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'Better research could have helped advisers avoid collapses'

Financial advisers’ lack of adequate research may have contributed to clients’ losses in finance company investments, a researcher says.

Friday, October 24th 2014, 6:00AM 12 Comments

by Susan Edmunds

University of Otago Professor in accounting David Lott, Dr Tom Scott from the University of Auckland and Otago honours student Ella Douglas have completed a study which shows  annual reports and other public disclosures contained enough information to predict more than 80% of New Zealand’s finance company failures.

They looked at 31 finance companies that failed between 2006 and 2009 and an equal number that did not fail.

“Our result suggests that failures were predictable and so the financial information was more useful than some believed. This is important, as our research suggests that warning signals were available prior to the failure of these companies, thus contradicting the overall media impression in the wake of finance company collapses, which often focused on CEO fraud and that financial reporting was unreliable,” Lont said.

The researchers found that failed finance companies had lower capital adequacy, inferior asset quality, more loans falling due, and a longer audit lag - a possible indicator of audit/client disputes.

Trustee monitoring was also a risk factor and the authors have suggested further research to better understand why that was the case.

Lont said financial advisers had a crucial role to play in providing advice to clients about the finance companies. “Clients weren’t understanding the risk of the underlying finance company but were attracted by interest rates and good marketing.”

He said advisers needed to have research capabilities within their businesses or to buy research that was doing the sort of analysis that would indicate problems.

“Everyone involved needs to take a hard look at the checks and balances in their systems,” he said.

Lont said some people would blame trustees, auditors or regulators or say that the companies office oversight was not adequate.

“But analysts and advisers were one of the voices. Were they getting commissions clients were unaware of that was tainting their advice? Were they aware risks were increasing but biased in the advice they were giving? If they were, that’s a serious issue.”

He said if it was merely ignorance to blame, advisers should look at their ability to access research to give them sufficient information. “If they had done that analysis there would have been up to three years’ warning. If you can nip the problem in the bud earlier, there’s a much great chance of survival.”

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Comments from our readers

On 24 October 2014 at 7:42 am Pragmatic said:
Whilst there is no argument against the value of good research, its worth remembering that over 75% of finance company investments were self directed (ie: without advice).

Mush of this direct investment was due to 'celebrity endorsements' (still prevalent today) and investor greed.
On 24 October 2014 at 9:28 am dcwhyte said:
With respect, this comes across as being wise after the event. Also, I understood that around 70% of money invested was done so without the presence of a financial adviser, and raising the question of commission and conflict is just plain publicity-seeking. If you don't know the answer, and your research didn't extend to suggest and answer, the more appropriate option is to couch such remarks in the context of a further research initiative. It should also be pointed out that not all advisers caught in the collapse were unaligned, 'independent' practitioners. Financial Advisers attached to large organisations were also part of the equation, but I guess in the current 'let's blame financial advisers for everything' climate, anything goes. Perhaps a more balanced approach to a research project which established what stimulated the 70% clients to invest directly and without advice would be helpful? If 'analysts and advisers were one of the voices'. where is the research on the other voices? Or is there less advantage in pursuing this?
On 24 October 2014 at 11:08 am Pragmatic said:
Well put David. I suspect a useful research report would be the attraction of 'celebrity' investing in NZ, and what this actually delivers to the consumer - versus - a researched objective impartial approach to investing
On 24 October 2014 at 11:19 am w k said:
assuming land transport allow the import of just about any vehicle, that is, promoters and sellers of these vehicles are self regulated. then a lot of bad and fatal accidents happened due to safety issues, who is to be blamed? the authority who allow the import, the promoter/sellers, or the owners of the vehicles?

these finance companies were allow to exist, promote themselves and collect public funds freely and legally. where do you think is the root of the problem?

On 24 October 2014 at 6:04 pm Realist said:
One of the major issues is that the accounts in a number of cases were not accurate, and in hindsight had been massaged to mask the real figures. Great work by the various accountants and associated auditors. Some of these people no doubt were former students.

We also know that the Securites Commission who were the authority at the time did not work their way through the accounts that were submitted for the various investment statements.

For many investors even if the accounts were accurate is that they were many months old at the time of the investments being made. So for someone making a two year investment the figures stated in the accounts could have been a year or more old at the time of the investment and three years old at maturity.

We all know how quickly the market conditions changed when the gfc started, something that no set of account analysis would have foretold. In fact most of the finance companies were reporting record profits.

As for the surviving companies (I didn't realise that there were that many) most would have enjoyed the benefits of the crown guarantee which reduced the run on funds.

Given that over 75% of the investments were direct from investors it's somewhat on the nose to blame advisers. If the accounts were really a true reflection of the state of financial health of the finance companies individual investors and advisers would have not invested. The account massaging to make the books look better than what they really were is the major problem. And who did the massaging? It certainly was not the financial advisers. So good on the academics for producing accountants who deliberately conceal the truth. Perhaps they should have more ethics training?

