On 28 September 2018, the Honourable Kenneth Madison Hayne AC QC (Commissioner), released the interim report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Commission).
This article highlights the main examples of misconduct that were considered during the hearings that are the subject of the interim report and sets out the issues that the Commissioner has determined require further consideration.
The contents of the interim report
The interim report provides a summary of the first four round of hearings held by the Commission.
In the interim report, the Commissioner has:
- summarised the misconduct that has been identified and considered by the Commission in each hearing; and
- identified issues (including potential avenues of reform) that require further consideration prior to the Commissioner's final report being delivered.
It is evident that the Commissioner has sought to use the interim report to guide and colour the Commission's final round of hearings, which will exclusively focus on policy questions arising from the first six rounds. Accordingly, while the Commissioner has made concluded findings in respect of the specific examples of misconduct that were considered during the hearings, he has made no recommendations for reform in the interim report.
Round 1 - Consumer Lending
In the context of consumer lending, round 1 of the Commission exposed misconduct in the provision of home loans, car loans, credit cards and 'add-on' insurance products, including:
- lenders' reliance on fraudulent documentation;
- processing or administration errors, resulting in consumers being charged incorrect fees, and incorrect higher interest rates; and
- multiple breaches of responsible lending obligations by financial services entities.
The Commissioner highlighted that much of the conduct identified in the first round of hearings can be traced to entities preferring pursuit of profit to pursuit of any other purpose. Specifically, the Commissioner noted that the importance of profit is clearly reflected in the remuneration policies for staff and third-party intermediaries (i.e. mortgage brokers, financial advisors and authorised representatives of financial services licensees) that reward volume and the amount of sales at the expense of the consumers' interests.
Another key issue that emerged from round 1 is the role that intermediaries play vis-à-vis the consumer and the providers of financial services. The Commissioner highlighted the confusion that often arises as to whose interests the intermediaries serve, and who owes what legal obligations to the consumer.
The Commissioner highlighted a number of key considerations which will no doubt form the basis of robust policy discussions in round 7, and potentially form the basis of recommendations in his final report. These include:
- legal obligations: the duties owed between financial entities and intermediaries to consumers;
- breaches: detection and prevention of breaches of responsible lending obligations, including the adequacy of the current verification process to assess suitability for loans; and
- conflict of interests: the adequacy of broker contracts in managing conflicts of interest, and their compliance with the Corporations Act 2001 (Cth).
Round 2 - Financial Advice
Round 2 of the Commission considered issues relating to the financial advice industry.
After financial institutions admitted certain misconduct prior to the commencement of the Commission, the hearings for round 2 focussed on the following issues:
- licensees or advisers charging fees to clients for financial advice that was not provided (i.e. "fees for no service");
- inappropriate advice, typically where a customer had been offered a particular product or service on the basis of the incentive payment that would be provided to the adviser, rather than being in the best interest of the customer;
- inappropriate (i.e. dishonest, illegal, deceptive, fraudulent or gross incompetence/negligence) conduct by advisers; and
- the adequacy of disciplinary procedures.
The Commissioner highlighted two reoccurring themes causative of misconduct in the financial advice industry; dishonesty and greed. He also recognised that as long as advisors and licensees stand to benefit from clients acting on the advice that is given, their interests will inherently conflict with those of the consumer.
Specifically, the Commissioner identified the following issues for further consideration and possible reform:
- culture and incentives: the extent to which the employer encourages sound advice being provided; whether any part of the remuneration of financial advisers should be linked to volume or value of sales; whether grandfathered exceptions to conflicted remuneration rules should still apply;
- conflicts of interest and confusion of roles: how vertical integration of financial product manufacturers and financial advisors be managed in a way that prevents conflicts of interest, or if such integration should be prohibited; whether a client should be required to positively review its fee arrangement every year (rather than every two years as is the case currently); whether a licensee should inform relevant clients and/or review their files where an adviser is terminated for fraud or other misconduct; and
- regulator effectiveness: whether financial advisors should be separately subject to a licensing regime by ASIC; whether negotiation and settlement should be the main approach for a regulator (as distinct from prosecuting cases of misconduct to judgment); whether more focus should be given to commencing criminal proceedings against licensees, rather than the individual advisers employed by them.
Round 3 - Small and Medium Enterprises
Round 3 of the Commission investigated issues specifically arising as a result of banks dealing with small and medium enterprises (SMEs).
In their submissions to the Commission, the banks admitted a range of misconduct regarding lending to SMEs. These included:
- using false, incomplete or inaccurate information (i.e. current/projected revenues and expenses) to approve loans to SMEs;
- exercising guarantees given by third party guarantors, where those guarantors were not in a position to understand implications for offering a guarantee; and
- other forms of unsuitable lending, including inappropriate sales practices and referral of unsuitable products to increase incentive payments.
Recognising the power imbalance between SMEs and banks, the Commissioner has queried whether there should be a change to the legal framework governing loans to SMEs. In particular, he has suggested that the National Consumer Credit Protection Act 2009 (Cth) could apply to loans made by banks to SMEs.
