Sent: 24-04-2012 12:21:02
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Independent Experts Should be Independent
'Independence' in financial markets is being more intensely policed since the 2007-09 financial crisis but, in a departure from standards applying elsewhere, consultants paid to pass opinions on the value of corporate transactions - 'independent experts' - are still paid by those they are analysing.
Conflicts of interest in financial markets loomed as important contributing factors in the 2007-09 financial crisis. In the aftermath, regulators around the world have put more emphasis on analytical independence among those with the ability to influence investment decision making.
The model for institutional independence in financial markets has been the central banks with a single mandate to fight inflation at all costs. With a clear objective and having shed their political masters, they are untouched by the influence of government and untainted by special interest lobbying or payments for any services provided.
But even the Australian central bank has shown through its note printing business how it, too, can be besmirched by commercial influences once they are permitted to play a role no matter how honest and upstanding the principals of the business.
Independent stock broking research now requires investment recommendations to be disentangled from a broking firm's corporate advisory or underwriting activities to ensure independence.
A debate about whether fund managers should pay for their products to be researched has not been fully resolved. Nonetheless, fund researchers have had to put in place more rigorous safeguards to reassure regulators that their recommendations are not being compromised by payments from promoters of investment products.
The demands on financial advisers to offer conflict free financial advice have increased. Now, independence is thought inconsistent with an adviser receiving payment from a promoter of a financial product.
The independence of company directors has been enshrined progressively in various laws and stock exchange listing rules. Directors who have received payments for services, prior to their roles as directors, from the companies on whose boards they sit cannot be called independent.
None of these roles - central banker, stock analyst, fund researcher or company director - need be independent to fulfil their roles but independence is thought a desirable way to mitigate risks.
An independent expert, on the other hand, is necessarily an autonomous participant showing no favour to any party involved in a transaction. Genuine independence is an intrinsic characteristic of the role.
ASIC has published clear guidance describing the nature of an appropriate relationship between an independent expert and a party commissioning a valuation report. The ASIC guidelines are primarily concerned about the possibility of a commissioning party influencing the content of an expert's report or the possibility that an expert has a financial stake in the outcome of a transaction on which it is presenting an opinion.
The ASIC guidelines take it for granted that, in all cases, a company commissioning a report will have had a financial stake in its outcome and will have paid an amount of money to the provider of the report.
By the standards applied in other contexts (e.g. company directors), the valuation expert referred to in the corporations laws is never going to be truly independent.
Aside from direct conflicts in individual situations such as those covered by the ASIC guidelines, experts face potential systemic conflicts.
An expert could, for example, have interests in other financial advisory and investment management activities. An expert involved as both market practitioner (e.g. as a fund manager) and market analyst (e.g. providing independent valuations) would have a vested interest generally in the way markets price securities. An expert might be reluctant to espouse a valuation methodology, for example, that was contrary to the way they would prefer markets to price stocks in a portfolio for which they acted as adviser or manager.
Experts also lose some independence when they simply reflect existing market prices in their analysis. Frequently, independent experts will value a resources company, for example, using current expectations among analysts about the future trajectory of commodity prices.
To the extent that a prevailing commodity price consensus is generally embedded in stock prices, a valuation by the independent expert will be biased toward transactions around existing share prices. This might favour one party over another in a transaction.
The independent expert profession depends, to some degree, on being able to deliver predictable outcomes. Companies might be less likely to embark on transactions in the first instance if they are unsure of the likely support of an independent expert, reducing the pool of revenue available to the independent expert industry.
Analysts employed as independent experts will be as susceptible to financial stimuli such as these as analysts in any other context.
Potential investors can probably retain a high degree of confidence that an appointed independent expert is not conflicted by having an explicit vested interest in a specific transaction.
Investors can be less certain, however, about getting genuinely independent thinking and analysis. Independent experts are prone to favour consensus views and, in weak markets, companies buying assets.
The reasons for having independent experts is, however, as strong as ever. An arbiter to opine on the value to investors of a particular corporate transaction is a potentially worthwhile contribution to an efficient market.
Perhaps the service should be treated as an important public good. The government, through the appropriate regulator, could retain suitably qualified financial analysts. The retainers to establish such a panel of experts could be funded from a levy on all listed companies. An expert would be allocated from the panel as a company requires a transaction to be reviewed.
To discourage resort to consensus views, periodic re-appointment to the panel would be subject to public consultation with alternative panel members able to bid for appointment based on their demonstrated skills and critiques of the reports that have been prepared by the incumbents.
A competitive process such as this would encourage peer review, continuous improvement, transparency and, ultimately, independence.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.