International developments in outsourcing point to future direction in Australia

As a body for securities regulators globally, the International Organization of Securities Commissions is an important standard setter for compliance, including in respect to the work of the Australian Securities and Investments Commission (ASIC). Given policy development in respect to outsourcing in Australia in recent times, IOSCO’s recent consultation in this area is a valuable pointer to regulation which may arise in Australia. Having initially delayed its planned consultation exercise to allow the financial services sector to focus on responding to Covid-19, IOSCO subsequently found the pandemic a catalyst to proceed. Therefore, at the end of May, IOSCO launched its consultation on proposed updates to the 2005 Outsourcing Principles for Market Intermediaries and the 2009 Outsourcing Principles for Markets; feedback on the proposed  new Outsourcing Principles (OPs) are requested on or before 1 October 2020. The decision to proceed reflects the acknowledgement that outsourcing is a key element for consideration when assessing operational resilience across the sector.

This post gives a high level summary of the consultation before focusing on the definition of outsourcing used by IOSCO, intragroup arrangements, concentration risk, and access and audit rights. To provide additional context, the IOSCO proposals considered alongside some country/region-specific examples. Followers of the outsourcing theme may not be surprised that IOSCO does not resolve the challenges associated with the focus topics. The post concludes with a focus on developments in outsourcing regulation in Australia.

 

Introduction

In common with some regional and national authorities among its membership, IOSCO has found that much has changed since its original efforts to define universal principles for outsourcing, not least the move towards use of cloud and the increased speed of markets. What has not changed in the view of IOSCO, and many other regulators across the globe, is that regulated entities retain full responsibility, legal liability, and accountability to the regulator for all outsourced tasks.

Clearly cloud has been a factor driving regulators to revisit their existing guidelines. However, it is clear that consideration of how cloud technologies may be used in the financial services sector has not prompted a fundamental rethink on firms’ responsibilities – much as some may have hoped this would be the case. Similarly, the ‘technology neutral’ mantra remains firmly in place, and some authorities have consulted on or have guidelines for cloud specifically, for example, the European Banking Authority (EBA) and the Australian Prudential Regulation Authority.

Increased and increasing reliance on third party providers is drawing greater regulatory focus as supervisors look to ensure the operational resilience of regulated entities – a condition that is unlikely to change anytime soon, particularly in light of the lessons being learnt under Covid-19. In this consultation, IOSCO explains that, ‘operational resilience refers to the ability of regulated entities, other firms such as service providers, and the financial market as a whole to prevent, respond to, recover, and learn from operational disruptions.’

 

An overview of the IOSCO proposals

The OPs comprise a set of ‘fundamental precepts’ covering issues such as the definition of outsourcing, the assessment of materiality and criticality, their application to affiliates, the treatment of sub-contracting and outsourcing on a cross-border basis. They also include seven principles, each of which is supplemented with guidance for implementation, covering:

  • Due diligence in the selection and monitoring of a service provider.
  • The contract with a service provider.
  • Termination of outsourcing arrangements.

The seven principles also cover information security, business resilience, continuity and disaster recovery, confidentiality issues, concentration of outsourcing arrangements, and access to data, premises, personnel and associated rights of inspection.

 

Scope of application – securities markets and FMIs

As noted above, IOSCO is the international policy forum for securities regulators and the global standard setter for securities regulation. Given this context, two fundamental caveats are:

  • The OPs are unlikely to be directly applicable in many, if any, jurisdictions; individual jurisdictions and/or authorities must legislate and/or regulate for implementation of the OPs by regulated entities in their jurisdictions. It is very likely that as part of the process of adoption, jurisdictions and/or authorities will apply their own filter or overlay to the OPs themselves or to their enforcement of standards which comply with the OPs.
  • The OPs have been developed in the context of securities markets.

The scope of application includes trading venues, intermediaries and market participants, credit rating agencies (CRAs) and financial market infrastructures (FMIs).

As is the practice with global standard setters, IOSCO accommodates jurisdictional differences in its definition of scope. For example, “intermediaries and market participants” includes “regulated entities, other than those that are trading venues, that are in the business of some or all of the following:

  • executing orders in, or distributing, securities or derivatives;
  • proprietary trading or dealing on own account;
  • receiving and transmitting orders from or to third parties;
  • providing advice regarding securities or derivatives or the advisability of purchasing or selling securities or derivatives; and
  • underwriting of new issues or products.

IOSCO’s definition of FMIs references (as a footnote) the Principles for FMIs which IOSCO penned in collaboration with the Committee on Payments and Market Infrastructures (CPMI). As such, the OPs appear to be intended to apply more widely to include payment systems.

The definition of outsourcing

As might be anticipated from a global standard setter, IOSCO spends some time in discussing the characteristics of outsourcing. What may be most helpful is to understand that the OPs are, ‘written to apply to outsourced tasks that pose risks to regulatory objectives.’

Outsourcing is described as, ‘a business practice in which a regulated entity uses a service provider to perform tasks, functions, processes, services or activities … that would, or could in principle, otherwise be undertaken by the regulated entity itself [although it is not a prerequisite that the entity should have previously performed a task for it to be considered as outsourcing]. This may also be referred to as onshoring, offshoring, near-shoring or right-shoring, depending on the organisational context and the relationship with affiliates and service providers.’ The OPs apply to both extra- and intragroup arrangements.

IOSCO’s approach also incorporates a principle of proportionality as it acknowledges that, ‘interpretation or implementation … should correspond to the degree of materiality and criticality of the outsourced task to the regulated entity’s business and its regulatory obligations…’ That the IOSCO OPs adopt a risk-based approach to the categorisation of outsourcing, applying the terms ‘material’ and ‘critical’ for the most important outsourcing arrangements and acknowledging the subjectivity of that assessment reflects the approaches taken by some member jurisdictions, including the EU and UK. IOSCO says that, ‘In simple terms, a material task is one that comprises or affects a significant proportion of the tasks of the regulated entity; a critical task may be a task that is small in scale but without which the regulated entity is unable to conduct its activities.’

 

Intragroup arrangements

The OPs will apply regardless of whether the service provider performing the tasks is ‘an affiliated entity of a corporate group’ or external. While acknowledging that the risks may be different, IOSCO’s commentary in the consultation should dissuade anyone from the view that intragroup outsourcing in inherently less risky and that intragroup arrangements will be viewed as such by regulators.

 

Concentration risk

Principle 5 in the OPs addresses concentration risk, articulating two aspects – in the first case, where the regulated entity is dependent on a single service provider for material or critical tasks and, in the second case, where the regulated entity ‘is aware that one service provider provides material or critical outsourcing services to multiple regulated entities including itself.’

In common with much of the regulatory cannon on risk management, IOSCO expects that firms will conduct ‘ongoing, periodic reviews of service provider capacity’. While this is difficult to challenge at the hypothetical level, in practice firms are likely to have very little insight into the build-up of concentration risk with a particular service provider. Key performance or risk indicators (KPIs/KRIs) may serve as a proxy for potential concentration risk issues and should trigger the regulated entity to conduct some inquiries, but KPIs and KRIs are unlikely to be conclusive. It would be difficult to construct e a KRI which tracks concentration at a service provider.

 

Access and audit rights

A thorny issue, particularly in respect of use of cloud technology, arises with access and audit rights. IOSCO’s Principle 6 reads: ‘A regulated entity should take appropriate steps to ensure that its regulator, its auditors, and itself are able to obtain promptly, upon request, information concerning outsourced tasks that is relevant to contractual compliance and/or regulatory oversight including, as necessary, access to the data, IT systems, premises and personnel of service providers relating to the outsourced tasks.’

Firms and service providers may argue that access to systems, premises, etc. can be difficult in practice for some types of outsourcing arrangements – notably, this comment is often made in relation to cloud services. Firms may also point out that their ability to negotiate for some outsourcing services may be limited if the market concerned has a small number of providers; again, a comment that is frequently made in respect of cloud services. This is reflected in the research on CRA use of cloud outsourcing which is appended to the IOSCO consultation.

In response, regulators tend to point out that if access is not practicable, then this presents a challenge to their ability to supervise the firm appropriately. Regulators may also remind firms that outsourcing a task does not mean that the firm can divest or lessen its own responsibility for compliance. This tension for regulated entities between maintaining compliance while also taking advantage of technology looks set to continue unless there is intervention from the official sector.

As IOSCO needs to accommodate its members, the global standard setter appears to provide for some  flexibility in its OPs. For example, reference is made to use of pooled audits and/or assurance statements. Similar allowances are made in guidance issued by the UK’s FCA. However, this is somewhat untested as, for example, in the UK there are no published enforcement cases related to outsourcing failures which discuss use of pooled audits or assurance statements. The suitable, or otherwise, of such arrangements is likely to be tested in the context of the individual regulated entity’s supervisory relationship which is unlikely to be publicly disclosed and/or enforcement.

