”You tend to see the retail guys put under pressure to sell something. When it becomes a marginal call the pressure comes and people say ‘you need to sell this and you’re doing it for the firm’.”

The retail head is part of the heirarchy and it can be difficult for him to push back because he’s a salaried employeed responsible to the CEO, the broker said.

”Professionally he’ll push back and talk about standards and what have you, but he can be in a much weaker position to do that than someone else in the market.”

That’s why brokers tend to be more objective about someone else’s issue than their own.

”That’s how the presssure comes to bear. I’ve seen it operate, and it’s very difficult to resist.

”The counter to that is always that the retail adviser will say ‘I’m hardly going to do something which isn’t best for my client which leads them to lose money’. But we’re talking matters of degree here.

”Would he put a bond into his client’s portfolio that yields 7 [per cent] but should really yield 7.25? Yes of course he will.”

So how to resolve the perceived conflict?

”A client if they’ve lost money and Forsyth Barr’s name is on the isue then quite rightly they’re going to perceive there’s a conflict,” says Edmond.

”What do you do to get round it? The only way to get rid of it is to not do your own product.”

That, of course, eliminates what brokers say is the main benefit of having an investment bank. So why not separate completely?

”From a cost perspective, I think it would be difficult to run a retail focused point of view without having the structures in place,” says Macquarie’s Gordon.

”You’d see a lot fewer competitors in the industry if they had to be completely separated.”

The likely scenario? ”I think adviser regulation is only going to get tougher.”

Big player Goldman Sachs last year sold 80 per cent of its retail business JBWere to National Australia Bank, so is now arguably less conflicted than before.

Even so, says its New Zealand CEO Andrew Barclay, the firm has a regional commitments committee to review every investment banking proposal.

”When an opportunity arose, we would decide before we pitched on an issue whether it made sense for our clients before deciding whether it made sense for the firm being the investment banker,” he says.

”During the period 2005 to 2007 we declined to participate in every CDO or CLO issue [structured debt products such as Credit Sails] on the basis of our view these were not suitable for retail investors.”

Edmond, also a member of the Code Committee for Financial Advisers who drafted a code of conduct for the advisory industry, says a particular focus for regulators is where a firm receives commission from someone other than the retail client.

”This is an issue globally that everybody’s trying to get their head around,” he says.

Commissions for lead management, for example, may not cost clients directly, but the money still has to come from somewhere.

”At the end of the day the client must pay it,” he says. ”It doesn’t just come out of magic.”

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