On 28 October 2014 at 11:39 am Brent Sheather said:
Agree better research could have helped. The research should have been as follows:

Question: To what extent are finance companies included in best practice portfolios?
Answer: Four fifths of five eighths of not much
Course of action: Ignore finance company debentures and concentrate on high quality bonds

Next question …

By the way, this research model was outlined in detail in the Herald from about 2002 onwards.
On 28 October 2014 at 7:31 pm w k said:
@brent: the then securities commission only need a few basic rules to avoid the collapse of the finance companies, and this is not in hindsight. i have written my suggestion years ago, but it is either i'm too small to be noticed or the suggestion was too difficult to understand. if i don't agree with something, i don't whine, i offer suggestion and this is one example.
my suggestion for the fin co was:
1. min 10% (or 5%) equity, ie. if the fin co want to raise $9m ($9.5m), it must have $1m ($0.5m) of s/holders cash in there which can't be used as working capital, period.
2. cannot loan more than 10% per borrower and its related/associated companies in aggregate.
3. compulsory half yrly financial reporting.
4. cannot loan more than 10% to companies where directors have any interest, ie. own shares or sitting on board as a director.
5. maintain min 5% liquidity.

i believe NONE of the failed finance companies passed the above test.

i do not think one need a rocket scientist to think of those rules. if the then regulators were not thinking of some kind of rules, they were plain irresponsible, incompetent and negligent in their duties and shouldn't be there in the first place. whoever appointed them were also partially responsible.
On 29 October 2014 at 11:39 am Brent Sheather said:
I am sure you are right. I might be approaching this problem from a different angle. I see it as an asset allocation issue in that the question for financial advisers should be to what extent should I be recommending finance company debentures and it seems the best way to approach that is to look at best practice as indicated by the portfolio of professional investors ie like pension funds. Typically they have next to no exposure to junk so the conclusion would be no finance company debentures in mum and dad portfolios.

I am not sure what sort of level of equity is appropriate for a finance company but even the 10% or so that you suggest would get wiped out if there were a 10% bad debt and no recovery of that debt. Anyway it was far easier just to ignore them.

On 29 October 2014 at 4:59 pm w k said:
hi brent,

the 5% or 10% requirement simply means that if the company went under, s/holders also get that %age of money recovered. in this scenario, bridgecorp lost around $500m, that means rod and gang would have lost $25-50m of their personal cash. put it this way, it was painful for him to lose his hundred grand plus porsche, don't you think he'll be extra careful if millions of his cash were at stake?

idea behind this is simple - people like them will risk or gamble away the mom's and dad's money, but when it comes to their own money it's a different story. asking one cent from them is like squeezing water out of a rock.

and i'll add one more condition to any company taking public funds, that trusts cannot be involved, that is, directors can't use trusts to own the company, it has to be in personal names. so, no such thing as you can touch my left pocket and not my right pocket. if the directors foul up, liquidators should be able to access their back and breast pockets as well, period. this trusts thingy is a pretty good tool for hiding other people's money and it should be banned!!!
On 31 October 2014 at 9:50 am John Makowem said:
With Brent on this one. Instead of trying to place the blame at the foot of the Regulators perhaps a little more introspection is required. I have seen portfolio's where the bulk of the fixed interest sector was made up of Finance Co Debentures. In fact one such portfolio was set up by a lady that has received numerous accolades from the financial planning industry and advises people on financial strategies. How could this ever have been best practice. The cynic in me would suggest that it all came down to commission and best practice was not a consideration. If we are serious about people viewing us as Professionals then it is perhaps time for us to acknowledge that many did get this wrong instead of trying to apportion blame elsewhere. The same could be said of Insurance Companies offering incentive trips based on production......but that is a debate for another day!
On 31 October 2014 at 3:31 pm w k said:
@john, i know where and brent are coming from. my point is this, for an organisation that is collecting public's funds, it should be fit to do so. if an organisation is investing in very high risks instruments, well managed, transparent, then i have no problem with that. but i do have problems when organisations run by thugs are even allow to exist. i don't think i need to tell you what those companies are and the background of the directors. i strongly believe the regulator should be the first line of "defense". no matter how much regulation is out there, dodgy advisers will bound to pop up. by stopping such organisations from operating, the authority is helping to reduced the risks of investors losing their money. as mentioned, they were legitimate organisations, so one can't say it is wrong to invest in them. it is no different from legal high, a health hazard, but it is (was) allow to be sold, people consume it and got health problems, who do we blame? if the regulator had banned it from day one, then there's no problem.

having said that, with all the legitimate companies, if an adviser invest his client's (who cannot afford to take risk) into high risk products and lose money, that's where he should be nailed.
On 3 November 2014 at 4:10 pm NoNoCents said:
Yes better research would have helped but it wouldn't have stopped the vast majority of investors putting money into the finance companies that went bust. Because they wouldn't have read it and if they had most wouldn't have understood it.

There is plenty of evidence that most money that was lost in the latest round of finance company collapses went direct to the company from the investor, no financial adviser was involved.

Marac (now Heartland Bank),UDC and Fisher & Paykel Finance are all finance companies and there are other well managed finance companies that got through. They are a valid part of the economy.

Education would be of far more use than legislation. Blaming others, the Government, financial advisers, the media or celebrities is easier than admitting the truth. People wanted the higher returns being offered (greed), most Kiwis' don't understand investment risk (ignorance) and many are far too trusting (gullible).

I do feel sorry for those who lost their entire retirement nest egg in failed finance company investments, sorry they didn't understand what they were doing, sorry they weren't educated, sorry they weren't listening when their grandparents said "don't put all your eggs in one basket", sorry they didn't understand the nature of the "assets" that were being used as security, sorry they weren't aware of the background of some of those running the finance companies.

But I am heartily sick of those who keep implying that it was advisers solely at fault. If not one single adviser had recommended a finance company to an investor it would not have made the slightest difference, they would have still failed and people would have still lost money. Yes there are bad advisers and yes there are those driven only by greed. I've met them but most advisers are good people trying to make an honest living helping people.

Lets get behind efforts to educate Kiwi's, including advisers, so they are better able to spot bad investments and less likely to make ridiculous investments like mortgaging their freehold home to buy Blue Chip apartments, or putting their entire nest egg with one company. Both of which appear to be legal.

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