 

Regulatory policy on outsourcing in Australia

Australian financial services and markets regulation has sought to cover outsourcing for many years, and the level of prescription and regulatory focus has increased substantially in recent times. Since 2007, ASIC has published policy in relation to the responsibility of Australian financial services licensees for services they outsource, and the Australian Prudential Regulation Authority (APRA) has issued Prudential Standard CPS 231 Outsourcing in 2002 to ensure management of prudential risks in the outsourcing of material business activities by authorised deposit-taking institutions (ADIs). These pronouncements have been reinforced by regulation and guidance in relation to information technology, such as:

  • ASIC benchmarking of cyber resilience of firms in Australia’s financial markets in Report 555 (November 2017);
  • ASIC’s revised policy on outsourcing by financial market operators in Regulatory Guide 172: Financial markets: Domestic and overseas operators (May 2018);
  • APRA Information Paper Outsourcing Involving Cloud Computing Services which classified the risks of cloud computing services into three categories, and set out APRA’s expectation for consultation for each of these (September 2018); and
  • APRA Prudential Standard CPS 234 Information Security, set out requirements for prudentially regulated institutions to take steps to enhance information security resilience (July 2019).

In 2019, ASIC conducted a consultation on proposed market integrity rules for securities and futures market operators and participants which, among other matters, explored the imposition of requirements regarding outsourcing arrangements for critical systems and the implementation of controls regarding such outsourcing. ASIC’s proposals seek to create obligations on regulated entities regarding notice of outsourcing to ASIC, conduct of appropriate due diligence on outsourced providers, terms of the outsourcing agreement and information access and audit rights. As part of this consultation ASIC also considered implementing obligations on operators regarding information security and cyber risk, reflecting a heightened focus on data protection and the criticality of data integrity to stable, efficient and effective operation of financial markets.

We expect that the focus of ASIC on outsourcing, and especially information technology outsourcing, will continue into the future, and that it will be informed by the IOSCO outsourcing consultation internationally and APRA regulation domestically. We also expect that the outcomes of the 2019 ASIC consultation will have regard to the IOSCO outsourcing principles, and that the ASIC consultation may be delayed further to achieve this.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Katherine Gregor
Katherine Gregor
Partner
+61 3 9288 1663
Steven Rice
Steven Rice
Special Counsel
+61 2 9225 5584

Regulatory “Rinkles” – Spotlight on Transitional Issues for Grandfathered Conflicted Remuneration

This edition of Regulatory Rinkles follows on from our previous edition on Spotlight on Conflicted Remuneration and focuses on the transitional issues facing product issuers and advice licensees who are looking to end or deal with their existing grandfathered arrangements before the grandfathering exemption is removed from 1 January 2021.

LEGISLATIVE BACKGROUND – THE END OF FOFA GRANDFATHERING

The current exemption from the ban on conflicted remuneration enjoyed by many grandfathered arrangements will be removed from 1 January 2021, following the enactment of the Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Act 2019 (Cth) (EGCR Act)[1] and the Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Regulations 2019 (Cth) (EGCR Regulations).[2]

Section 1528 of the Corporations Act 2001 (Cth) (Corporations Act) has been amended to provide that, from this date, the prohibition on conflicted remuneration will apply:

“…to a benefit given on or after 1 January 2021 to a financial services licensee, or a representative of a financial services licensee, if the benefit is given under an arrangement entered into before, on or after the application day” (emphasis added).

The “application day” is 1 July 2013, which is the date from which compliance with the FoFA package of legislation that introduced the prohibition on conflicted remuneration became mandatory.

It should be noted that a new “pass-through” regime will co-exist with the prohibition on the payer continuing to pay the relevant conflicted amounts and the recipient continuing to receive those amounts, provided the amounts are passed through to product holders under the requirements of the pass-through scheme (see below).

It should also be noted that the amending legislation does not remove the separate life insurance (or LIF) grandfathering exemption that is provided under section 963B of the Corporations Act for life products entered into, or applied for, prior to 1 January 2018. This exemption is due to be reviewed by ASIC in 2021, but continues for the time being.

PASS-THROUGH SCHEME FOR PAYMENTS OF CONFLICTED REMUNERATION

Introduction

To help mitigate the effects of the end of the grandfathering regime on persons who are legally obliged to continue to pay monies or other benefits under existing contractual arrangements after 1 January 2021, which will now be banned conflicted remuneration, the Corporations Regulations 2001 (Cth) have been amended to provide for a scheme for these benefits to be paid to the ultimate product holder.

In essence:

  • product holder rebates must be provided within a year of the obligation to pay conflicted remuneration arising; and
  • the amount to be rebated must be objectively “just and equitable” in the circumstances, and can be paid as an amount of money directly to the product holder or by providing some other benefit, such as reducing a fee the product holder is liable to pay.

It should be noted that the pass through scheme applies only to conflicted remuneration for the purpose of section 963A of the Corporations Act. It does not apply to volume-based shelf-space fees that are prohibited under section 964A of the Corporations Act, and in respect of which the EGCR Act will also end the current grandfathering regime from 1 January 2021.

The “just and equitable” requirement

The term “just and equitable” as used in the EGCR Regulations is not defined, but the concept may usefully be compared to other similar statutory legislative concepts, such as the “fair and reasonable” requirement under the superannuation regulations in relation to a superannuation trustee’s obligations when charging fund expenses to members.[3]

EGCR Regulation 7.7A.15AK(3) provides that certain matters must be taken into account when determining whether amounts to be paid are just and equitable, as follows:

  • the amount of conflicted remuneration that would have been payable;
  • the amount invested by each product holder in the financial products. The Explanatory Statement to the EGCR Regulations notes, not surprisingly, that the larger the investment, the larger the rebate should be;
  • the structure of the fees that the product holders have paid in respect of the financial products. The Explanatory Statement states this is relevant to whether the product holder has incurred the cost of the conflicted remuneration;
  • the extent to which the amounts to be paid and the amount of benefits to be provided to product holders equals the amount or present value of the conflicted remuneration paid; and
  • any other relevant matters, but noting that the Explanatory Statement states that a lack of information or records is not a relevant matter that can be taken into account.

The Explanatory Statement provides the following additional guidance on the assessment of what is just and equitable:

  • in recognition of the practical difficulties that can be inherent in the process of calculating the amount of conflicted remuneration paid, the total aggregate amount of the rebate need not exactly match the conflicted remuneration that would otherwise have been paid, but must closely match it;
  • in practice, overcompensation will generally be expected as it is expected that the situations where it would be just and equitable to rebate less than the conflicted remuneration paid will be rare;
  • where the cost of conflicted remuneration has been spread out across an entire cohort of product holders, but the conflicted remuneration only relates to advice provided to a smaller cohort of product holders, it will be just and equitable to provide a rebate to the entire group of product holders;
  • in some situations, it may be appropriate to pay a one-off lump sum to clients to reflect the present value of future conflicted remuneration. However, this is unlikely to be just and equitable if there is uncertainty about the total amount of conflicted remuneration to be paid over the period the product is held;
  • the costs of rebating the monetary benefit back to product holders (such as the administrative costs involved) cannot be taken into account in determining whether an amount is just and equitable; and
  • there may be situations where a product holder holds a financial product on behalf of another product holder, in which case it is expected that the ultimate owner of the product will receive the benefit of the rebate.

Some additional observations

  • As the rebate obligation applies to “covered persons” under the EGCR Act, the obligation can apply not only to product issuers but also to licensees who pay benefits to their representatives.
  • While primarily concerned with the rebate of monetary benefits, the regime will extend to cover non-monetary benefits as well (given that it relates to conflicted remuneration). This flows from:
    • the definition of section 963M(1)(a) of the Corporations Act, relating to a person who is legally obliged to give conflicted remuneration on or after 1 January 2021; and
    • section 963N(1) of the Corporations Act, whereby a covered person must pay amounts or monetary benefits based on the conflicted remuneration.
  • Determining the amount of a non-monetary benefit to be rebated will presumably require a valuation of that benefit to be made, which can then be converted into an amount which satisfies the “just and equitable” criterion.
  • In relation to record keeping, it is beyond the scope of this article to canvas all the stipulated record keeping objections but in general terms, records will need to be maintained in order to show:
    • how the just and equitable assessment has been made, including assessments of the amounts of conflicted remuneration paid; and
    • compliance with the requirement to pay rebates within 12 months of the obligation to pay the conflicted remuneration arising.

