Financial Mis-selling - Really World Mis-Selling - Assessment Answer

Financial Mis-selling Assignment

Assignment Task

Financial Mis-selling Assignment

Within your assignment you are required to one, consider the causes of mis-selling and two, relate these causes to some really world mis-selling cases:

How and why does financial mis-selling occur?

Critically discuss the question making reference to different perspectives and theories.

Outline and describe two real world cases of mis-selling [as provided on the module blackboard site or from your own research] and indicate how and why financial mis-selling has developed in these cases.

Introduction – The how and why of financial mis-selling

Financial miss-selling occurs when a salesperson adopts an ethically and morally questionable practice and misrepresents or misleads the investoror a prospective investor about the nature of the product or service that he purports to sell. This misrepresentation could take the form of hiding certain important information or description of the financial product that would have majorly impacted the investor decision to invest in the product or service in question. Financial miss-selling is often resorted to in order to increase the revenue and sales base of the company and commission and similar linked benefits for the sales person totally undermining the investor benefits and sentiments.

To illustrate the phenomenon; when an investor without any dependents and thereby no resultant need for life insurance is induced and misguided by a salesperson to urgently invest in a life insurance policy so as to protect his assets and investments; a classic case of financial miss-selling occurs. The nature of miss-selling often includes an element of illegality, induced purchases not suited to the investors needs and a bent towards the miss-sellers profit.(Investopedia, 2006)

Critical discussion with reference to different perspectives and theories

The how’s of the mis-selling usually occur through the modus operandi of omission or misrepresentation of material facts and non -suitability of the product or service sold to the customer’s needs. The first category of miss-selling is done by deliberately dressing the product or service as something which it is not, thereby misleading the customer, by providing inadequate or incorrect details so as to complete the sale. (Ericson and Doyle, 2006) Sometimes material information may be completely missed out taking advantage of the knowledge gap and experience level of the customer in respect of the financial product dealt with. The other category of mis-selling known as Suitability mis-selling occurs when an unsuitable product or service is provided to the customer as explained in the above mentioned example and the customer is lured to do so by the sales person. (Georgosouli ,2011) Financial mis-selling also takes place where banks inappropriately advise customers. (Carlin and Manso, 2010)

The classic examples of mis-selling in the UK are those of the Lloyd’s Banking Group. Regulations in the form of severe repercussions and compensation have been introduced so as to keep a check on this practise. The mis-selling of payment protection insurance or the PPI with 400,000 unresolved cases resulted in £23.8 billion of PPI-related compensation till date to the aggrieved parties. Endowment and self-certification mortgages are other scandals within the gamut of this practise.(Comply Advantage, 2016)

The why of the financial miss-selling is attributed to reasons like regulatory demands and expectations that are not in tune with the organization goals and objectives which may force the firm to resort too unfair practise of selling. The other attributable reasons aligned with academic literature available in this regard are both consumer specific as well as organization and executive specific. Due to Conflicts of interest between the individual’s personal interests and the organization and societal interests often termed as impersonal interest, individuals are forced to resort to the practise of mis-selling as it takes care of their pecuniary benefits (a benefit that is preferred normally by all individuals)(Carlin and Manso,2010). Due tomanipulation of customers, given the variety and complexity in pricing of the financial products and services, firms resort to product differentiation thereby increasing the choice base of the customer.(Ericson and Doyle ,2006) This results in the confused customers makingsub-optimal decisions. This happens due to information overload which increases the fear of poor decisions. Carlin terms this phenomenon as ‘obfuscation’wherein a ploy is made to add friction to the consumer rational decision making wisdom.

The complexity perception in spite of similar functions in the financial sector whether in terms of return or security is deliberately created so as to impress the prospective customer with the better product or service tag; sometimes even resorting to mis -selling. Here, a close link is observed between the information provided and the customers decision. Financial sales often involve an element of advice from the sales person; firms often take advantage of this elementand present information toinvestors not resulting in an optimal decision or these firms have a tendency to behave in a way so as totake advantage of these observed anomalies.(Ferran,2012) Since the advisor is equipped with a better knowledge of the nature of the financial products and services’ dealt with by his organization that he purports to represent; it becomes easier to mislead customers and take advantage of the knowledge gap thereby. This acts like anincentive for inflating the perceived value of the financial product or service, especially in cases where the sale is directly linked to the commission component of the advisor. (Inderst and Ottaviani 2009).

Added to this, the dilemma faced by the sales staff of the financial services concerns are often characterized byunsupervised settings with absolutely no guidance or mentorship. Their job is directly linked to generating the revenues and their evaluations and incentives are driven by short term performance goals. This induced them to indulge in the mis- selling practise. Other benefits like promotions and recognition also motivate the employees to succumb these actions. Legal regulation are mere ethical standards which are easily over ridden by the pressure and demands of the top management with a bent towards achieving or exceeding the profit numbers.

