Australian Prudential Regulation Authority v Kelaher 2019 FCA 1521

The Federal Court has dismissed APRA's 'best interests duty' test case against certain IOOF entities, directors and officers and ordered the regulator to pay costs.   APRA has said that has not yet made a decision on whether it will appeal.

Key takeouts

  • The Federal Court has dismissed the Australian Prudential Regulation Authority's (APRA's) case against certain APRA-regulated IOOF entities and five individuals who were responsible persons of those entities for alleged breaches of the SIS Act and prudential standards (including alleged breach of the trustee duty to exercise the requisite degree of care, skill and diligence; to act in the best interests of the beneficiaries of the superannuation funds; and to give priority to the interests of the beneficiaries in the event of a conflict of interest).  
  • Justice Jagot found that 'none of APRA’s claims of contraventions of the SIS Act against the respondents are sustainable with the consequence that there is no foundation for the making of any disqualification orders and the further amended originating application should be dismissed'.
  • APRA has not yet determined whether it will appeal.  
  • APRA Deputy Chair Helen Rowell said that despite the disappointing result, it was a worthwhile exercise.  'This case examined a range of legal questions relating to superannuation law and regulation that had not previously been tested in court, relating to the management of conflicts of interest, the appropriate use of super funds’ general reserves and the need to put members’ interests above any competing priorities…APRA still believes this was an important case to pursue given the nature, seriousness and number of potential contraventions APRA had identified with IOOF'.

On 20 September, Justice Jayne Jagot handed down her decision in Australian Prudential Regulation Authority v Kelaher 2019 FCA 1521. Justice Jagot rejected APRA's case and awarded costs against the regulator.

The decision has received a high level of media coverage, in light of the Financial Services Royal Commission (IOOF was a case study considered by the Financial Services Royal Commission) and in the context of APRA's stated forward focus on improving superannuation member outcomes.

[Note: Round 5 of the Financial Services Royal Commission Hearings included a case study concerning IOOF. Counsel Assisting suggested in closing submissions, that it may (or may not) be open to the Commission to find that Questor and IIML breached s52 of the Superannuation Industry (Supervision) Act Act (SIS Act). See: D.3 para 228-230 Financial Services Royal Commission Round 5 (Superannuation) Closing Submissions. In his final report, Commissioner Hayne said 'These proceedings having been instituted, I will say nothing about what emerged in evidence before the Commission about events and circumstances referred to in the papers filed by APRA in the Federal Court. See: Financial Services Royal Commission Final Report at p244.]

[Note: APRA's latest corporate plan lists among other things, improving outcomes for superannuation members as a key priority. For a summary see: Governance News 04/09/2019]

A high level summary of some of the issues considered in the case is below.

APRA's case

Broadly speaking, APRA alleged that two registrable superannuation entities (RSEs) within the IOOF Group of companies — IIML (trustee and licensee of various superannuation funds including IPS Super) and Questor (trustee and licensee of various superannuation funds including TPS Super) — and two of their directors, Mr Kelaher and Mr Venardos contravened their obligations under the Superannuation Industry (Supervision) Act 1993 (Cth) (the SIS Act) — s 52(2)(b) and s52A(2)(b) (due care, skill and diligence covenant); s 52(2)(c) and s52A(2)(c) (best interests covenant); s 52(2)(d) and 52A(2)(d) (conflicts covenant) and s55 Recovering loss or damage for contravention of covenant as well as prudential standards — by failing to act in the best interests of superannuation members over the course of various incidents.

For context, both IIML and Questor were dual regulated entities meaning that in addition to being a trustee of one of more superannuation funds, they were also the responsible entity (RE) for one or more managed investment schemes. Both IIML and Questor invested the assets of superannuation funds of which they were trustees in the managed investment schemes of which they were REs. As REs, IIML and Questor also acquired and held interests in those schemes.

APRA alleged that Questor and IIML failed to maintain the structures, policies and procedures required to manage conflicts of interest in their superannuation business. More particularly, APRA argued that Question and IIML contravened the SIS Act by 'differentially' compensating superannuation beneficiaries and other superannuation investors for losses caused by Questor and IIML (or their service providers) 'using their own [ie the members' own] reserve funds rather than the trustees' own funds or third party compensation'.