OPTIONS AND TRANSITIONAL ISSUES FOR GRANDFATHERED ARRANGEMENTS

Product issuers and licensees have the following options (among others) to deal with their existing grandfathered arrangements:

  • rely on provisions in existing contractual agreements that have the effect of permitting the relevant party to cease the payment of grandfathered remuneration from 1 January 2021, such as provisions that provide that payments can cease where change in law will make such payments prohibited, or where payments can be varied and reduced to nil. It is unlikely that a party will be able to assert that the prohibition results in the arrangement being terminated through the doctrine of frustration (however, this will ultimately be a question of construction);
  • where the above types of contractual provisions do not exist, then the parties may instead agree a variation that removes the contractual right to pay conflicted remuneration. Both parties will have the same interest in avoiding being exposed to the prohibition from 1 January 2021, given that it applies to both the payment and receipt of conflicted remuneration;
  • where there is an ongoing contractual obligation to pay grandfathered remuneration that is not varied and does not automatically cease by these payments becoming prohibited, or there is a commercial desire to continue to pay notwithstanding any contractual rights to the contrary, then a product holder rebate scheme may be used;
  • seek to render the payments non-conflicted by relying on applicable exemptions under the Corporations Act, or by relying on no-action positions from ASIC (see below);
  • alternatively, seek to render the payments non-conflicted by negating the relevant influence element, thereby taking the payments outside of the definition of conflicted remuneration; and
  • product issuers may wish to stop making grandfathered payments ahead of the 1 January 2021 date, by making lump sum accelerated payments to reflect payments that will become due up to 31 December 2020. Although this gives rise to certain legal issues that need to be navigated, they can be addressed with proper planning.

ENDING GRANDFATHERED PAYMENTS EARLY

The risk in attempting to agree the amount of an early lump sum payment, assessed up to 31 December 2020, is that this amount may well be inaccurate and so be either:

  • an underpayment of the amount due, in which case the product issuer may be obliged to make a corrective payment before it becomes unlawful to do so from 1 January 2020, which may well be commercially unattractive; or
  • an overpayment of the amount due, in which case the licensee will need to reimburse any overpayment.

At present, any overpayment would create the risk that each party would, at the time of the making and receipt of the overpayment, be in breach of the conflicted remuneration provisions of the Corporations Act as these amounts would be in excess of the grandfathered payments.

One solution to this problem would be for the parties to enter into a deed of variation which provides for a lump sum advance payment to be made at the nominated date that is assessed at a level that is a slight overpayment of its assumed liability as at 31 December 2020, so long as the parties agree to amend their existing arrangement to provide that:

  • the payment does not fall due to be paid until 31 December 2020;
  • the advance payment is an agreed estimate of this liability; and
  • the parties agree a process by which the final total amount due will be assessed immediately prior to 31 December, with the licensee remitting the relevant balance due prior to that date.

An alternative, if a formal deed of variation is not practical, would be to rely on the broader concept of consent by the licensees to the variation and the arrangements by way of acceptance of them through the conduct of accepting the accelerated payment.

In our view, a variation to an original agreement that is required to give effect to either scenario is unlikely to constitute a new, non-grandfathered agreement.

ALTERNATIVE CHOICES AVAILABLE

Of course, a clear choice open to a payer of grandfathered conflicted remuneration is to transform conflicted payments into non-conflicted payments. As mentioned above, this could be done by either relying on existing exemptions in the Corporations Act (including for present purposes, no-action positions from ASIC, which include its pronouncements made in ASIC RG 246) or by taking the payments outside of the conflicted remuneration regime by negating the influence on the provider of the financial product advice.

In our view, where this is done appropriately and for a proper purpose, it will not amount to a breach of the anti-avoidance provisions in section 965 of the Corporations Act.

Using existing exemptions and no-action positions

For example, consider the following scenarios where money is currently paid by a product provider to a licensee under a grandfathered arrangement:

  • The payment is retained by the licensee

Where the licensee passes on all the benefit of the payment to the relevant clients, then this is unlikely to be conflicted as the influencing effect of the payment is removed.[4]

  • The payment is paid from the product issuer’s pockets but it is restructured so that it is paid by the client from the client’s monies

In this scenario, it is submitted that this is not anti-avoidance and would be outside of the concept of conflicted remuneration where the so-called client paid exemption is used (as provided for in section 963C(1)(d) of the Corporations Act).

What about a situation where the payment is made by a provider in circumstances where personal advice has been given by the product issuer? Section 963B(1)(c) of the Corporations Act exempts the making of payments given in relation to the issue or sale of a financial product so long as the relevant retail client has not received any financial product advice in the 12 months preceding the payment being made.

Leaving aside the issue of whether reliance on an exemption is outside the reach of an anti-avoidance prohibition, it is submitted that the structuring of payment obligations to take advantage of this exemption is permissible and should not be anti-avoidance. That said, as always, each situation will need to be considered on its own facts.

Rendering the payments non-conflicted

The core of the conflicted remuneration prohibition is the definition of the term contained in section 963A of the Corporations Act which, as we know, refers to benefits, which because of either the nature of the benefit or the circumstances in which the benefit is given, could reasonably be expected to influence the choice of financial products recommended by the licensee or representative to clients ,or could reasonably be expected to so-influence the financial product advice given.

Completely neutralising influence on an adviser is harder than it might appear, particularly since the conflicted remuneration regime does not contain, or allow, any concept of materiality.

In practice, this means that when influence could exist, rigorous controls would need to be put in place to neutralise any potential influence. This could include:

  • independent research as to the quality of the products being recommended;
  • training of advisers about the primacy of their best interests obligations under the Corporations Act, including prioritising the interests of clients;
  • file recording and auditing to ensure compliance; and
  • remuneration elements to disincentivise non-compliant behaviour.

 

[1] A link to the EGCR Act is here.

[2] Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Regulations 2019 (Cth) (link here), which introduce new provisions into the conflicted remuneration regime contained in Division 4 of Part 7.7A of the Corporations Regulations 2001 (Cth).

[3] See regulation 5.02 of the Superannuation Industry (Supervision) Regulations 1994 (Cth). It is also further evidence of the prevalence of a fairness doctrine in financial services law, as we have previously commented on here.

[4] See ASIC RG 246 at 246.95.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Philip Hopley
Philip Hopley
Special Counsel
+61 2 9225 5988
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160

Spotlight on Regulatory Risk in Financial Services

This edition of our FSR Australia Notes focuses on the concept and dimensions of regulatory risk.

We see this as an increasingly important area of financial services regulation, as following the Financial Services Royal Commission, a financial institution’s relationship with the regulators is particularly paramount.

There are many factors underpinning this observation, including the more prominent role of community expectations and the related issue of regulatory reputation. This latter concept has been given legislative recognition under the Banking Executive Accountability Regime (BEAR) (with the accountability obligation to deal with APRA in an open, constructive and co-operate way) and will likely also be reflected in similar terms in the proposed Financial Accountability Regime (FAR). This recognition was without precedent in Australian statute law.

Concept of Regulatory Risk

We start the discussion by tackling the concept of “regulatory risk” itself.

“Regulatory risk” for these purposes is the uncertainty associated with whether a regulator will take an interest in particular activities of a financial institution, leading to the possibility of action by that regulator.

The term can be defined with more granularity by reference to, and contrast with, the concept of “legal risk”.

Legal risk is, of course, the risk in relation to whether certain activities comply with the relevant legal requirements.

By contrast, regulatory risk encompasses legal risk but transcends legal risk in one of at least four major respects as follows:

  • the regulator could disagree with a particular legal interpretation and adopt a contrary or different legal interpretation;
  • the regulator could focus on criteria beyond the legal position, such as customer centricity or community expectations;
  • outside of either of the above scenarios, the regulator seeks to enforce its particular view of conduct of the financial institution, regardless of the actual legal position; or
  • reputational risk, where the relevant regulator is looking into the conduct or activities of the relevant financial institution.

Drill-down into Regulatory Risk

The different limbs of regulatory risk canvassed above require further consideration.

With respect to the risk that a regulator will take a different legal interpretation, the way in which financial institutions engage and react with the regulator will depend on the particular matter. This is a particularly important area of regulatory risk, noting an increased desire from regulators after the Royal Commission to run “test cases” on points of financial services law.

The strength of the relevant legal opinion/interpretation held by an institution is a useful starting point. The greater the strength of the legal opinion, the greater the way in which the institution can engage in good faith with the regulator to seek to arrive at common ground.

Sometimes, it will make sense for the institution to obtain an opinion from Senior Counsel, which may or may not then be provided to the regulator, noting the legal privilege dimensions here.

In general terms, a bona fide and strong legal opinion provides a good basis for engaging with the regulator, and seeking to arrive at a consensual outcome. This applies regardless of whether the regulator is projecting an image of “toughness” or focussing on enforcement: no regulator can act outside its powers, and a financial institution having a strong legal opinion about its position starts engagement with a regulator from a position of equivalent strength.

The second scenario relates to where the regulator might seek to look beyond the legal position, regardless of whether it agrees with the legal interpretation of the financial institution. In particular, there is an increasing trend for the relevant regulator to look beyond the strict black letter legal position. Further, this focus might be expressed in terms of the need for the institution to focus on customer’s interests, often expressed as customer centricity.

Naturally, as lawyers, we cannot help but consider whether such a focus has a wider legal foundation. In this context, concepts such as “community expectations” can be examined, although this latter concept is still not tied to an enforceable legal obligation.

