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Retail financial advisers at the crossroads

Lotte Pang

Regulators must try harder to find a happy medium between maintaining a vibrant industry and adequate protection for consumers

An end-of-year report card on Hong Kong's retail financial services sector would be mixed, with some reprehensible behaviour, feathers in a few caps and an over-riding sense that the industry must try harder.

Let's start with good news. The sector has continued to broaden the range of products and financial tools available to retail investors and educate distributors and investors alike.

But before any smugness sets in, let's review the catalogue of bad behaviour. It begins with the collapse of two hedge funds heavily sold by the once reputable, now disgraced, advisory firm Towry Law International (TLI). TLI's parent company agreed to pay compensation without admitting liability.

TLI was also one of many financial advisory firms involved in selling geared with-profits funds, which left investors trapped in underperforming investments by hefty and unforeseen withdrawal penalties. Two life insurance companies involved have left the lucrative Hong Kong market. But for many investors the saga continues.

Susan Field did what many investors would like to do when she sued her financial adviser, Barber Asia in July. She won $3.2 million in damages after the Court of First Instance ruled the adviser failed in its duty of care to warn her of the risks involved with gearing - a strategy that involves using borrowed money to boost leverage, and which also enables the adviser to charge lucrative commission fees.

Just as hedge funds started to take off in the retail market, along came Charles Schmitt. This Hong Kong-based fund manager, whose fund was heavily sold locally, was arrested on charges of misappropriating investors' money. As with the TLI hedge funds, the case raises questions about whether there is enough protection for investors in the large market for hedge funds not authorised by the Securities and Futures Commission (SFC).

Finally (we hope, though the year is not over yet), groups of brokers allegedly signed up numerous bogus investment policies to take advantage of the large up-front commissions paid out by insurance companies. Although no investors were harmed directly, it lifted the lid on the competition-driven world of insurance companies and the lax hiring policies of so-called financial consultants.

The scandals are unlikely to end with 2004. Jumbo insurance policies, now selling like hotcakes in Hong Kong, bear all the markings of a problem in the making.

Like lambs to the slaughter, Hong Kong investors fall victim to scandal after scandal. This raises the question of whether we are adequately protected when buying financial products. Shouldn't a well-regulated market provide a safety mechanism that heads off these kinds of cases before they happen?

Of course, even highly regulated markets such as that of Britain have their scandals and no amount of regulation can prevent outright fraud. But this does not make it okay. Failure to regulate adequately will in the long run undermine the financial services sector. Investors will learn to distrust advisers - which is hardly fair on the good ones out there. It shouldn't be a case of buyer beware for anyone seeking help with investment.

So what can be done? To begin with, the obvious loopholes must be closed. Investment products should be regulated in the same way, regardless of who sells them.

The regulation of insurance people selling investment products needs to be brought into line with the tougher rules applied to SFC-regulated investment advisers. If this must be done by self-regulating industry bodies rather than an independent regulator, it should be done under the threat of a far more draconian regime if self-regulation fails to do the job.

An SFC report due next month is likely to highlight the differences in standards and practices of different types of financial advisers, which may start this ball rolling.

Beyond this, it is easy to prescribe measures that would improve investor protection: full disclosure would put an end to exorbitant commissions; rigorous and independent inspection regimes would ensure clients were sold appropriate products; and professional insurance would protect clients if things went wrong.

But regulators also have to consider the impact of such measures on the sector as a whole. Could an ethical, fee-based and fully insured advisory sector survive and, if not, is the alternative worth saving?

If all these measures were introduced there's a good chance that many independent financial advisers would be put out of business, leaving only large financial institutions to shoulder the costs of offering financial advice; which is more or less what has happened in the United States.

Consumers are less likely to be sold products wrongly by the larger financial institutions. But neither are they likely to get a truly excellent standard of advice of the kind available from some independents.

In taking steps to improve the market, regulators risk changing it irrevocably. In protecting investors from the worst of financial advisers, they risk eliminating the best too.

Regulators will perhaps be pondering such issues as they consider this year's crop of scandals.

It is up to them, and ultimately the government, to decide how to respond and, in doing so, how to shape the industry. When it comes to finding a happy medium between a vibrant industry and adequate consumer protection, they too must try harder.

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