APRA also alleged that in rejecting a proposed fund transfer — transferring the Optus employee default superannuation arrangements from IPS Super to an AMP fund by way of a successor fund transfer — Mr Kelaher did not take steps to consider whether it was in the best interests of the relevant superannuation beneficiaries.

Finally APRA alleged that Mr Kelaher, Mr Venardos and three responsible officers of the entities Chief Financial Officer David Coulter, General Manager – Legal, Risk and Compliance and Company Secretary Paul Vine, and General Counsel Gary Riordan had refused to properly acknowledge APRA's concerns since 2015 and failed to cause Questor and IIML to take the necessary actions to ensure ongoing compliance with their legal obligations.

APRA sought disqualification orders against the directors and against Mr Coulter, Mr Vine, Mr Riordan and a declaration that IIML and Questor (which at the material times were RSE Licensees owned by IOOF Holdings Limited) breached the SIS Act.

Outcome?

Justice Jagot found that APRA failed to prove that there had been any breach of any covenant.

She rejected APRA's case on the basis that 'none of APRA’s claims of contraventions of the SIS Act against the respondents are sustainable with the consequence that there is no foundation for the making of any disqualification orders and the further amended originating application should be dismissed'.

Why did APRA's case fail?

'I have found APRA's approach unpersuasive' and 'fundamentally inadequate'

Justice Jagot commented that 'it was for APRA to prove the primary facts on which its allegations of contraventions depended. The way in which it sought to do so was fundamentally inadequate'. Some of the weaknesses identified by her Honour with respect to APRA's approach the production and presentation of evidence (overall) include the following.

Over-reliance on IOOF documentation

Justice Jagot observed that 'it was for APRA to prove its case of contraventions by such evidence as it saw fit. The fact that it has chosen to run a purely documentary case means that it must take the documents as it finds them – as documents brought into existence for specific purposes, mostly by authors whose qualifications and experience are unknown, using the benefit of hindsight, often expressed at a high level of generality, and assuming otherwise unproven knowledge of IOOF’s systems, policies and procedures'.

Insufficient detail about IOOF's actual systems and procedures to support the allegations

Justice Jagot also considered that a 'systemic weakness in APRA’s case is that it has asserted contravention of the covenants [under the SIS Act] and, in so doing, has alleged defaults and inadequacies in IOOF’s systems, policies and procedures, without descending into the detail of proving the actual systems, policies and procedures in play in respect of the incidents in question'.

More particularly, Justice Jagot found that 'APRA has not realistically confronted the need for reliable evidence of the particular factual circumstances said to give rise to the breaches of the statutory covenants…There is an evidentiary vacuum when it comes to the existing systems and procedures making it impossible to perform the kind of analysis that would be required for APRA to make good its claims'.

Use of minutes as evidence of breaches of the no conflicts covenant

APRA relied on the minutes of the meetings of the various boards all of which recorded no conflict of interest, in support its case of breaches of the no conflicts covenant. Justice Jagot rejected this approach on the basis that 'the minutes of a meeting are not required to record everything that was said…The Courts have consistently recognised that while minutes of board meetings should record decisions and resolutions made by the board, minutes are not expected to be complete transcripts of words spoken at the meeting and nor do they need to record arguments for or against resolutions'.

As such, she concluded that 'the absence in the minutes of a detailed record of discussion or consideration about matters before the board does not support the conclusion that such discussion or consideration did not occur.'

Reliance on APRA's own opinion

In addition, Justice Jagot was critical of APRA's reliance on its own expressions of opinion (either by communicating its views directly to the respondents or via policy publications) observing that 'the fact that a particular person was aware of APRA’s opinion is not relevant to the existence of any of the asserted contraventions'.

The group's alleged 'profit motive'

Justice Jagot found that to the extent that APRA’s case was that conduct was 'driven by the relevant companies saving expenditure on reimbursing beneficiaries for losses, the case theory is tenuous in the extreme'.