One needs to go to the next level and consider whether the regulatory point connects to, and is supported by, a more fluid legal obligation, such as the obligation of the financial services licensee to carry out the relevant financial services, efficiently, honestly and fairly in accordance with section 912A of the Corporations Act. It is true that an obligation such as efficiency, honesty and fairness can be affected and moulded by community expectations.

Similarly, where legal remedies are conferred on consumers by pieces of legislation, such as under the AFCA jurisdiction, then obligations such as the obligation to act fairly and reasonably might be seen as interacting in this space.

This discussion then leads into the third limb raised above, which is where the relevant regulator may seek to enforce a position without specific reference to either a legal interpretation or a wider concept of fairness. This scenario really enters into the realm of negotiation with the regulator. The relevant financial institution may be influenced to resist or not resist the regulatory standpoint based on a whole range of considerations, including other current or historical engagement pieces with the regulator as well as whether the financial institution believes that the regulator’s requirement should be met based on the desire or need to look after the interests of the relevant customers, such as whether those requirements are consistent with any customer charter the institutions may have.

In this last regard, we note that abstract interests of the customer usually should not be considered, at least initially, as interests. Relevant case law supports the position that the relevant interests of customers are to be defined by the constituent documents of the financial product that confer rights on the customers, such as a contract or trust deed. This will be contrasted with a view that equates customer interest to any conceivable advantage to the customer without regard to what provisions or benefits the relevant financial product is said to confer on the customer.

Increasingly, financial services legislation contains requirements for financial institutions to prioritise the interests of the relevant clients.

Several observations can be made in this regard:

  • the concept of “interests” should be as suggested above; and
  • prioritisation duties of this nature in many cases will not prevent the financial institution from acting in its own interests, but are only activated if there is a conflict between the interests of clients and the interests of the financial institution. Exceptions of course exist to this proposition, such as where fiduciary/equitable obligations require the holder of the obligation to only act in the client’s interests and/or preclude the institution from acting in its own interests.

Turning to the fourth limb, reputational risks are often a very powerful reason why a financial institution may not wish to, or has reduced appetite to, challenge a regulator’s standpoint formally.

Regulatory Engagement Strategy (RES)

It is clear that in accordance with the above analysis and trends, there is an increased need for financial institutions to institute, evolve, update or refine their RES, depending on where they may be up to in their development of an RES.

In particular, the following areas might be relevant:

  • Focus on community expectations, efficiently, honestly and fairly and fit and proper
    1. Has the RES got enough detail around how ASIC’s increased interest in this area is being addressed?
    2. How is your RES addressing APRA fit and proper requirements, noting that this goes beyond honesty and also covers competence, diligence and judgement?
    3. What governance structures, compliance processes and procedures underpin/support this area?
  • Focus on reputation generally and regulatory reputation more specifically
    1. With the introduction of a specific accountability measure under the BEAR/FAR, does the RES deal sufficiently with this area?
    2. What is meant by prudential reputation and being open, constructive and co-operative with a relevant regulator under the BEAR/FAR in different contexts which the institution is likely to face (eg requests for waiver of legal privilege as part of openness)?
  • Dealings with the regulator(s)
    1. Given the introduction of a new duty of transparency vis-à-vis APRA in the BEAR legislation, as well as the joint regulatory role of ASIC in the FAR, does the RES deal sufficiently with what we will call the “duty of candour” towards the regulator(s)?
    2. Is there a new duty of transparency when dealing with the regulators?
    3. What does this duty involve beyond breach reporting?
    4. Is there now a duty to report events which might transcend breach reporting?
    5. How does any such duty of candour interact with the area of legal professional privilege?
    6. How does a RES seek to preserve legal professional privilege (eg in briefing of experts in regulatory matters)?
  • Arms’ length dealings
    1. Given the increased focus in the Royal Commission and ensuing focus by the regulators, does the RES deal sufficiently with how the intra-group dealings of an organisation can be explained and justified in the event of a regulator focussing specifically at the institution or at an industry level more generally?

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Tony Coburn
Tony Coburn
Consultant
+61 2 9322 4976
Steven Rice
Steven Rice
Special Counsel
+61 2 9225 5584
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160

Regulatory “Rinkles”: Spotlight on conflicted remuneration

This edition of Regulatory Rinkles focuses on certain aspects of the conflicted remuneration regime under Part 7.7A of the Corporations Act 2001 (Cth) (Act), which are often ill understood.

This focus is timely following the Royal Commission and the proposed end of the grandfathering regime. While the grandfathering of conflicted remuneration is coming to an end through the advent of amendments to the Act made by the Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Act 2020 (Cth) (which comes into effect from 1 January 2021), the fundamental issues discussed here will continue to be relevant. This is because there will continue to be a need for licensees to work out whether payments are conflicted remuneration in the first place.

This analysis will take the form of “furphies” to be discussed and dismissed.

FURPHY 1: Benefits provided to a licensee, as opposed to a representative, will not be conflicted remuneration.

The typical thinking behind this furphy is that if a representative provides the financial advice, then a benefit provided to the relevant licensee (rather than the representative giving the advice) cannot be conflicted remuneration.

With respect, we disagree with this proposition and hold it to be incorrect for a number of reasons.

First, at the most simple level, a licensee can in fact be the provider of the advice, and is treated as such, where the relevant individual providing the advice is an employee of the licensee (ie a representative). In other words, where a representative of a licensee gives the advice, as opposed to an authorised representative, then the licensee is the provider of the advice. Here, the employee representative advising the client is the licensee for these purposes. The Act makes it clear that for most purposes, the provider of the advice in such a circumstance is, in fact, the licensee (see for example section 944A of the Act, relating to financial disclosure. The best interests obligation regime contained in Division 2 of Part 7.7A of the Act is a specific exception to this regime).

Second, the licensee can still be seen to be providing the advice even where it is provided by an authorised representative of the licensee. In this regard, the relevant text of the definition of “conflicted remuneration” in section 963A of the Act is instructive, viz:

“Conflicted remuneration means any benefit, whether monetary or non-monetary, given to a financial services licensee, or a representative of a financial services licensee, who provides financial product advice … “

So a threshold issue is who provides the advice. But even where the individual giving the advice is an authorised representative (rather than an employee representative), the licensee can still be seen to be providing the advice on the basis of the operation of section 52 of the Act, where:

“A reference to doing an act or thing includes a reference to causing or authorising the act or thing to be done.”

In this context, the licensee causes or authorises the representative to provide the advice. Of course, the authorised representative is still also providing the advice (in conjunction with the licensee).

Third, even disregarding this last point, the fact is that payments to a licensee can still influence advice provided by a representative, such as an employee who is not an authorised representative. The payment to the licensee may result in the licensee inducing or influencing (either directly or indirectly) the representative to provide certain advice favouring certain products. For example, the licensee may receive amounts from a product issuer if the representative succeeds in the client acquiring financial products issued by the product issuer, which in turn may result in the licensee being able to give greater support, financial or non-financial, to the representative.

All this said, it is true that in ASIC Regulatory Guide RG 246 Conflicted and other banned remuneration (RG 246), ASIC states that where certain payments are made by a platform operator to a licensee but no payments are passed on to the individual adviser:

“…we are less likely to scrutinise the benefit under the ban on conflicted remuneration if there are controls in place to ensure that the benefit does not influence the advice given by representatives of the AFS licensee.”[1]

This position has, in our experience, been used by industry in the wider (but analogous) context of payments made by product issuers more generally and not just platform operators. Some industry participants have treated ASIC’s statement as a de facto exemption, but this is risky for several reasons, as follows:

  • first, the formulation ASIC uses of it being “less likely to scrutinise” is of lesser force than other formulations used by ASIC for other factual scenarios (such as where fees are payable by product issuers if they are passed through to the client or where a product issuer provides general advice about its own products and accepts management or administration fees for those products);[2]
  • second, ASIC does not anticipate that such payments would be made without controls in place, such as to ensure that the payments will not be passed on from the licensee to the adviser; and
  • third, and most importantly, these payments will be conflicted remuneration if they have the requisite influencing effect on the advice (under section 963A of the Act). While these payments are not necessarily impacted by the impending removal of the grandfathering exemptions, ASIC’s statement of being “less likely to scrutinise” is not as emphatic or concrete than the formulations it uses for other “quasi-exemptions”, and noting also that ASIC is not bound legally to any of these pronouncements.

Certainly, maintaining strict controls around:

  • ensuring the payments are not passed on to the individual providing the advice; and
  • reducing, mitigating or (less easily) eliminating influence,

will be very central to this issue but at the end of the day, the strict legal position is that the payment controls must neutralise any influence.

FURPHY 2: When non-monetary financial benefits may constitute conflicted remuneration.

This is less of a furphy and more of a clarification of the concept of non-monetary benefits. Clearly, the Act includes non-monetary benefits in its prohibition on conflicted remuneration, but is a non-monetary benefit a straightforward concept?

It is certainly very broad, encompassing any benefit that is not money. So this will include the provision of goods but it goes much, much further. For example, a product issuer who gives advisers access to its clients at promotional events could be providing a non-financial benefit to those advisers.

