There have been reports in the mass media about people losing most if not all of their capital in Lehman Brothers’ MiniBonds and DBS High Notes 5. I have some comments:

It is claimed that some people who went to the bank to open a fixed deposit were persuaded to invest in such products to earn a “higher” interest rate. I feel that the banks are employing a very dangerous practice when its staff tries to upsell in this way. Why I say that? It is because customers who want to open fixed deposits have intention to earmark these monies for purposes that require zero risk. Attempting to divert this money to something else is likely not appropriate to the clients’ objectives. If the RM attempts to compare the fixed deposit with the product being proposed, misrepresentation has already occurred. Both instruments are entirely not the same and thus have no basis of comparison. The only instrument safer than fixed deposit is Singapore Government Bonds. Even so, the bond has to be held to maturity to ensure capital is preserved.

Many investors are now complaining about their losses. They say they have been misrepresented that XYZ product is safe. There are always two sides of the coin to a story. Some advisers might have really misrepresented to their clients that it was safe. On the other hand, some investors knowing the high risk of the product still proceed to invest. My question is: if the product is making a profit, will consumers complain they have been misrepresented? In practice, it is hard to proof misrepresentation because it is a matter of “your words” verses “my words.” The only thing is documentation which usually the client cannot understand anyway. Does that mean that the client is always at a losing end? Not really. For this they must understand how compliance works in the financial industry and once they fully understood how the compliance works, you can use this knowledge to safeguard yourself. Before I talk about something about compliance, I want to talk about Willingness and Ability to take risk.

The Willingness to take risk is the emotional and psychological ability to take risk. Questions such as “Are you able to sleep well at night if you make losses of 10%?” attempts to find out about the client’s Willingness. Financial advisers usually assess a person’s Willingness to take risk through a questionnaire typically consists of less than 10 questions. Depending on the answers given, the score is given which indicates the client’s Willingness to take risk.  But all knowledgeable advisers know that the risk profiling is not accurate because it is based on sampling theory. For less than 10 “sample” points, how to come to an accurate conclusion? A more accurate method will be at least 30 questions (or “sample points”). But I have never seen a 30 question risk profiling questionnaire. The use of questionnaire is what we call quantitative method. In addition to this, the more experience adviser would also use qualitative method such as asking the client’s past experience in investment, their personal characters, personal preferences, etc. For example, if the scoring system say a client is “Aggressive” but through qualitative method I found the client to have no experience in investment, than I “discount” the scoring and give her a “Moderately Aggressive” risk profile.

The Ability to take risk on the other hand considers whether does the client has the financial resources to take this kind of risk. For example, if the net worth of a client is $10,000, he has no Ability to invest in stocks because the impact to his net worth will be detrimental should the stock price collapse. The Ability to take risk would consider a person’s Cash Flow, Net worth, the type of debts he has, existing insurance cover, the number of dependents, the type of occupation whether commission based or salaried, and so on. Many retirees have no Ability to take risk (even if they are willing to take risk) because any losses in investment cannot be recovered through future income. Moreover, they are unable to average down and practice dollar cost average when markets come down. (BTW, only traditional assets are worth doing dollar cost averaging like equity markets. There is no point averaging down a structured product that is already zero in value).

If the Financial Adviser does not perform a more thorough fact find, than the Ability to take risk is unknown. The Adviser is not liable for not considering the Ability of the client to take risk because the client will be made to sign a form indicating that he or she did not wish to disclose his or her personal financial situation. Normally walk-in client into a bank or if a client is approached by an unfamiliar adviser would not disclose their personal details to the adviser. If this happens, the client’s Ability to take risk is completely unknown to the adviser and if any mishap happens, the client cannot sue the adviser for not considering the Ability to take risk.  Therefore, it is important that the client approaches an adviser who is trustworthy and competent to do a full fact find. Besides being trustworthy and competent, the advisers should be able to transact in many product ranges from different product manufacturer. Otherwise, the client will have to purchase everything from the adviser’s own company range which is not wise from diversification point of view (Think AIG). However, if the adviser is capable of charging financial planning fee (for doing the fact find and dispersing the advice) than having limited product range may not necessarily be that crippling since the adviser can recommend products or solutions he or she cannot transact. However, clients must be aware of the potential conflict of interest that exists for an adviser who recommends a competitor's product. It is important to realize that in any case, the client might be obligated to purchase something if the adviser is not charging any planning fee.

