Brent Sheather: Spotlight on dark side of disclosure

One of the biggest features of all the new legislation about to impose itself on the financial planning industry is the vexed issue of disclosure.

Advisers must now, or very soon, disclose any conflicts of interest they have: whether they are tied to certain products, whether they will receive commission from the product provider, whether they will be eligible for a bonus on a certain volume of sales, etc.

In view of all the naughty behaviour and massive loss of savings due to conflicted investment advice, any reasonable person would naturally conclude that these changes can only be for the good.

Disclosure is certainly better than no disclosure but, as we shall see, the very action of disclosure illicits some not-so-positive responses from the discloser and the person being disclosed to.

There is apparently a dark side to disclosure and perhaps it needs to be recognised by consumers and regulators.

From Mark Brighouse of Brook Asset Management comes a recent research paper entitled The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest, by three Carnegie Mellon University, Pennsylvania, academics.

First some practical background on conflicts of interest (COI). According to the Carnegie professors, COIs occur when an individual's professional responsibilities diverge from their personal interests and can lead experts to give biased advice.

We know all about that. Finance company debentures and Feltex shares were good examples as they put advisers into potentially conflicted positions because they paid much higher levels of commission than other more suitable investments. Consequently financial advisers and stockbrokers pushed these things to their clients.

But there were, even before the legislation, varying levels of disclosure.

The fact that stockbrokers received commission from Feltex was fully disclosed but millions of dollars of retail investors' money was lost nonetheless.

This column has argued for some time that high fees are ultimately responsible for bad investment advice because genuinely low-risk investments cannot sustain high fees.

The accepted wisdom among regulatory bodies around the world to address COI is simple: disclose it and all will be well.

Commonsense also suggests that the recipients of advice will be better informed and thus make a better decision once they have been made aware of an adviser's COI.

But compulsory disclosure can, and often does, induce other actions on behalf of the person doing the disclosing and the person receiving the disclosure.

The Carnegie Mellon study and experiments suggest that disclosure does not happen in isolation. The key findings of the COI study are as follows:

* Firstly, a financial adviser selling managed funds exclusively from provider ABC which pays him/her higher levels of commission is much more likely to embrace disclosure as the lesser of two evils as it generally involves minimal disruption of their business model.

For example, most doctors will prefer disclosing paid holidays from pharmaceutical companies rather than not going on the free holiday.

Disclosure also offers another benefit to advisers and policy-makers: it diminishes those party's responsibilities for adverse outcomes. An example is the warning labels on cigarette packets, a great victory, consumer advocates said at the time.

But since the labels first appeared the tobacco industry has fended off smokers' lawsuits by citing the labels as evidence that smokers should have known the risks.

* Secondly, for disclosure to be effective the recipient of the advice must understand how much the conflict of interest has influenced the adviser and be able to correct for this.

The Carnegie study showed that "people generally do not discount advice from biased advisers as much as they should even when COIs are honestly disclosed". People tend to think X is a great guy and he wouldn't rip me off.

* Lastly, experiments conducted as part of the Carnegie study showed that "disclosure can increase the bias of advice because it leads advisers to feel morally licensed and strategically encouraged to exaggerate their advice even further".

The professors conclude that disclosure may fail to solve the problems created by COI and may even make matters worse.

So there you go, disclosure isn't all it has been cracked up to be. It is probably better than no disclosure at all but it is no silver bullet.

Perhaps the best strategy for a consumer is to deal only with financial advisers with the least in the way of conflicts of interest and that generally means fee-based advisers who don't get commission.

On the subject of disclosure and ethics, how ethical was it for Consumers' Institute to secretly collect the research, methodology and product recommendations contained in the investment plans of 33 financial planners and then disclose this potentially precious intellectual property to three competitors?

Fortunately I wasn't mystery-shopped but would personally be livid if Consumer passed the result of 25 years of experience to my competitors without me knowing.

Consumer needs to be aware of the commercial sensitivity of its activities and its obvious potential for bias. When Consumer reviews washing machines and toasters made by Fisher & Paykel, presumably it doesn't get Whirlpool to review the product.

Who knows, maybe it does, but it shouldn't because objectivity would be out the window.

Consumer generally does a good job and it is great that the mystery shopping gets done - for a start, it is highly amusing - but it must be said that Consumer has in the past made some very basic errors in its analysis of matters financial.

If it hasn't got the internal resources to review financial plans it should find a couple of genuinely disinterested experts who can do the job dispassionately without giving away other people's intellectual property to competitors.

If Consumer can't get this right, perhaps it should stick to toasters in future.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.