The real issue is where to draw the line. For example, is the promise by a product issuer to indemnify the advice licensee under a distribution agreement a conflicted non-monetary benefit, particularly in circumstances where the distribution agreement has been negotiated at arm’s length?

In this context, it is suggested that one way to evaluate non-monetary benefits as conflicted remuneration is to ask if the relevant item is in fact a “benefit” in the true sense. It seems to us that an item which is paid for at market rates by the licensee or adviser, or for which the licensee or adviser provides commercial consideration, will not usually be a “benefit” that section 963A was designed to catch. In other words, the concept of “benefit” imports the notion that there is a favourable outcome bestowed by the provider on the recipient.

In contrast, the sale of something by the licensee to a representative for less than market consideration is clearly a benefit, as would be a loan at lower than commercial rates.

FURPHY 3: The client-paid exemption can operate where a product provider is giving a benefit to a licensee (or a representative), or a licensee is giving a benefit to a representative provided the benefit is sourced from client funds.

For this exemption (in section 963B(1)(d) of the Act) to operate successfully, the benefit must be given by the retail client.

In order for the client to give that benefit, as ASIC correctly notes in RG 246, the benefit must come from the client’s own funds.[3] Importantly, the Act contains a note to section 963B of the Act, which makes it clear that superannuation amounts that are caused or authorised to be paid by the client are to be treated, under section 52 of the Act (commented upon above), as given by the client. Superannuation amounts are not necessarily a benefit of a client.

The relevant text of the note to section 963B is:

“Under the governing rules of some regulated superannuation funds, a member may seek advice on the basis that the trustee of the fund will pay the licensee or representative for the advice and then recover the amount paid from the assets of the fund attributed to that member. In that case, the member has caused or authorised the amount to be paid to the licensee or representative and so, because of section 52 of the Act, paragraph (1)(d) would apply to this amount.”

With respect, this analysis seems correct. The relevant trustee may under the governing rules of the fund require the relevant member’s consent to the application of amounts in his or her account balance to pay for financial advice. As such, the application of trust money towards an expense must be appropriately incurred under usual trust law principles. Unless the amount is an unrestricted non-preserved amount (and hence, the member has a vested entitlement which it can direct payment of), the payment will be in the nature of an expense of the fund, albeit paid from the member’s account balance.

Note that generally, a member cannot direct a trustee to pay such an amount due to the restriction in section 58 of the Superannuation Industry (Supervision) Act 1993 (Cth), which precludes trustees being subject to direction under the governing rules. However, relevantly, an exception exists in relation to a benefit payable to the member (ie an unrestricted non-preserved benefit (see section 58(2)(c))).

In order for the client to give the benefit, he or she must determine not just to pay a benefit but also, the specific quantum of the benefit. If the client simply delegates that decision to another party, such as a product issuer (or a licensee), as to how much to pay to the adviser, it is hard to say that the client has given the amount to the adviser. So for example, if the client authorises the licensee to pay up to $1,000 to the adviser, a discretion resides in the licensee as to how much it actually pays the adviser. As the client has not determined the amount paid, it is difficult to establish that the client has given that benefit.

FURPHY 4: The client-paid exemption applies whenever a benefit is given by the client to the licensee or representative.

This interpretation would be far too wide.

Under the Act, only benefits given by the client in relation to the issue or sale of a financial product or for the provision of financial product advice to the client qualify under the Act (see section 963B(1)(d)).

Under the Corporations Regulations 2001 (Cth), a benefit given by a client to a “provider” dealing in a financial product on behalf of the client also qualifies (see Corporations Regulation 7.7A12E), noting in this regard that the dealing must be one made on behalf of the client. For example, an arranging by the licensee for the client to acquire the product would only qualify if the arranging was affected by the licensee acting on behalf of the client and not on behalf of the relevant product provider.

TRANSITIONAL ISSUES

Having discussed these Regulatory Rinkles, many organisations will be examining how to transition away from grandfathered remuneration, given the new legislation referred to above.

In that context, a frequently encountered issue is whether a product issuer can bring forward (ie accelerate) the payments that would otherwise be payable under a grandfathered arrangement with a licensee. We will deal with this issue and other transitional issues in our upcoming edition on “Transition of Grandfathered Remuneration”, which will be published in the next few weeks.

[1] ASIC RG 246 at 246.120.

[2] ASIC RG 246 at 246.77 and 246.139.

[3] ASIC RG 246 at 246.72.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Philip Hopley
Philip Hopley
Special Counsel
+61 2 9225 5988
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160

Regulatory “Rinkles”: Efficiently, honestly and fairly (Part 2)

This is the second part on this theme. The first part examined the concept of ‘financial services’ as a key component of the scope of the duty. This continues the analysis by looking at how financial institutions can respond to the duty, particularly at a practical level and also given the increased regulatory sanctions with the obligation now being transformed into a civil penalty provision.

1    The status quo

For many years, the ‘efficiently, honestly and fairly’ obligation was seen as one which involved an aggregate obligation. This interpretation followed from the decision of Young J in Story v National Companies & Securities Commission,[1] a matter involving consideration of whether a securities dealer had acted “efficiently, honestly and fairly” for the purposes of the Securities Industry (New South Wales) Code 1980. Relevantly, his Honour said:

Thus I turn to the phrase “efficiently, honestly and fairly”. In one sense it is impossible to carry out all three tasks concurrently. To illustrate, a police officer may very well be most efficient in control of crime if he just shot every suspected criminal on sight. It would save a lot of time in arresting, preparing for trial, trying and convicting the offender. However, that would hardly be fair. Likewise a judge could get through his list most efficiently by finding for the plaintiff or the defendant as a matter of course, or declining to listen to counsel, but again that would hardly be the most fair way to proceed. Considerations of this nature incline my mind to think that the group of words “efficiently, honestly and fairly” must be read as a compendious indication meaning a person who goes about their duties efficiently having regard to the dictates of honesty and fairness, honestly having regard to the dictates of efficiency and fairness, and fairly having regard to the dictates of efficiency and honesty.[2]

2    Quo vadis the status quo?

The position in Story was settled law for many years. However, after the discussion in the 2019 case of ASIC v Westpac Securities Administration Limited,[3] there was good reason to doubt that the law from Story should be followed. From reading this decision of the full Federal Court, one could be forgiven for holding the view that the provision is made up of three individual obligations; that is (at the risk of repetition!) to:

  • carry out the relevant financial services efficiently; and
  • carry out the relevant financial services honestly; and
  • carry out the relevant financial services fairly,

with each operating as three separate obligations.

In ASIC v Westpac, the Chief Justice stated:

The phrase [efficiently, honestly and fairly] has been held to be compendious as a single, composite concept, rather than containing three discrete behavioural norms.  That said, if a body of deliberate and carefully planned conduct can be characterised as unfair, even if it cannot be described as dishonest, such may suffice for the proper characterisation to be made.[4]

While the Chief Justice was prepared to focus on fairness as the primary obligation in the circumstances where the financial services licensee “set out for [its] own interests to seek to influence a customer to make a decision on advice of a general character when such decision can only prudently be made having regard to information personal to the customer”, he also suggested this was an issue for examination in proceedings where it was fully argued. Justice O’Bryan, on the other hand, more firmly rejected the “compendious” view:

it seems to me that there is no reason why it cannot carry its ordinary meaning which includes an absence of injustice, even-handedness and reasonableness. As is the case with legislative requirements of a similar kind, such as provisions addressing unfair contract terms, the characterisation of conduct as unfair is evaluative and must be done with close attention to the applicable statutory provision: cf Paciocco v Australia and New Zealand Banking Group Ltd (2015) 236 FCR 199 at [364]. It seems to me that the concepts of efficiently, honestly and fairly are not inherently in conflict with each other and that the ordinary meaning of the words used in s 912A(1)(a) is to impose three concurrent obligations on the financial services licensee: to ensure that the financial services are provided efficiently, and are provided honestly, and are provided fairly.[5]

Justice Jagot did not express such reservations and agreed with the conclusions of the trial judge on this issue.

We note that the High Court has given special leave to Westpac to appeal the full Federal Court decision, however we do not expect that the issues around the interpretation of the efficiently, honestly and fairly obligation will be ventilated.

3    Back to the future?

Since the decision in ASIC v Westpac however, in the subsequent Federal Court decision of Australian Securities and Investments Commission v AGM Markets Pty Ltd (in liquidation) (No 3),[6] Justice Beach was prepared to revert to the previous historical and conventional judicial interpretation where the obligation is seen as an aggregate obligation comprising the three combined limbs and essentially concerned with ethical conduct. His Honour referred to his earlier decision in Australian Securities and Investments Commission v Westpac Banking Corporation (No 2)[7] and said:

First, the words “efficiently, honestly and fairly” are to be read as a compendious indication requiring a licensee to go about their duties efficiently having regard to the dictates of honesty and fairness, honestly having regard to the dictates of efficiency and fairness, and fairly having regard to the dictates of efficiency and honesty.