Here is how compliance works in a nushell. There are 4 modes of financial advisory in any financial transaction as long as the product is an “investment product.” Currently “investment products” are life insurance, unit trusts and structured deposits (there could be more.) The client will have 4 choices namely:

1. No advice
2. Product advice
3. Specific need advice
4. Full fact advice

The “No advice” is the silliest option to take for the client. It just means that he is merely using the adviser’s company as the platform to transact. It is only good for DIY type of clients. Typically this will be the adviser himself. For “product advice,” he would only want to know about the fact of the product. He can only sue if the fact was misrepresented. Normally it is almost impossible to proof misrepresentation because it is a matter of “your words” vs “my words.” Under product advice, the client will be given a prospectus or equivalent which in a nutshell has disclose everything. The client cannot sue if he or she has received such document.

For specific need advice, normally the Willingness to take risk is recorded through a questionnaire. The adviser must recommend a product that is based on the Willingness score from the questionnaire. Say, if the client’s Willingness is “Conservative” but the adviser recommends a China equity fund, than it is clear cut incorrect recommendation and for this the client can sue. Actually there is no need to employ a lawyer to sue. Just complain to MAS and the necessary will be done because this is a clear outright violation of compliance. However, say if the risk profiling says the person is “Aggressive” and the adviser recommends a China fund, than client has no case against the adviser even if the client only has a networth of $1,000.

The “full fact advice” is the most thorough amount all four. In this case, the client has to complete a thick set of questions detailing his or her assets, liabilities, income, expenses, investment portfolios, insurance portfolios, dependents’ details and sometime even existing health problems. This will provide the adviser a wholistic bird’s eye view of the entire situation. In the following example, the adviser is liable to be sue:

1. Client is an elderly man 80 years old but with networth of $10,000; risk profiling “aggressive”. If the adviser recommends a Russia fund he will be liable for incorrect advice. This is because the client has no Ability to take risk despite Willing to take risk.
2. Client is shown to have the Willingness as Aggressive and has the Ability to take risk. If the adviser recommends an India fund when the client is already 90% in India, than the adviser is liable because of the lack of diversification in the investment portfolio. The adviser has no excuse because he has knowledge that the client is in 90% India. This knowledge is known because of the full fact find.
3. Client is shown to be willing to take risk but has no medical insurance cover. If the adviser recommends investment first, he is liable because insurance cover is the foundation of financial planning. The adviser has full knowledge that the client has no insurance because of full fact find. Of course if the client insists in doing investment first, than the adviser is discharge from liability but this has to be documented to indemnify the adviser.
4. Client is a “balanced” investor and has the Ability to take risk. Adviser recommends that he invests in a bond fund for his retirement. In this case, the adviser is liable for recommending a fund that is below his risk profiling. The liability still exists despite the bond fund having lower potential losses than a balance fund because the client – on a long run – will not meet his retirement goals. If there is a retirement fund shortfall and that is attributed to wrong asset allocation (in this case lower risk than permitted), than the adviser is liable. The adviser cannot give an excuse he does not know about the client’s required retirement goal because of the full fact find.
5. The adviser's personal risk profiling is Conservative. As such he always recommends safe instrument like single premium endowment and capital guaranteed notes to his clients regardless of their risk appetite and ability to take risk. The adviser is liable. He is acting unprofessionally by mixing his personal risk profile with his client's risk profile. He cannot claim ignorance of the client's Willingness and Ability to take risk because of the full fact find.
6. The adviser's personal risk profiling is Aggressive. As such he always recommends high risk investments like hedge funds, equities and derivatives to his clients regardless of their risk appetite and ability to take risk. The adviser is liable. He is acting unprofessionally by mixing his personal risk profile with his client's risk profile. He cannot claim ignorance of the client's Willingness and Ability to take risk because of the full fact find.

It can be seen that the full fact find is highly desirable for the client as their interest is protected. All advisers are taught that this is the most professional and beneficial way of giving advice. This is taught in the MAS compulsory CMFAS exams which all advisers must take.

In summary,

1. The proof of misrepresentation is not easy in practice.
2. Understand how compliance works: Advisers have the obligation to understand the client’s Willingness and Ability to take risks. Advisers will be less liable or have no liability if the client discloses very little or no information such that the Willingness and Ability to take risks because these are unknown to the adviser.
3. To maximize the probability of obtaining suitable advice, a full fact find is required. Client should do some homework to find a trustworthy and competent adviser that can do this job well.
4. Be conscious how you are going to pay the adviser for doing this work. If in doubt, ask the adviser how he or she is compensated and judge for yourself whether are you comfortable with the arrangement or not.
5. Be also conscious of any conflict of interest and do not "ignore" it. For example, it is a conflict of interest for an adviser who could only represent one company's product to recommend another competitor's product.