In addition, the Commissioner has identified the following issues for further consideration and possible reform:
- obligations under the Code of Banking Practice: whether the obligations of banks under the Code need to be further clarified. These include the specific inquiries that a diligent and prudent banker (being the relevant standard) should make when deciding to lend to an SME and if the test of whether a customer can repay the proposed loan based on their financial position and account conduct is sufficient;
- guarantees: whether there should be certain circumstances where a guarantee ought not be able to be enforced, beyond those already enunciated in the common law and statutory provisions (i.e. unconscionability); and
- external dispute resolution: whether the Australian Financial Complaints Authority should be able to award compensation for losses or harm caused, rather than putting a borrower back in the position they would have been in if the loan had not been made.
Round 4 - Remote and Regional Communities
Round 4 focussed on two key areas; agricultural lending and the interactions between Aboriginal and Torres Strait Islander people and financial services entities.
The Commissioner highlighted the complexities of agricultural lending unique to this industry, being that all agricultural enterprises are subject to the effects of events beyond their control, including the onset of persistence of drought or other natural disasters, regulatory decisions of both foreign and domestic governments, and outbreaks of pests or disease. Unsurprisingly, the main issues presented to the Commission in this round were said to stem from a single overarching cause; how are borrowers and lenders to deal with the consequences of uncontrollable and unforeseen external events?
The misconduct revealed in this round said to stem from how securities were valued and revalued, the way in which farmers are able to access banking services and appropriate support, the change to conditions of lending and the appointments of external administrators.
Issues for further consideration and potential policy reform include:
- context specific approach: the way in which borrowers and lenders in the agricultural sector might deal with consequences of uncontrollable and unforeseen external events; the method for valuing agricultural property and businesses in the context of lending; the necessity of a national system for farm debt mediation; the management of distressed agricultural loans; and
- applicable regulation: the adequacy of the 2019 Banking Code of Practice in protecting agricultural business.
Round 4 also examined banking services in remote communities. In this context, the overarching theme was that of banks failing to recognise indigenous customers' circumstances. This failure has resulted in banks' unwillingness to provide "basic accounts", charging overdrafts fees and dishonour fees, and failing to recognise the difficulty indigenous people face in providing appropriate identification when communicating with a bank. In the provision of funeral insurance to indigenous people, the Commissioner highlighted inappropriate sales practices including misrepresentations and pressure selling tactics, and sales where what was sold was of little or no benefit to the purchaser.
The Commissioner highlighted a number of issues for further consideration and possible policy reform, including:
- dealing with barriers: the adequacy of banks' current systems to address cultural, linguistic, geographical and financial literacy barriers faced by Aboriginal and Torres Strait Islander people;
- suitability of accounts: the types of accounts sold to customers, including allowing overdrafts, whose main source of income is Centrelink benefits; and
- funeral insurance: the provision and regulation of funeral insurance.
Regulation and the Regulators
After considering the outcome of the hearings, the Commissioner looked at how the relevant regulations and regulators were conducive to the misconduct being so widespread.
The Commissioner was particularly critical of ASIC. He noted that ASIC has almost always sought to negotiate with organisations who have committed misconduct, with the focus being on remediation rather than denunciation.
Specifically, the Commissioner noted that civil penalty proceedings have seldom been brought and criminal prosecutions have only ever been commenced against individuals, rather than entities. Instead, ASIC has relied upon enforceable undertakings and infringement notices as enforcement methods. Infringement notices have recovered less than $1.3 million from banks in the last ten years, an amount that the Commissioner considered had no deterring effect on the banks' conduct.
The Commissioner observed that when considering what to do in response to misconduct, ASIC's starting point has been to ask the question, "how can this be resolved by agreement?" He indicated this was unsatisfactory for a regulator and instead inferred that a decision to not bring proceedings should be the exception, rather than the rule. Whilst the Commissioner acknowledged that the finite resources available to ASIC meant that there was a limit to the litigation that could be pursued, he stated that he did not accept "that the appropriate response to the problem of allocating scarce resources is for a regulator to avoid compulsory enforcement action and instead attempt to settle all delinquencies by agreement".
The Commissioner has proposed the following issues as being worthy of further consideration and possible reform:
- the present regulatory regime: whether the current regulatory regime is too complicated and whether it impedes effective risk management and regulatory enforcement;
- codifying industry codes: whether codes such as the Banking Code of Practice be formally recognised and applied by legislation;
- ASIC: whether ASIC's remit is too large (and, if so, who would take on detached responsibilities); whether ASIC's enforcement practices are satisfactory; whether ASIC's enforcement priorities should change; and
- APRA: whether APRA's regulatory and enforcement practices were satisfactory (and if not, how they should be changed); whether APRA, after having conducted the Prudential Inquiry into CBA in late 2017/early 2018, could take further steps regarding governance, culture and accountability in other financial services entities.