Second, the words “efficiently, honestly and fairly” connote a requirement of competence in providing advice and in complying with relevant statutory obligations. They also connote an element not just of even handedness in dealing with clients but a less readily defined concept of sound ethical values and judgment in matters relevant to a client’s affairs. I have emphasised here the notion of connotation rather than denotation to make the obvious point that the boundaries and content of the phrase or its various elements are incapable of clear or exhaustive definition.[8]

His Honour applied similar principles in the more recent decision in Australian Securities and Investments Commission v Commonwealth Bank of Australia [2020] FCA 790 (5 June 2020) (ASIC v CBA).

As mentioned, in this edition, we will attempt to provide practical guidance for financial institutions in terms of how they can assess and respond to the dimensions of the obligations.

4    Fairness as a lynchpin – practical issues

Given that fairness is a core element of the obligation to act efficiently, honestly and fairly, what does being ‘fair’ mean in this context? In fact, ‘fairness’ can be broken down into six principles.

Principle 1:  Fairness is heavily concerned with outcomes (although it will also capture procedural or process fairness). Even as a compendious obligation, the cornerstone of the obligation is fairness, not least because the concepts of efficiently and honestly are fairly uncontroversial.

Honesty is a well understood concept (although see our comments in Principle 4 below).

Efficiency is a little more complex insofar as various case law such as Story points out, it could operate contrary to the concept of fairness insofar as something might be seen as efficient but might not be seen as fair to the relevant client-base.

The first point to note is that fairness is a concept which applies to not just the relevant clients but also to the licensee. In other words, it requires and justifies consideration of, and allowance for, the interests of the licensee and of the clients.

It would be wrong therefore, to proceed on the basis that fairness is solely about the interests of the relevant clients.

The second point to note is fairness is different to other seemingly similar obligations such as the common law duty of care or the equitable duty to act in the best interests of beneficiaries.

We note that the latter obligation of best interests is concerned with process and the conduct of the trustee in its decision making, not outcomes.

This is the key conclusion of the New South Wales Court of Appeal in the decision in Manglicmot.[9]

So fairness looks to outcomes. As such, it is clear that the obligations must focus on the interests of both the licensee and the client(s).

This leads to the next principle which relates to interests.

Principle 2:  Fairness is about protecting clients’ interests in a broad sense. The interests that the duty of fairness protects includes the interests of clients as conferred by a constituent document such as the relevant contract or trust deed but it also is likely to be construed by a court as extending to general interests of clients going beyond the narrower interests which arise from the relevant “bargain” or arrangement made between the client and the licensee. It is suggested that this position contrasts with specific statutory duties which require the prioritisation of the interests of clients where case law suggests that the relevant interests to be prioritised are those conferred by the relevant constituent document.

So interests of the client are likely to now encompass the way in which the licensee discloses information to the client, the way in which the licensee communicates more generally to the client and the way the licensee deals with the benefit of the client, and other types of similar interactions with the client.

This said, it is only the conduct of the licensee in the provision of a financial service which is captured (see Part 1 of Spotlight on efficiently, honestly and fairly).

Principle 3:  the concept of fairness has a core of reasonableness.

When evaluating the scope of content of the obligation, a useful starting point is whether the licensee is acting reasonably in the provision of the financial service.

In this sense, a useful comparator might be the duty of good faith as it exists in various areas of the common law.

Often this duty is referenced as requiring the holder of the duty to not unreasonably deal with the interests of the counterparty. For instance, in Dillon v Burns Philp Finance,[10] in the context of an superannuation trust deed under which the settlor company was tasked with forming an opinion as a means of determining a fact significant for the rights of the employee and employer sponsor, Justice Bryson stated:

“the parties cannot be supposed to have contracted on any view that the principal company could form an opinion with a view to serving its own interests, to the exclusion of a fair consideration of the interest of the employee and of the rights which the rules purport to confer.”

Principles of unconscionability and other related concepts may also be part of the chemistry of the obligation; for example, Chief Justice Allsop’s observation in Paciocco can be considered:[11]

honesty in behaviour; a rejection of trickery or sharp practice; fairness when dealing with consumers; the central importance of the faithful performance of bargains and promises freely made; the protection of those whose vulnerability as to the protection of their own interests places them in a position that calls for a just legal system to respond for their protection, especially from those who would victimise, predate or take advantage…

Translated into an obligation of fairness, the core of the obligation might be referenced as:

Does the conduct involved in the provision of the financial service unreasonably affect or erode the interests of the client(s)?

So one approach to assessing whether conduct of a licensee is fair, is to consider:

  • What are the consequences of the conduct vis-à-vis the client?
  • As part of that, how does the conduct affect their interests?
  • Have the clients’ interests been dealt with reasonably or unreasonably?

Before proceeding to looking at some examples, the relationship between the fairness element of the total obligation and the elements of honestly and fairly needs to be considered.

As has been commented on above, efficiency stands apart from fairness and honesty.

If the relevant financial service is governed by a contract with the client, if the licensee properly carries out the terms of the contract and provides the relevant consideration required of it, prima facie this would not seem to be able to be characterised as a breach of the obligation.

But if the licensee engages in misfeasance such as misrepresentation or the consideration provided by the licensee is illusory or arguably does not provide real and genuine value, the obligation might be seen to be activated.

One particular way to reconcile these elements as a single composite obligation is to envisage that efficiency could be viewed as operating in tandem with fairness so that a licensee must perform activities not just efficiently, but efficiently in a fair way. This standpoint flows from the dictum from ASIC v Westpac (No 2) cited in section 3 above.

This approach is not too dissimilar to the historical case law interpreting the obligation which sought to see the obligation as essentially one of ethical conduct, first in the tribunal decision of Re Hres and ASIC[12] which was then followed by the Federal Court in ASIC v Camelot Derivatives Pty Limited[13] a decision of Foster J which was supported by Beach J in ASIC v CBA as discussed above.

Principle 4: Whilst the current judicial interpretation might favour the composite nature of the obligation, a court in our opinion is unlikely to require all three elements to be breached in order to find an overall breach.

For example, one criterion might be breached in such a material way that the other elements will be regarded as being breached. This seems to be the approach taken by the Chief Justice in ASIC v Westpac. We also would observe that the criterion of honesty might be treated as more verging on ethical conduct rather than the strict concept involving mens rea.

Principle 5: Is there a specific statutory provision that the deficient conduct breaches, such that the efficiently, honestly and fairly obligation may not have been intended to apply?

We know that the obligation does not require a contravention or breach of a separately existing legal duty or obligation. But, Justice Beach said in ASIC v AGM Markets that the duty “is not a back door into an “act in the [best] interests of” obligation. Other specific provisions of the Act nicely fulfil that role”.[14]

Principle 6:  The extent of the relevant deficient conduct. As we know, the obligation applies to the provision of the relevant financial services.

The Corporations Act does not specify or clarify whether the obligation is breached if a particular financial service is carried out deficiently (although this must be the effect as the plural reference will include the singular) or indeed if there is any materiality or extent of the deficient conduct which acts as a threshold.

In other words, just what extent of deficient conduct in the provision of a financial service activates the provision? Is it activated when only a small element of a financial service or services is deficient or only where some more substantial activity is deficient?

A very minor incident proportionate to the total activity comprised in the relevant financial service might not mean that the financial service has been carried out inefficiently, dishonestly or unfairly.

5    Examples

Some examples serve to illustrate the relevant issues licensees will need to consider:

  1. Out of 10,000 annual statements for a superannuation product, 500 are issued late.
  2. A licensee formulates an approved product list (APL) with some of its own products on the list but the majority are not its products.
    It commissions research for the other products to justify their inclusion on the APL but does not do so for its own products.
  3. A licensee who is a product issuer determines to launch a new financial product.
    The product provides insurance cover for certain events which although represent some real risks of occurrence, could be covered in terms of risk by a simpler, cheaper alternative insurance product, and so lack of value is an issue.

In example A, consider whether mere oversight or negligence would breach the obligation. It is true that courts are probably moving to see negligence as constituting inefficiency. Actual circumstances of the incident will still be very relevant; for example, reckless failure of relevant compliance systems might tip the balance.

In example B, again the actual circumstances may tip the balance; was internal research commissioned and, if so, would that be sufficient validation (by way of general analogy only, cf ASIC Regulatory Guide 256 Client review and remediation conducted by advice licensees, where independent expert input for remediation may or may not be required)? Consider if the licensee did not benchmark its own products because of self-interest (i.e. conflicts of interest played a role).

In example C, an issue here is whether again the licensee deliberately formulated the product with no regard to the value of the product to the customer; i.e. absence of value is the issue.

6    Working through ‘efficiently, honestly and fairly’: a different calculator!

Rather than provide specific answers, it seems to us that one can synthesize an assessment tool which can be used to assist in the evaluation of any given perceived deficiency in the conduct of the licensee.