Reliance on res ipsa loquitur is misplaced: Commenting overall on APRA's approach, her Honour said that APRA's 'case consisted of identifying an apparent error by the trustee which may or may not have occasioned loss to the beneficiaries, asserting that the error gave rise to reasonably arguable causes of action against the trustee and IOOF Service Co, relying on IOOF documents as constituting admissions (including purported admissions as to legal conclusions), and then treating the mere fact of error and loss as a form of res ipsa loquitur sufficient to establish that the relevant respondents breached their statutory covenants'.

'Without expressly saying so APRA’s approach involved reliance on the doctrine of res ipsa loquitur when the one thing that is clear is that the facts of the incidents in question in this case by no means speak for themselves'.

Extension of legal principle?

In addition to taking issue with the way in which APRA approached the task of proving the alleged contraventions, Justice Jagot also rejected APRA's characterisation of the scope of duties of trustees under the SIS Act.

'APRA has effectively cast the trustees in the role of insurer to the beneficiaries, which is contrary to principle. APRA has also sought to extend legal principle by applying the kind of requirements to which a trustee is subject in deciding whether or not a beneficiary is entitled to a payment out of the trust, a circumstance in which the trustee is bound to give proper consideration to the relevant information and if necessary obtain relevant information to fulfil its trust duty, to the day-to-day decisions which a trustee of a large fund must make in the administration of the trust. APRA has not explained why this extension of legal principle is warranted and…I am unpersuaded that it is warranted' she writes.

Care, skill and diligence covenant — discussion of the scope of the covenant

Acting in the best interests of members? The application (or not) of Finch v Telstra Super Pty Ltd (2010) 242 CLR 254?

Justice Jagot comments that a 'consistent theme of APRA’s case is its attempts to draw an analogy between the kind of decision with which Finch v Telstra was concerned, and the kinds of decisions which the trustees were making in the present case'. APRA argued that Finch v Telstra is authority for the principle (among other things) that knowingly excluding relevant information from consideration or failing to seek relevant information in order to resolve a conflict is a breach of a superannuation trustee's obligation to act in the best interests of members.

'I am not persuaded that the analogy is sustainable'

But, Justice Jagot observed that in effect APRA was seeking to extend 'the principle applying it to decisions about entitlements to any and all matters potentially affecting the capital of the trust'. She observed that 'there must be a myriad of decisions taken every day by trustees of large superannuation funds which potentially affect the fund both materially and immaterially. The extension of the principle which APRA proposes appears onerous in the extreme and highly impractical'.

Justice Jagot writes, 'APRA’s case, insofar as it relies on Finch v Telstra to suggest that the relevant respondents were making non-discretionary decisions and had to obtain information, such as independent legal advice, before they could make a decision is unpersuasive and not supported by authority. The core trustee duty of determining whether a beneficiary has an entitlement is not analogous to a decision as to whether or not a chose in action, such as the right to make a claim for loss, should or should not be pursued. The latter decision is more akin to an exercise of discretion because it involves a potentially wide range of relevant considerations and an evaluation of all of those considerations including the amount at stake, the prospects of success, the practical and legal issues which will be confronted, and the available alternatives (at the least). Accordingly, I do not accept a fundamental plank in APRA’s case that the alleged existence of causes of action or reasonably arguable causes of action imposed on the trustee a duty to “exhaust” consideration of the potential choses in action and to inquire and obtain further information if any such further information was necessary to enable that exhaustive consideration to be given' Her Honour states.

In Justice Jagot's view 'A decision which is taken to ensure and is objectively in the best interests of beneficiaries at the time it is made does not lose that character because, at that time, more information could have been obtained…It will frequently be the case that there is more than one course of action which may be regarded as being in the best interests of the beneficiaries. The test is objective and is to be applied prospectively, that is, from the position of the trustee at the time of the decision, without impermissible hindsight'.

Further, she observed that 'As far as I am aware, there is no authority that supports this proposition as some form of rigid principle which is to be applied irrespective of the circumstances of the particular case'.

(Alleged) misuse of the reserves?

APRA argued that The Operational Risk Financial Requirement (ORFR) and the general reserve constituted 'members' money' and therefore could not properly be used to compensate members for losses caused by other companies in the IOOF group or a third party.

More particularly, APRA argued that in deciding to use the ORFR the trustee and its directors were bound by ss 52 and 52A. As such, any decision to use the reserve 'must be made in the best interests of beneficiaries and that cannot be the case where there are other sources of compensation available, outside of the trust fund, that are not being considered and pursued'.

