Appropriateness of gearing and margin lending strategies

The economic downturn in Australia has shown financial planning and banking practices that have called into question whether gearing and margin lending strategies were appropriate for investors in certain instances.

Gearing and margin lending have often featured in disputes that we have considered. Below is an overview of the general approach followed when considering the merits of disputes involving these types of strategies.

This information is provided as an indication of our general approach. We will continue to consider each dispute about gearing or margin lending on its own merits.

The Investments, Life Insurance & Superannuation Terms of Reference set out a requirement to have regard to amongst other things, the law and good industry practice. Our primary duty, however, is to be fair in all the circumstances.

In addition, we consider the obligation on all Australian Financial Services Licensees to operate their businesses in an efficient, honest and fair manner, as required by s.912A of the Corporations Act.

Further, for AFS licensees that provide personal financial advice, we take into account the more stringent obligations of s.945A of the Act. Given the nature of gearing, this consideration is based on the principle that a financial planner must not recommend a financial product or strategy to a person, who may reasonably be expected to rely on it, if the adviser does not have a reasonable basis for making the recommendation.

This means that an adviser must research the recommended products and then ascertain that the recommendation is appropriate for the investment objectives, financial situation and particular needs of the particular investor. As a general principle, an adviser must match the risk exposure and return potential of the strategy being recommended with the investor’s objectives and tolerance to risk.

Whilst exceptions can be made in a variety of circumstances, gearing is usually a strategy for high-income earners who have a reasonable period of their working life remaining and have a suitable tolerance for risk. We will assess the suitability of a recommended gearing strategy with these general circumstances in mind.

Important factors in gearing disputes considered by the Panel have included the following:

• What type of investor was involved? Was he/she an

aggressive/growth-oriented investor or conservative investor?

• Did the investor have any prior experience with a gearing strategy or margin lending?
• What was the extent of the investor’s existing debt liabilities prior to adopting the gearing strategy?
• Was there double gearing? Had geared securities been provided by the investor as collateral for further lending?
• Did the strategy rely upon dividends to service the borrowing costs?
• Had the adviser discussed the history of dividend payments and stability of company earnings with the investor?
• In the case of margin loans, had the adviser explained to the investor the nature of the loan to valuation ratio (LVR) and its potential impact on the investor if the value of the investor’s portfolio reduced in value?
• Had the adviser explained any clause of the finance contract relating to the effects of a suspension of trading in a stock?

Whilst each case is determined on its own particular merits, some broad points can be made based on disputes regarding gearing strategies that have come before the Panel to date:

• if the investor had little or no ability to resource the loan facility, aside from investment proceeds, it would be difficult to establish that the recommendation was suitable;
• if the adviser’s recommendations could only be achieved through the use of gearing and were in conflict with the investor’s investment objectives and risk profile, it would be difficult to establish that the recommendation was reasonable;
• if the loan was secured over an investor’s primary residence with few other liquid assets in the investor’s portfolio, it would be difficult to establish that the recommendation was reasonable;
• if the recommendation to enter into a gearing strategy was based on general or limited advice, it would be difficult to establish that the facility was appropriately entered into.

Other criteria may also make a particular recommendation to adopt a gearing strategy or enter into a margin loan unsuitable for a particular client, and therefore in breach of an obligation under the Corporations Act 2001.

We recommend that financial services providers consider all of the above issues when considering the suitability, or otherwise, of a gearing or margin loan strategy for a particular investor, as well as when assessing its responses in the event of a dispute before the Financial Ombudsman Service.