First, did the conduct/activity occur in the provision of a financial service?

A drill down question here is whether the relevant conduct/activity is either core to the relevant financial service for a licensee or an integral element of the service.

Second, is the conduct unethical or at least unfair?

A drilldown question here is to consider whether the relevant conduct/activity unreasonably affects or erodes the interest of/position of the client.

Refer to the more micro questions set out above under Principle 2.

Third, is there some materiality threshold that could/should be applied?

Note, that this issue is not crystal clear.

Most case law discussions have not had regard, at least not explicit regard, to the extent the relevant deficient conduct impacts on the relevant financial service(s).

It may be that unless the impact is very minor (i.e. de minimis) a court would hold that any deficient conduct of the relevant type in the provision of a financial service means that it has not been provided efficiently, honestly and fairly and since the plural term “financial services” used in section 912A(1)(a) indicates the singular, there has been a breach of the obligation.

[1] (1988) 13 NSWLR 661 (Story).

[2] (1988) 13 NSWLR 661 at 672.

[3] Australian Securities and Investment Commission v Westpac Securities Administration Limited [2019] FCAFC 187 (ASIC v Westpac).

[4] [2019] FCAFC 187 at [170].

[5] [2019] FCAFC 187 at [426].

[6] [2020] FCA 208 (ASIC v AGM Markets).

[7] [2018] FCA 751 (ASIC v Westpac (No 2)).

[8] [2020] FCA 208 at [505].

[9] Manglicmot v Commonwealth Bank Officers Superannuation Corporation Pty Ltd [2011] NSWCA 204.

[10] Unreported, Supreme Court of New South Wales, Bryson J, 20 July 1988.

[11] Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50 at [296].

[12] [2008] AATA 707.

[13] [2012] FCA 414.

[14] [2020] FCA 208 at [522].

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Steven Rice
Steven Rice
Special Counsel
+61 2 9225 5584

ASIC spotlight on client money

In the wake of ASIC’s recent announcement on enforcement in this area, we thought that it would be timely to set out:

  • some key points about how the client money provisions operate, particularly with respect to application money;
  • the pitfalls to look out for; and
  • how some of the more technical provisions interact with each other.

To this end, we adopt a “Ten Point Synthesis” to hone in on the most pertinent points.

Point 1

The client money provisions apply not just to money paid to acquire an interest in a product, but also to client payments that top up an existing investment (see section 1017E(1)(c) of the Corporations Act viz payments to acquire an interest or an increased interest in a financial product).

Point 2

The provision is activated when the product issuer does not immediately issue the relevant interests after receiving the money (section 1017E(1)(d) of the Corporations Act). For these purposes, an issue arises as to what “receiving the money” means. The Corporations Act seems to contemplate that money means the amount paid by the client. For example, where the money is paid as a cheque, the question is whether the issuer can wait until the cheque clears. In this example, this issue is resolved by Corporation Regulation 7.9.61C, which provides that payment equates to when the cheque is honoured.

Point 3

Probably the lynchpin requirement is that which provides that the money must be paid into an account which is held with an Australian ADI (section 1017E(2)(a) of the Corporations Act) and importantly, the only money that can be paid into the account is money to which section 1017E applies. This means it can apply to money attributable to multiple financial products issued by a single product issuer (for example, money with respect to different superannuation and investment products issued by the relevant product issuer). Of course, with the recent proposed reforms requiring separation of RSE functions and other fiduciary functions, separation of the 1017E account is also likely to be required.

It should also be noted that several exemptions to this rule apply under the applicable regulations. In particular, where the money is paid to a life insurer, then a statutory fund may be used as a section 1017E account (Corporations Regulation 7.9.08).

Point 4

Money paid into the account is to be treated as trust money (section 1017E(2A) of the Corporations Act). This is important as such money is impressed with trust characteristics and obligations. Notably, such money is to be held on trust for the person paying the money and hence, any interest on that money would, under ordinary trust principles, also be held on trust for that person. However, the Corporations Regulations modify this usual position by providing that the product issuer “is entitled to the interest on the account” where “the product provider discloses to the person who paid the money that the product provider is keeping the interest (if any) earned on the account.” This is often disclosed to investors via a product’s disclosure documents.

Point 5

Restrictions apply as to when the account money can be withdrawn (section 1017E(3) of the Corporations Act). Primarily, the money can only be withdrawn to pay back the payer of the money or to issue the product in accordance with the instructions of the payer (or otherwise in accordance with applications of the money provided for in the Corporations Regulations).

Here, it should be noted that there may be money which is received by the product issuer that is not actually being paid to acquire an interest in the product (or an increased interest in the product). Such money may have been paid as inbuilt commission to a third party adviser for example. There is an issue here as to whether this type of money can be paid into a section 1017E account on the basis that it is not paid for the acquisition of a financial product. However, if combined money is paid by a single cheque (ie application money and third party commission), then under Corporations Regulation 7.9.61C, the total amount is deemed to be received by the by the product provider where the cheque is honoured. So the cheque could be banked into a non-1017E account. Under section 1017E(2), the product provider would then have to deposit the application money into the section 1017E account on the day of deemed receipt or the next business day.

Point 6

The Corporations Act provides a strict regime for the permissible period during which account money can remain in the section 1017E account (section 1017E(4) of the Corporations Act). Within one month of the money being received, it must be returned to the payer or applied towards the relevant acquisition. The exception to this is where it is not reasonably practical to return or apply the money by the end of that month. In such a case, it can be maintained in the account until the end of such period as is “reasonable” in the circumstances (see Point 7!).

Point 7

Case law sheds light on what is “reasonable” in the circumstances and has taken a strict view in this regard (see Basis Capital Funds Management Ltd v BT Portfolio Services Ltd [2008] NSWSC 766).

Point 8

A product provider can utilise multiple accounts to comply with the relevant requirements (section 1017E(5) of the Corporations Act).

 Point 9

As noted above, interest on a section 1017E account can only be retained by the product issuer if properly disclosed (see Corporations Regulation 7.9.08A).

 Point 10

There is an interplay between section 981B and section 1017E of the Corporations Act in a number of ways. For example, money received in respect of section 1017E can be paid into a section 981B account (under Corporations Regulation 7.8.01(6)). In this case, it is important to remember that where this is done, Part 7.8 of the Corporations Act applies (Corporations Regulation 7.8.01).

However, if section 1017E money is paid into a section 981B account, then one needs to consider how the money can be applied (see Corporations Regulation 7.8.02(1)), as there is no explicit reference to section 1017E money being applied for the purposes contemplated under section 1017E.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160

COMPLIANCE AND GOVERNANCE IN FINANCIAL SERVICES IN THE AGE OF COVID-19

By Michael VrisakisCharlotte Henry and Philip Hopley

This article is the third in a series by our financial services team which will explore the practical implications of Covid-19 on the financial services industry and our clients’ businesses, following our articles on disclosure and operational issues.

This edition will examine how the standards, procedures and processes in regulatory compliance and governance that are being affected by Covid-19 are reflective of the particularly unique circumstances that prevail under Covid-19.

 

Setting the compass

The circumstances in which financial services businesses are now required to operate are, not surprisingly, vastly different from those that prevailed prior to the onset of Covid-19.

What financial institutions need to know as a priority, however, is how these circumstances affect, shape, temper or otherwise interact with a range of legal obligations, under statute and general law.

First, there is the question of whether these circumstances do have some impact and effect on a variety of legal obligations. The answer, in our opinion, is resoundingly yes.

The overarching reason for this is because a vast number of legal obligations are framed in terms of a standard of conduct which contains, deliberately, some fluidity and elasticity.

This trait is a very deliberate feature of much legislation and other law, which seeks to be fluid to accommodate evolving circumstances. A classic example is the standard of reasonable care historically under the general law (ie negligence which is now also a staple regulatory standard of conduct under statute.

The interesting aspect of this in-built elasticity is that it can adjust itself not just to industry standards of conduct (such as community expectations) but also to market conditions.

We will provide some examples of this phenomenon in four different areas.

  1. section 912A of the Corporations Act;
  2. statutory regulatory duties involving reasonable steps;
  3. general law (common law); and
  4. compliance standards.

 

Section 912A of the Corporations Act

As we know, this provision is now a civil penalty provision and it covers a raft of different obligations relating to the provision of financial series (see our previous edition specifically dealing with the obligation of efficiency, honesty and fairness under section 912A).

It is appropriate to start with an analysis of efficiency, honesty and fairness from the point of view of what we have called the Covid Syndrome (CS).

Honesty is a standard of conduct that is less likely, for obvious reasons, to be affected in its scope by the CS. Last year, a new definition of “dishonesty” was introduced under the Corporations Act to provide that conduct is dishonest if it is “dishonest according to the standards of ordinary people”. The effect of this change is that unlike the test for dishonesty in the Criminal Code, it is no longer necessary to prove that the defendant knew that the relevant conduct was dishonest or had intended to act dishonestly, thereby lowering the threshold for dishonesty for the purposes of the Corporations Act.