The ORFR is not 'members' money'

In rejecting APRA's argument, Justice Jagot observed that 'it is misconceived and a complete mischaracterisation to describe the ORFR as “members’ money”…it is money in a dedicated fund, held in accordance with the provisions of the SIS Act, for the express purpose of paying compensation to members for losses arising from operational risk, including risks arising from the trustee’s conduct. Using that fund to compensate members in such circumstances does not involve compensating members with their own money in any relevant sense; rather, it is to use the fund for the very purpose for which it was created'.

Likewise, Justice Jagot was unpersuaded that the 'general reserve' could not be used for the purposes for which they were established and are maintained, including compensation of members.

Her Honour writes 'APRA has sought to put a gloss on the use which may be made of the ORFR to the effect that it is available to reimburse members for losses but only when consideration of all other potential avenues for redress have been exhausted. Further, in oral submissions APRA said that any use of the ORFR or the general reserve to reimburse members could not be considered to be “compensation” of the members for loss because they were being given their own money…The propriety of the use of the ORFR (and any reserve) is to be determined by the statutory scheme and the instruments and policies which regulate the use of the reserve. APRA’s construct is not founded on anything in those documents and must be rejected. This undermines a large swathe of APRA’s case, founded as it is on the impropriety of the respondents’ conduct in proposing the use of or using the ORFR to reimburse members for certain losses'.

No legal principle supports this view?

Elsewhere in the judgment, her Honour expands on the duty of a trustee to 'get in trust property'. Her view is that 'APRA has sought to graft onto the duty of a trustee to get in trust property the notion that this duty extends to pursuing to the point of "exhaustion" every possible claim, regardless of its legal or practical complexity or its prospects of success. I agree with the first respondent that: The consequences of this error for APRA’s closing submissions is profound. In many respects, the entire architecture of APRA’s new case regarding the Pursuit, Sweep, CMT and Bendigo matters depends on the correctness of its assertion that pursuing choses in action is an incident of the trustee’s duty to get in trust property. The rejection of the proposition leaves those cases without any clear basis in legal principle'.

Reliance on management?

APRA submitted that 'it is no longer the law that directors can rely upon officers without verification', but Justice Jagot found that this 'goes too far'.'As the first respondent submitted there are many circumstances in which a director is entitled to rely on management provided that there are not circumstances from which the director knew or ought reasonably to have known that such reliance was misplaced' Justice Jagot writes. With respect specifically to directors' oversight of compensation plans, Justice Jagot rejected what she described as 'APRA's attempt to label compensation plans as matters uniquely within the sphere of responsibility of directors'.

No actual conflicts proven?

APRA alleged that the conflicts of interest arising from IOOF Group's 'conflicted' structure, were not managed in the particular circumstances, and these conflicts led to various breaches of statutory obligations.

More particularly, APRA alleged that the corporate and governance structures of the IOOF Group (as distinct from the structure of IOOF Group itself) gave rise to potential conflicts between: a) the interests of beneficiaries and the obligations to beneficiaries of each of IIML and Questor in its capacity as trustee and licensee of the relevant superannuation entity; and b) the interests of other entities in the IOOF Group, or of individuals within it, or the obligations of IIML, Questor and their responsible officers to other persons.

[Note: The diagrams in Annexure A to the judgement show that the IOOF Group resulted from the merger in 2009 of AWM Ltd and IOOF Holdings Ltd, referred to as IOOF Hold Co. The post-merger structure, and relevant directors, officers and employees are shown on p 2 and p 3 of Annexure A. Page 4 of Annexure A shows the different capacities in which the various entities in the IOOF Group acted and the locations within the structure where the alleged contraventions arise. Annexure A can be found at the end of the judgement here.]

For example, APRA alleged that Mr Kelaher as managing director of IOOF Hold Co, Questor and IOOF service Co has a conflict between his duties to superannuation beneficiaries under s52A and his duties to non-superannuation investors.

Justice Jagot found that APRA failed to establish that any actual conflict existed. 'APRA’s contentions about conflicts of interest remained at the level of theory. That is, as will become apparent, APRA has not established the necessary factual foundation to support the conclusion that any actual conflict of interest existed…Its case on the no conflicts covenant exists at a level of generality and theory which is inapt to make the case it apparently wants to make'.