Due to the imposed consumer loyalty in the financial services sector. Evidence in this regard based on survey results indicate that customers to not prefer switching brands in this market. A BERR (2000) survey attributed the reasons of loyalty to the familiarity and trust. The firm in such a scenario induces switching by resorting to mis-selling tactics influenced by the Klemperer (1995) Switching model. The model is basically a multiple time period model wherein in the first time period, products are competitively priced so as to capture market share. However, in thesubsequent time periods, as a comfortable customer base is in the process of becoming and the switching costs, tend to increase the product pricing; the rates are increased. The existing customers will however expect a lower deposit rate. Banks then resort to mis-selling.

Due to the nature of financial services advertising and the marketingfunction are normally associated with revenue and profits for the financial products sold by the firm. (Georgosouli,2011) Drawing in from ‘The Marketing Revolution (Keith 1960 JM)’theory, the marketing function operates independently of the risk management and operation function which results ininevitable conflicts due to the difference in the goals of each department.Theriskmanagement perspectivejudges the marketing function on the basis of sales volume generated ignoring the quality aspect while the marketing function judges the Risk management on the basis of rigid parameters imposed and wasted marketing efforts. This lack of coordination is also often cited as one of the reasons for the marketing executives to resort to the mis- selling practice. So Advertising could be informative resulting in increased customer knowledge butmay be anti-competitive where it is of a persuasive nature. Linking the commission of the marketing executives on the basis of their performance further acts as an incentive for them to resort to mis-selling. The nature of Financialservices is prone to fear and uncertain benefits which make them complex and prospective customers tend to fear the poverty, loss of assets in this scenario.Financialservices like insurance may be legally compulsory and executives take advantage of the fear factor to further boost up salesthrough advertising. This is done by encouraging the fear factor.

The customer level causes of financial mis-selling may be attributed to Irrational Heuristicsapproach from Hahnemann and Tversky where the customer decision making is majorly affected by framing the product. the regret and loss aversive nature of the customer whereby they presume the recent past to represent future combined with the endowment effect in a desire to make profit.

On the regulatory front, the financialized world where indebtedness is prominent (38% in EU to be precise) (EC 2009); abusive and predatory lending stressing on credit scoring, value of security, high interest rates and fees clubbed with an aggressive marketing may have urged Davy to resort to mis-selling. The modern financial world is characterized by the declining role of the state. Even after earning more than previous generations, people in the and an insatiable desire for growth and money. (Stegman,2007). Consumers are urged through marketing and other gimmicks to spend more and are recognized accordingly. Huberman and Jiang (2006). Marketing gimmicks also encourage misleading the customer through mis-selling (Schwartz et al. ,2011)Increasing globalization also has led to increase in borrowings and mis-selling. In 2007, the European Union borrowed more than 1 trillion Euro. Carlin (2009). The household debt phenomenon has increased in relation to income as depicted in the graph below.

The Economists View

Financial miss-selling may involve aggressive sales tactics and misguiding the customer such that customer is financially at a disadvantage. The practice is often considered from the perspective of the individual salesperson represented by and representing the Organization as well as the entire organization. These perspectives are academically considered by Economists from the point of view of deceptive individuals and group level reasons. Individual sales Commission linked to the sale is often cited as a very strong cause for the phenomenon to occur. The linkage induces the salesperson to resort to unethical modes of selling. In this scenario, the salesperson resorts to churning of customers at any costs so as to make the sale.

The Corporate culture and its tolerance of the deceptive practices are strong motivators of the practice. The degree to which an Organization favours the tolerance of mis-selling ultimately is decisive of the degree of its perpetration. The marketing function is usually associated with this phenomenon as it is here that most of the selling occurs. The HR department also perpetrates these practises by not conducting proper integrity checks, and by recruiting people solely based on references. Other reasons for the adoption of this practice is the fact that the layman customer is not aware that he has been potentially misguided and place total reliance on the sales person without comprehending what they have bought (Hill and Kosup ,2007)

Outline and description of two real world cases of mis-selling

In deciding the case for mis-selling, the regulatory authorities will normally take a decision on the basis of the suitability of the recommendation rather than the performance of the product or service. Where the product or service was suitable at the time of sale, and the risk was reasonably explained, allegation of miss-selling will normally be dismissed.

1Enfield Credit Union v Davy Stockbrokers [2008].

In this real world case from Ireland, the Credit Union invested €500,000 on Davy’s recommendation in perpetual bonds and suffered a loss of €77,000. A case for mis-selling was alleged against Davy on the following grounds of no adequate disclosure of relevant material information including the fact that they where they were perpetual and subordinated was made to the union at the time of selling; not suitable to the union given the conservative risk profile of the Credit Union. The Stockbrokers should have accordingly made their recommendation; A case for mis-selling was made by the FSO on the above mentioned grounds.(Finfacts.ie, 2016)

The how and why of the case Material information related to the risk of a possible loss of investment was deliberately hidden clubbed with the non-suitability of the investment to the Credit Union risk profile. Also given the fact that the union was not in possession of the wisdom as well as the information to take the decision in such a scenario was used by Davy’s at their advantage. Mis-selling here involved breach of duty, breach of contract, misrepresentation and breach of fiduciary duty as well as statutory duty.

