As part of its Inquiry into Financial Products and Services in Australia, the Parliamentary Joint Committee on Corporations and Financial Services recommended that the Government "investigate the costs and benefits of different models of statutory last resort compensation fund for investors" (Financial Products and Services in Australia, Committee Report, 23 November 2009, Recommendation 10). As part of its response to the Committee Report, the Government engaged Richard St John to consider this recommendation.
Compensation arrangements for consumers of financial services (Report) was released in April 2012. In it, St John considers the current compensation arrangements in place for retail clients who suffer loss through Australian Financial Services (AFS) licensee misconduct (such as misleading or deceptive behaviour).
Summary of the Report
St John examines the current AFS licensing structure and the insurance arrangements and compensation mechanisms in place in the industry. He also traces the history of compensation schemes in the financial services sector generally, examines recent collapses of managed investment schemes and financial services providers, and considers regulatory reforms in the UK.
In summary, the Report recommends that, rather than introduce a new scheme, steps be taken to strengthen existing regulatory and compensation arrangements. St John suggests that "the regulatory platform for financial advisers and other licensees needs to be made more robust and stable before a safety net, funded by all licensees, is suspended beneath it". Introducing a last resort scheme to underpin the existing framework would not address problems with that framework, and "could well introduce an element of regulatory moral hazard by reducing incentive for stringent regulation or rigorous administration of the compensation arrangements".
The Report also recognises the need to take a more robust approach to licensees at risk, rather than increasing the regulatory burden on licensees generally. A last resort compensation scheme would "have the effect of imposing on better capitalised and/or more responsibly managed licensees the cost of bailing out the obligations of failed licensees" and "would not work to improve the standards of licensee behaviour or motivate a greater acceptance by licensees of responsibility for the consequences of their own conduct".
The AFS licensing regime
St John concludes that the current regulatory approach is "light-handed". There is a relatively low threshold for applicants wanting to obtain AFS licences. The regime relies on licensees self-assessing the adequacy of their professional indemnity cover. ASIC's financial standards are not set with a view to ensuring that licensees are able to compensate clients, perhaps because there appears to be considerable reliance placed on licensees having adequate insurance cover. ASIC's current approach is reactive, and it has only limited powers of enforcement or sanction. St John suggests that licensees should be required to demonstrate that they have adequate insurance cover and capital resources, and that ASIC should take a stronger, more pro-active role to policing the system.
Imbalance between financial advisers and issuers of financial products
The Report also concludes that, for various reasons, financial advisers bear a greater part of the compensatory burden for financial product failures when compared with product issuers. This in turn impacts on financial advisers' ability to access insurance, the cost of that insurance and consumer access to financial advice. St John recommends a review of the current regulation of financial product issuers (particularly managed investment schemes) and the possible adoption of a more stringent, interventionist approach to the development and marketing of these products.
A number of insurance-specific issues are raised and discussed, including:
Defence costs in professional indemnity insurance cover: The Report addresses concerns about professional indemnity insurance policies being drawn down substantially to meet an insured's defence costs, leaving third parties with no real recourse against the insurer. St John identifies the need to strike a reasonable balance between the interests of licensees and insurers on the one hand and consumers on the other, and suggests that this problem warrants consideration by ASIC.
Direct access by third parties to insurers: St John suggests that s 51 of the Insurance Contracts Act 1984 (Cth) be amended so that third parties can recover directly from insurers where judgment has been obtained but its execution is unmet (and not just where the licensee dies or cannot be found). He also suggests that ASIC be required, in certain circumstances, to disclose information about existing licensee insurance arrangements to third party claimants.
Run off cover: The reluctance of insurers to provide such cover on an automatic basis as a term of a licensee's professional indemnity insurance is noted, and it is suggested that ASIC explore ways to secure protection for consumers where licensees cease trading.
Product development: The Report refers to and seeks to encourage initiatives by insurers, brokers and industry bodies to develop insurance solutions that better cater for the insurance obligations of licensees, such as arrangements by industry bodies for master policies that are offered as individual policies taken out by members. It suggests that these arrangements might incorporate recognition by insurers of a lower risk of misconduct by members who are bound by the ethical and professional standards of the industry body. Reference is also made to the possibility of developing a group insolvency insurance policy (negotiated and administered by a group administrator, such as an industry body) to cover compensation that cannot be paid by an insured licensee because of the licensee's insolvency.
The Report makes many other recommendations, including:
- greater efforts at early identification of "outlaw" activity, such as that involving unregistered managed investment schemes or unlicensed financial services providers;
- additional enforcement powers for ASIC to deal with phoenix activity by licensees; and
- remedying the inability of External Dispute Resolution schemes such as the Financial Ombudsman Service Ltd (FOS) to apportion liability for misconduct among responsible licensees and make awards recognising proportionate liability.
Observations on a last resort scheme
While the Report concludes that it would be undesirable to introduce a last resort compensation scheme into the current regulatory environment, it also includes a discussion of the various elements that any such scheme should have.
The Government has sought submissions on the Report, and expects to finalise its formal response by the end of August 2012.