There were once three brothers who, despite their common upbringing, had very different personalities and could be said to be cautious, a little carefree and quite irresponsible, respectively.
They had inherited a sizeable sum of money from their parent’s estate and decided to visit a financial adviser. The irresponsible brother was voted as spokesman for the three due to his gift of the gab and his prior dabbling in the stock market.
The money was a windfall for the three and they each sought ways to maximise returns on the investment of the money. As part of this, the planner requested some background information from each of them.
Two of the brothers complied but the irresponsible third was more interested in discussing the phenomenal returns he had heard of associated with a particular investment.
This brother spoke of his plans to run his own business and mentioned an investment strategy of this kind might help in reaching his goals faster.
The planner responded and said the strategy had some considerable risk attached to it, but that the foundations were solid and in his view, it offered potential for significant returns if the clients could afford to bear the risk. He also spent some time covering the correlation between risk and return.
This third brother was keen to pursue this strategy. The planner was frantically busy and figured that as they were brothers and were secure to their desired lifestyle and the monies were surplus, he could save time by simply investing the three clients’ funds the same way. Accordingly, he proceeded to prepare financial plans for each of the three clients.
What would you have done? Was the planner wrong in his approach to the brothers’ investments? If the investment returns are strong, who is going to complain? But this is exactly why, as the current markets so pointedly prove, that proper client engagement is critical to a healthy and vibrant financial planning business.
While the above scenario is of storybook simplicity, it serves to highlight the importance of knowing your client — the rule is not about knowing your client’s general circumstances. This rule, which in part is embodied in the statutory requirement to ensure the appropriateness of your recommendations to a client’s objectives, financial situation and needs, extends to include an understanding of their individual and personal tolerance to risk. This is not new.
Centuries of tort law support the view that you take the plaintiff as you find them, not as you believe you have found them. And every client is a potential plaintiff, so it’s in the interest of advisers to find out who they are dealing with — and not just their general background — their attitude to investments generally, and risk. Another way to look at it is to adopt the legal maxim: don’t judge a book by its cover.
Let’s get down to basics and build from there. Essentially the elements which are required to establish negligence, and resulting liability, are fourfold: a duty of care existing between the parties, reasonable foreseeability, proximity and loss arising from a breach of the duty of care.
The standard of a reasonable and prudent man is the criteria for determining the existence of a duty of care. A quote serves to best illustrate this — “the standard ought to be to require … what it is reasonable to expect of him in his individual circumstances. Thus, less must be expected of the infirm than the able-bodied; the owner of a small property where a hazard arises … should not have to do as much as one with larger interests of his own at stake and greater resources to protect them … he should not be liable unless it is clearly proved that he could, and reasonably in his individual circumstances should, have done more”. (Goldman -v- Hargrave 1967)
Note the central theme — ‘his individual circumstances’.
In 1951, the House of Lords considered the case of a man, already blind in one eye following a war injury who, while working in his employer’s garage, was struck in his good eye with a metal chip, blinding him completely. The man argued that the employer was negligent in failing to provide him with goggles.
It was accepted that the employer had no duty to provide goggles to the two-eyed workers. However, it was found that in circumstances where the employer knew the employee was a one-eyed man, it must also have known that the risk of injury was fraught with far greater consequences for that man than his two-eyed workmates. The employer had failed in its duty of care toward him.
However, before you say, ‘I knew all you had to know was what the client looked like…’, read on.
In 1941, the New South Wales Supreme Court considered the case of a girl who had received samples of beauty products. The girl used one of the products, bath salts, which had the effect of causing severe and persistent redness and itching of her, as it transpired, particularly sensitive skin. The court made it clear that such circumstances gave rise to two quite separate issues.
Firstly, whether there had been a breach of a duty of care as that term is ordinarily understood. The second was whether sensitivity of itself creates a special duty to be careful which does not exist in the case of a normal person. To that question, the court answered no. To the first, the court answered yes.
The court recognised that while special circumstances may give rise to a duty to take special precautions to persons known likely to be affected by a particular act, the mere existence of sensitive persons in the community did not alter the general standards by which rights and duties are established.
An obvious response to this is to say: “that means if I didn’t know about a client’s particular sensitivity to risk, I am not obliged to take any particular care. In the future, I just won’t ask the question — what I don’t know, can’t hurt me.”
Sorry, but it isn’t quite that simple. The courts have on numerous occasions noted the special duty of enquiry attributed to professional advisers. It isn’t a question of what you knew, but rather what you ought to have known.
In the financial planning context, this infers a requirement to enquire into and understand the client. “A discussion that risk and return are related is a discussion about what return you want, not about risk and attitudes to risk, or risk tolerance and profiles. Whatever the term, the obligation to understand the client’s story and not just their story book cover exists and largely defines a financial adviser’s duty of care.
When assessing standards of care, the courts seek to establish objective criteria which is reflective of the general community. The more objective a risk assessment is and the more reflective of the general public, the more readily will the courts adopt the standard represented by it as a suitable objective standard of care. Another way of presenting this is to say that a well-founded and balanced but systematic approach to risk assessment and risk discussion will answer the duty of care.
There is no doubt that risk assessment is now an accepted and vital part of the financial planning process. But what do you do with it? It has been suggested that the potential for liability arises where a client’s goals are mismatched with their risk profile. The emerging lifestyle and life goals approach to financial planning relies on this. It suggests that the true mismatch is between the client’s financial goals and their current financial position. The client’s risk tolerance becomes relevant for the adviser in assessing what the recommendation to the client should be.
Regardless of your approach, the law (both Corporations Act and common law) requires that the adviser must have an understanding of the client’s risk tolerance and must make an informed judgement as to whether that risk tolerance is suited to the strategy or strategies necessary to achieve the client’s goals. If not, it is the adviser’s role to inform the client of their options. This may be to take on more risk than they are comfortable with, to invest more by spending less, saving more or converting personal use assets to investments, or to alter their goals.
Remember, the client won’t necessarily understand their own attitude to risk, they will be focussed on their goals. It is only when they are bitten in the proverbial that they will achieve a sudden clarity in this regard. The adviser’s ability to provide evidence of the process outlined above will go a long way toward defending claims of negligence.
Lisa Chambers is a solicitor with the ArgylePartnership.
