Your conflicts of interest compliance framework will need to be reviewed to ensure it takes into account the changes brought in by FOFA.
Mandatory compliance with the Australian Government's Future of Financial Advice (FOFA) legislation is quickly approaching with a 1 July 2013 deadline. One change as a result of these reforms which may be deceivingly insignificant is the introduction of the "conflict priority rule".
Many licensees would already have a conflicts of interest compliance framework as a result of the general obligations applying to licensees to manage conflicts. However, the conflict priority rule arguably takes this regime a step further and licensees will need to review their existing procedures to ensure they meet any new obligations arising under the FOFA reforms.
In this article, we examine the conflict priority rule in further detail and how this may impact your existing conflict of interest framework.
What is the conflicts priority rule?
On 13 December 2012 the Australian Securities and Investments Commission released final guidance on prioritising the interests of the client when providing financial advice, in an update to Regulatory Guide 175 Licensing: Financial product advisers – conduct and disclosure (RG 175).
The conflicts priority rule is set out in Division 2 of Part 7.7A of the Corporations Act 2001 (Cth) and is new to RG 175. This rule states in more defined terms what many advisers would consider was already implicit in their previous obligations to provide "appropriate advice". The rule expressly requires an advice provider to prioritise the interests of the client if the advice provider knows, or reasonably ought to know, when they give the advice that there is a conflict between the interests of the client and the interests of:
the advice provider;
the associate of the advice provider;
the advice provider's Australian Financial Services (AFS) licensee;
an authorised representative who has authorised the advice provider to provide financial services on behalf of an AFS licensee; or
an associate of an authorised representative who has authorised the advice provider to provide financial services (or a financial service) on behalf of the AFS licensee (section 961J),
collectively referred to as "related parties" in RG 175.
Additionally, ASIC has warned the financial services industry that it is on a mission to weed out "bad apples" ahead of the introduction of the FOFA reforms with a particular focus on conflicts of interest, stating that "we are taking a tough line on enforcement because we want to see better standards in financial planning, better compliance and we want to ensure conflicts of interest don't undermine advice."
In preparation of the FOFA reforms, licensees will need to be reviewing now all potential conflicts of interest with related parties to ensure they are covered in existing conflict of interest management procedures. Furthermore, it will be necessary to review procedures for managing these conflicts interest in preparation for the FOFA reforms mandatory commencement date, to ensure that these procedures meet the extended obligations under this new rule. Later in this article, we identify some practical implications which we consider will be relevant when reviewing existing conflict of interest management procedures.
Before considering these practical implications, we examine the conflicts priority rule in further detail.
When does the conflicts priority rule apply?
The conflicts priority rule applies only when an advice provider knows, or ought reasonably to know, a conflict exists. To determine whether a conflict exists, advice providers should give consideration to what benefits (if any) an advice provider or their related parties will receive if the client adopts the advice. The rule does not apply if an advice provider does not know of the conflicting interest (RG 175.369), and nor does ASIC expect an advice provider to make inquiries to determine any conflicting interests of their related parties.
ASIC provides some limited guidance on when an advice provider "reasonably ought to know" a conflict exists, and states that advice providers will be aware of conflicts that are disclosed in Financial Services Guides (FSGs) issued by related parties and Statements of Advice (SOAs) the advice provider helps prepare for their AFS licensees and authorised representatives (RG 175.371).
In its proposed guidance (CP 182), ASIC suggested that information barriers could be used by an AFS licensee or authorised representative to control what information an advice provider is aware of, or should reasonably be aware of (REP 319.63). However, this has not been included in the final guidance because, according to ASIC, information barriers will be of limited effectiveness given the conflicts of interest must be disclosed on FSGs and SOAs (Rep 319.64). Of course, this does not prevent information barriers being used as a compliance tool for their intended purpose.
Giving the client's interest priority
Section 961J requires that an advice provider should not act to further their interests or those of their related parties over those of the client when giving the client advice. In complying with this obligation, advice providers should consider what a reasonable advice provider without a conflict of interest would do (RG 175.375, 376).
This is arguably an extension of what a financial adviser may have traditionally undertaken to manage conflicts of interest and in some circumstances, could extend beyond merely disclosing the conflict of interest. Indeed, some respondents to ASIC's draft guidance expressed concern with this concept, particularly given that conflicts of interest are very common in the financial advice industry, however ASIC has affirmed that it considers it a relevant consideration for an advice provider complying with section 961J [Rep 319 at 60].
A key consideration will be the materiality of the conflict of interest, that is, the more material and direct the conflict of interest, the more rigorous the processes an advice provider must adopt to ensure they give priority to the client's interest (RG 175.377). The conflicts priority rule means that (RG 175.381)]:
while advice providers can recommend a product issued by a related party, they cannot do so to create extra revenue for themselves, their AFS licensee or the related party, where additional benefits for the client cannot be demonstrated;
advice providers can accept remuneration from a source other than the client (eg. the product issuer), however Division 4 of Part 7.7A prohibits advice providers from accepting certain types of remuneration which could reasonably influence the financial product advice they give or the financial products they recommend to clients;
advice providers must not recommend products on an approved product list that only has products issued by a related party, unless a reasonable advice provider would be satisfied that it is in the client's interests to recommend the related party product rather than another product with similar features and costs;
advice providers must provide an appropriate level of service for the client's needs, and not over-service the client to generate more remuneration for themselves or one of their related parties; and
non-financial product solutions relevant to the client's situation should be recommended where appropriate, even if this means the client is less likely to need financial advice in the future.
ASIC will expect advice providers to keep records of the reasoning behind any recommendation that the client acquire new financial products or increase their interests in an existing product, where the advice would benefit the related party (RG175.390).
Practical challenges and considerations
As discussed earlier in this article, we consider the conflict priority rule introduces some new challenges for managing conflicts of interest which licensees will need to have regard to in the context of reviewing their existing procedures for managing conflicts of interest.
In our experience, conflicts of interest are commonly managed by the financial services industry through disclosure. Importantly, ASIC has indicated that an advice provider cannot comply with the conflicts priority rule merely by disclosing a conflict of interest or getting the client to consent to a conflict (RG 175.372). In support of this guidance, section 960A makes a condition of a contract (or other arrangement) void if it seeks to waive any of the obligations in section 961J, and use of notices or disclaimers provided to the client to avoid these obligations is prohibited (RG 175.213). It will therefore be necessary for licensees to consider what further steps (if any) need to be undertaken to manage conflicts of interest.
Other practical challenges and considerations when reviewing your procedures for managing conflicts of interest in readiness for the FOFA reforms include:
- How should advice providers evidence what additional benefits the client will receive? In the Statement of Advice, or as a notation on the client's file?
- How do you determine what are genuinely "additional benefits"? What guidelines or other processes are required to assist advisers in determining genuine additional benefits?
- How should advice providers/licensees evidence the reasoning behind the formulation of approved products lists? And to what extent will ASIC require this reasoning to be contained in SOAs? What processes should be used where advisors recommend a product that is not on an approved product list?
- What other conflicts should be considered beyond conflicted remuneration (eg. share holdings, alliance partnerships)? What controls need to be in place to manage these conflicts? Will disclosure be enough?
- What should organisations do about managing structural conflicts and is disclosure of these conflicts enough?
The Clayton Utz Governance and Compliance Team and Financial Services teams are well placed to assist you with these practical steps and the practical implementation of FOFA more widely.
ASIC's guidance on section 961J is principles based, and like other guidance on the best interests duty and related obligations, ASIC will assess whether there is a need for further guidance after observing how industry complies with these obligations and in light of their regulatory experience and any case law on these obligations.