Assessing compensation: Financial planning losses

Assessing compensation: Financial planning losses

Abstract

Axiom has been engaged to assess claims for compensation as a result of losses arising from negligent financial advice or inappropriate lending activities. The claims are brought by a class or an individual, against financial institutions or advisors.

The events leading up to the loss are often very similar.

Regardless of the individual’s circumstances, the method to calculate a compensation claim should be consistent, with the purpose being to restore the investors financial position to that if the advice never been given, and never been acted upon.

Whilst a consistent approach should be adopted, we have seen a wide range of methods put forward, some of which overreach in their compensation amounts and ultimately do no favours for the individual investor’s claim.

In this article Axiom address the assessment of compensation for negligent financial advice where the objective of the compensation is to restore the investor to the financial position had the advice never been acted upon.

Compensation for the loss incurred

To assess a compensation amount that will restore the investor to the financial position they were in prior to acting on the advice involves assessing the total costs and total benefits that arose over time from that advice.

  • The total costs include items such as the purchase price of the investments, the fees and commissions paid, any interest on loans used to fund the investments and any other charges that may have arisen over the life of the investment. There is also an opportunity cost on any cash contribution the investor made towards the purchase of investments. The rate of opportunity cost needs to be considered carefully.
  • The total benefits include items such as cash dividends received, the redemption value of the investments, the refund of fees or charges and any tax benefits, such as franking credits or a capital loss that otherwise would not have been available had the negligent advice not been acted upon. A benefit may also include an ‘opportunity benefit’ on amounts redeemed or extracted from the investments that were not used to pay down the loans used to fund the investments, but rather extracted for personal use. The rate of opportunity benefit would mirror the rate of opportunity cost.

The total cost less the total benefit over the period of the investment horizon (also referred to as the ‘profit and loss approach’) is equal to the compensation required by the investor to return them to the position they would otherwise have been in.

The advantage of this method is its transparency. The method lists each item within the claim and each of those items can be quantified by reference to actual cash inflows and outflows over the investment horizon.

The assumption likely to raise a debate is the rate of opportunity cost (or opportunity benefit on the income extracted). Assumptions may also be required in determining personal tax implications.

The other benefit of this method is that the amount being compensated is directly referable to the consequence of loss, such as the investor repaying negative equity out of their own funds.

This can be demonstrated in a very simplified example, where an investor purchased a $200 investment that was funded by a $150 margin loan and $50 from cash savings. Two years later the investor received a margin call and was required to redeem the full investment, now worth only $100:

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Let’s assume the investor used the $100 of redemptions to pay down the $150 margin loan. At the end of the investment horizon the investor still has a $50 margin loan outstanding, or $50 of negative equity.

The compensation amount of $140 allows the investor to repay the $50 margin loan to zero (as if it had never been taken out) and refunds the investor for the cash contribution, the interest paid and the fees and commission paid ($50 + $30 + $5).

The compensation also includes $5 for the opportunity cost of the cash contribution. In this example, this is the only portion of the compensation amount that is not directly referable to a bank statement or investment statement.

As you can see this method accurately calculates the amount of compensation that will restores the investor to the financial position had the negligent advice never been acted upon.

 Compensation as the change in financial position

The primary alternative approach that Axiom has seen adopted involves the assessment of the investor’s financial position prior to the negligent advice compared to the investor’s financial position at the end of the investment horizon (also referred to as the ‘balance sheet approach’).

In a perfect world the balance sheet approach and profit and loss approach would equal. However, the difficulty with the balance sheet approach is that a movement in financial position is likely to both:

  • Capture events that were unrelated to the negligent financial advice. For example, the movement in a loan balance may include draw downs that were not used to purchase an investment; and
  • Exclude cash flows that are related to the negligent financial advice, such as dividends or redemptions that are used on living expenses, as they are not reflected in any asset or liability balance.

Further, an investor’s financial position may require an assumption as to the value of the residential home, both before and after the investment horizon.

The difference calculated can then be difficult to reconcile to actual events, such as the repayment of negative equity.

Compensate for loss incurred not value forgone

We have also seen calculations that value the investments, not at the purchase price incurred, but at a higher value reflecting the price of the investment at some point along the investment horizon, even as at the date of the height of the market.

Unless the claim made concerns negligent advice that resulted in the higher value not being realised, this method amplifies the loss, as the compensation includes the difference between the high value point and the low exit point.

While it is true the investments were at some point in time worth their high value, it is a value that was never realised. The compensation calculated would both:

  • Enrich the investor for costs not incurred (being the difference between the actual purchase price and the high value); and
  • Fail to reflect an amount that is designed to restore the investor back to the financial position had the negligent advice not been actioned, but rather suggests the investor should have known to exit at the high value.

While the amount being claimed may impress the client, a calculation of loss prepared on this basis lacks credibility.

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