By manipulating the union,given the variety and complexity in pricing of the financial products and services, Davy’s took advantage of this fact thereby increasing the choice base of the customer resulting insub-optimal decisions. This happened due to information overload which increased the fear of poor decisions. The complexity perception in spite of similar functions in the financial sector whether in terms of return or security was deliberately created so as to impress the union with the better product or service tag resorting to is -selling. Here, a close link is observed between the information provided and the customers decision.

The sale involved an element of advice from the sales person; Davy took advantage of this elementand presented information tothe Union not resulting in an optimal decision and behavedin a way so as totake advantage of these observed anomalies. Since the advisor was equipped with a better knowledge of the nature of the financial products and services’ dealt with by his organization that he purported to represent; it became easier to mislead the customer and take advantage of the knowledge gap thereby. This also acted like anincentive for inflating the perceived value of the financial product or service, especially since the sale was directly linked to the commission component of the advisor. (Inderst and Ottaviani 2009).

Due to the nature of financial services advertising; thefunction is normally associated with revenue and profits for the financial products sold by the firm. Drawing in from the The Marketing Revolution (Keith 1960 JM)theory, the marketing function operated independently of the risk management and operation function which resulted ininevitable conflicts due to the difference in the goals of each department.Therisk management perspectivejudged the marketing function on the basis of sales volume generated ignoring the quality aspect while the marketing function judged the Risk management on the basis of rigid parameters imposed and wasted marketing efforts.Linking the commission of the marketing executives on the basis of their performance further acted as an incentive for them to resort to mis-selling.

Where investment products tend to misrepresent information or fact that is untrue due to which the customer is induced to enter into the contract; mis-selling is proved.The customer level causes of financial mis-selling may be attributed to Irrational Heuristicsapproach from Hahnemann and Tversky where the Union decision making was majorly affected by framing the product. the regret and loss aversive nature of the Union whereby they presume the recent past to represent future combined with the endowment effect in a desire to make profit.

On the regulatory front, increased borrowings; abusive and predatory lending stressing on credit scoring and preference for value of security clubbed with an aggressive marketing may have urged Davy to resort to mis-selling.

It was observed while studying the cases with allegations of financial mis-selling that the reasons are increasingly attributed to the nature of the product complexity and a desire for higher returns by the firms as well as the investors. The second case depicted below presents a real word scenario where mis-selling was proved. The case has been enumerated below so as to clarify the causes and modes of mis-selling very precisely.

2 Deutsche Bank AG v Chang Tse Wen [2012] SGHC 248

In this Singapore based case, it was held that where a bank has a pre-contractual duty of advice to his client; the duty cannot be negated by any standard documentation claiming non-reliance or non-advisory clause. In this case, the customer had clarified at the pre-contractual stage that he had limited knowledge and experience and intended to rely on the bank’s advice. It was held that duty of care was extended to the customer thereby in spite of the fact that the agreement was not documented. This was held even though the customer had signed the Standard Service Agreement containing standard own judgement and non-reliance clauses as the customer was not a sophisticated customer. It was also held against the bank that a breach of duty had taken place and no evidential estoppel of the standard agreement against the customer could be used by the bank. Where the executive had expressly denied and informed the customer about the own judgement clause, the ruling would have been in favour of the bank. Also, the doctrine of contractual estoppel in cases where the customer had little or no financial experience and the bank committed to advise him in the pre contractual stage itself is not tenable. (Lexology.com, 2016)

The how and why of the case

An element of advice from the sales person was there and the bank took advantage of this elementand presented information toinvestors not resulting in an optimal decision or the bank had a tendency to behave in a way so as totake advantage of these observed anomalies.

Where investment products tend to misrepresent information or fact that is untrue due to which the customer is induced to enter into the contract; mis-selling is proved. The Pressure or opportunity theory claims that the business environment create pressure for violation of regulations and provides an impetus for these violations to remain undetected. The theory further argues that illegitimate practices are resorted to for personal gains where employees are compared to ‘amoral rational calculators’ who calculate the cost and benefits of the rules to their own advantage. The corporate culture supports these practices and they become a way of life.(Inderst and Ottaviani, 2009)

Mis-selling here involved breach of duty, breach of contract and misrepresentation. Here, a close link is observed between the information provided and the customers decision. On the regulatory front, the banks resort to abusive and predatory lending, preference for customers with higher value of security, high interest rates and fees clubbed with an aggressive marketing strategy which promote unfair means. (McGovern and Moon ,2007)

Conclusion

The customer level causes of financial mis-selling may be attributed to framing the product or service to make it appear attractive; the regret and loss aversive nature of the customer whereby they presume the recent past to represent future combined with the endowment effect in a desire to make profit which may sometimes result in a bias towards the wrong decision and lack of knowledge giving an edge to the practice of mis-selling.

On the regulatory front, the banks resort to abusive and predatory lending, preference for customers with higher value of security, high interest rates and fees clubbed with an aggressive marketing strategy which promote unfair means. (McGovern and Moon ,2007)

The two case analysis also proved the above points where inexperienced customers were manipulated by the banks driven by unethical profit making desire. It is recommended that the regulatory set up be made more stringent and steps be taken by the regulatory authorities to make the customer more aware of the pros and cons of investing in financial products through the medium of advertising and other marketing tools.