Exclusion of liability? IIML and Questor could not be exempted from liability for contraventions of the s52 covenants

Though ultimately no breach of any covenant was proven, Her Honour did consider the operation of the right of indemnity under the Act.

APRA argued that despite their governing rules IIML and Questor could not be exempted from liability for contraventions of the s 52 covenants and could not indemnify themselves from the assets of the trusts in respect of liability for such contraventions.

In support of this, APRA contended that:

  1. s 55 does not provide that it is a defence to liability to rely on an exemption or indemnity in a trust instrument;
  2. s 55 cannot be modified or excluded by a trust instrument. If it were otherwise, s 55 would not apply according to its terms as provided for in s 7;
  3. the object in s 3 reinforces this approach to the construction of s 55;
  4. s 56 preserves a trustee’s general right of indemnity out of the trust assets for liabilities incurred in the proper performance of its duties or exercise of its powers;
  5. ss 56(2) and 57(2) do not specify the universe of limitations on the provisions of a trust instrument; and
  6. the terms of the provisions, in the overall context of the SIS Act, mean that no provision of a trust instrument can purport to exclude or modify liability under s 55(3).

The respondents contended that the governing rules of the trusts, in conformity with the SIS Act, excluded liability for the alleged contraventions of the s 52 covenants and enabled IIML and Questor to indemnify themselves from the assets of the trusts in respect of any such liability.

Justice Jagot found that though 'resolution of this aspect of the dispute' is not straightforward, on balance, APRA's approach better reflects the provisions construed in the context of the SIS Act as a whole.

APRA's response to the decision

In a statement noting the judgement, APRA said that it is 'examining the lengthy judgment in detail and will then make a decision on whether to pursue an appeal'.

Although disappointed by the decision, APRA Deputy Chair Helen Rowell said that despite the result, the regulator considers that it was a worthwhile exercise. 'This case examined a range of legal questions relating to superannuation law and regulation that had not previously been tested in court, relating to the management of conflicts of interest, the appropriate use of super funds’ general reserves and the need to put members’ interests above any competing priorities. Litigation outcomes are inherently unpredictable, however APRA remains prepared to launch court action – where appropriate – when entities breach the law or fail to act in an open and cooperative manner. APRA still believes this was an important case to pursue given the nature, seriousness and number of potential contraventions APRA had identified with IOOF' Ms Rowell said.

Ms Rowell went on to say that despite the decision, APRA's tougher approach to enforcement had led to IOOF being better placed to deliver sound, value-for-money outcomes for its members. 'APRA has seen significant improvement in the level of cooperation from IOOF since this case was launched. Additionally, the new licence conditions have enhanced IOOF’s organisational structure and governance, including the role and independence of the trustee board within the IOOF group. This will better support effective identification and management of future conflicts of interest'.

[Source: APRA media release 20/09/2019]

IOOF's response to the decision

In a short statement welcoming the decision and confirming the court's conclusion that neither IOOF's APRA regulated entities or the five individuals named in the proceedings contravened the SIS Act, IOOF said that it is currently reviewing the written judgment in detail and expects to issue a further announcement in due course.

[Source: IOOF ASX Announcement 20/09/2019]

A loss for APRA but not an endorsement of IOOF's approach to managing conflict?

Professor Michael Adams is quoted in the AFR as cautioning that the result should not be interpreted as an endorsement of IOOF's approach. 'This is a technical win due to the incompetence of the regulator…Financial services entities and businesses would be very naive to interpret the decision otherwise…That would be very dangerous.'

Further, Professor Adams reportedly opined that though APRA failed to make out its case, it does not mean that no breaches occurred. '[IOOF's] decision to use members' funds instead of [its] own funds remains a conflict of interest with director's duties…The conduct on the face of it goes against the relevant superannuation legislation. That is supported by testimony at the royal commission' he is quoted as saying.

With respect to the possibility of an appeal by the regulator, Professor Adams reportedly said 'I certainly think they should be looking at an appeal'.

[Source: [registration required] The AFR 24/09/2019]