However, the concepts of “efficiency” and “fairness” are more likely to be affected by the impact of the CS. In other words, what can be achieved and measured as efficiency will likely be impacted by the practical and operational constraints caused by the CS.

For example, the provision of efficient financial advice can depend on resourcing constraints, processing constraints and systems constraints, which are all affected to varying degrees by the CS. Moreover, each organisation may be impacted in different ways and to different extents.

This is not to say that the CS can excuse non-compliance with specific legislative or general law obligations. But it can affect the scope and content of general conduct obligations under legislation and general law. ASIC has stated that while it is prepared to provide support to entities in assisting them to respond to CS, it expects them to continue to treat customers fairly, and for financial services licensees to continue to act fairly, honestly and efficiently. There will be a point where CS disruption no longer just affects the scope and content of the general conduct obligations, but means that services can no longer be performed efficiently, honestly and fairly, which may in turn impact on the ability of the relevant financial institution to charge fees for the services.

A good example is the operation of call centres where compliance is a key part of providing financial advice and monitoring of the advice is a key part of compliance. In circumstances where staff are by necessity working from home, recording of phone calls, which otherwise might be regarded as efficient and fair, as well as part of a good compliance framework, may not be possible. So the standard of conduct, which includes the appropriate supervision of the provision of financial services, must reflect these practical exigencies to a reasonable degree. If recording is not possible, then other replacement measures may be needed. The CS may justify changing the makeup of the licensee’s compliance arrangements (eg to include more frequent training and other monitoring) if it is really not possible to record calls for people working at home. This is where the compliance framework intersects with the business continuity plan.

Dealing with the issue of a financial product interest might ordinarily mean processing the application within a certain reasonable timeframe (see discussion on section 1017E below). However, where administrative constraints are caused by the CS, one can see how this standard of conduct can be tempered/affected by the CS.

The next relevant obligation in section 912A is the obligation to have in place adequate arrangements for the management of conflicts of interest. Here some fluidity exists in the concepts of both “adequate” and “management”.

What is adequate and constitutes management of conflicts may depend on what is both possible and practical under the CS. While the question of adequate is likely to be an objective test, the CS can be relevant to the question of why the arrangements were still adequate in the circumstances or alternatively, why they were not adequate despite the CS.

Having weekly compliance meetings where conflicts issues are addressed may need to be altered because of staffing issues (including employment restrictions) or systems issues (including diversion of, or limitations on, systems and resources) to prioritise other operational issues (such as dealing with redemptions and liquidity issues).

Another example of the CS at work is the obligation to take reasonable steps to ensure that representatives comply with financial services laws (section 912A(1)(ca)). As we will see later in this discussion, what is reasonable can again be impacted by the CS in terms of available resources, systems etc.

The same is true in relation to the obligation to have adequate resources to provide relevant financial services (section 912A(1)(d)). As noted above, there will be a point where CS disruption no longer just affects the scope and content of the obligation but means that the licensee does not have adequate resources to keep providing the services. While CS can move the line in relation to what are adequate resources, there is a point beyond which the resources are no longer adequate and need to be supplemented (and the CS cannot exempt the need to supplement to that minimum standard).

 

Standards involving reasonableness

There are a myriad of provisions in relevant pieces of legislation regulating financial services which utilise the standard of reasonableness as a benchmark, including:

  • the Corporations Act;
  • the ASIC Act;
  • the Life Insurance Act;
  • the Superannuation Industry (Supervision) Act; and
  • the BEAR and FAR legislation.

An example that we have already addressed to some extent in our previous disclosure edition is the requirement to disclose information in a product disclosure statement (PDS).

Under section 1013F of the Corporations Act, information can be excluded from a PDS if it would not be reasonable to expect to find the information in the PDS. Sub-section 1013F(2)(c) provides that a relevant factor capable of being taken into account is “the kinds of things such persons may reasonably be expected to know”.

In the CS world, certain events such as the existence of the pandemic phenomenon itself, the fact that markets have been disrupted, and the fact that the Government has allowed early withdrawal of superannuation benefits may all fit within this umbrella. This aspect is addressed specifically in section 1013F(2) of the Corporations Act, which permits the taking into account of “the kinds of things such persons may reasonably be expected to know”.

But, beyond this, there are many provisions of this and other laws which impose obligations in the nature of “reasonable steps”; for example, section 961L of the Corporations Act, which provides that a “financial services licensee must take reasonable steps to ensure the representatives of the licensee comply with sections 961B, 961G, 961H and 961J”.

Such an obligation of reasonable steps applies in other legislative regimes such as the Banking Executive Accountability Regime (BEAR) and the proposed Financial Accountability Regime (FAR), where various obligations exist on an entity as well as on an accountable person to take reasonable steps to ensure compliance with a particular standard. In the case of BEAR, there is a standard of reasonableness within a standard of reasonableness, where the entity must take reasonable steps to ensure that each of its accountable persons meets his or her accountability obligations, with such accountability obligations including the obligation to act with due skill, care and diligence.

Of course, what are reasonable steps or a reasonable standard of care are likely to be impacted by the extraordinary circumstances of the CS, at least temporarily.

Notwithstanding the above discussion on reasonable standards, we have found that appropriate governance standards are being approached slightly differently, particularly with the overlay of BEAR where that is applicable. Most financial services providers have implemented some form of a Covid-19 Response Team involving stakeholders from across the business with an executive management lead point of contact, which is taking over the day-to-day governance and management of the Covid-19 response. The role of the Covid-19 Response Team is critically important for a number of reasons not covered here (eg communication), but its role in enhancing the governance of a financial services provider is important. The Response Team will be amassing an enormous amount of information during this time, which is essentially stress testing each element of the business continuity plan to allow the provider to update it going forward to include, for example, additional back-up/alternative business processes to ensure continuation of critical business services.

 

General law

The classic example of the application of the standard of reasonableness to general law is in the area of the tort of negligence. Here, the concept of reasonable care could very well be affected by what is possible, practical, and feasible under the CS.

An example might be that ordinarily, work performed by an organisation might have safety precautions which, because of the lack of mobility of staff, might be temporarily impacted.

Of course, in evaluating what is reasonable, one must look at other ways of acting reasonably that might still be possible under the CS and where not possible, may require activity to be suspended or modified.

 

Compliance and governance standards

Compliance is a broad area of focus for financial services licensees.To narrow down its compass, one can start with a key area of supervision.

As indicated earlier in this discussion, supervision standards by necessity are subject to resourcing and systems constraints. Again, this area may be one where the CS effect is only of temporary impact.

A question arises as to whether it is legitimate that these obligations are subject to such constraints. This question is somewhat beside the point. The point is that compliance standards will by necessity be affected to an extent by what is possible, viable and reasonable. As observed earlier, there is again a line beyond which compliance standards cannot be reduced and the financial service should not be provided as it cannot be provided to an appropriate standard. Here, what is reasonable may be raising or using additional capital to invest in better business continuity measures and alternative monitoring systems to minimise disruption to the compliance framework.

To some extent, technology can overcome many practical difficulties caused by the CS but it will not always be the case.

Outsourcing is a prime example. Where compliance is outsourced to a third party supplier where resourcing or systems are affected by the CS, then naturally, usual compliance standards are likely to be affected.

It is then a question whether the reduction of compliance levels is reasonable in all the circumstances.

There are some particular limbs of section 912A of the Corporations Act that are relevant in this context, as follows:

  1. section 912A(1)(d), which requires adequate resources, including financial, technological and human resources, to provide the financial services covered by the relevant licence and to carry out supervisory arrangements;
  2. section 912A(1)(aa) relating to management of conflicts of interests also employs the concept of adequate arrangements; and
  3. section 912A(1)(f) refers to the concept of “adequately trained”.

The CS definitely can impact on all these areas. Does this mean that a licensee is in breach if there is a marked difference in these areas during the CS as opposed to prior? It is suggested that one must look at this issue holistically and not just at a particular moment. If there is a deficit, then the licensee should be afforded a reasonable time to shore up its resources and supervisory capabilities.

So again, it is suggested that, particularly due to the unusual phenomenon of the CS, a particular moment in time test is not the appropriate test point.

 

Risk management

The CS brings with it new risks that will need to be evaluated and responded to. In many cases, the risks are novel.

This in itself presents challenges from a risk management perspective. Identifying and responding to these risks is part and parcel of a licensee’s dynamic risk management framework and capability.

At the same time, the CS will in some organisations place stress on the risk management ecosystem in terms of pre-CS risks.

Both of these areas will no doubt be the focus of a financial institution’s risk function.

Evidence of consideration and documentation of these issues and the organisation’s response are already a first step in the management of these issues.

 

Action

We would welcome any examples, case studies or questions you might have in relation to the above and encourage you to email our team.

 

Subscribe to our FSR Australia Notes to receive updates on our latest FSR insights and participate in industry discussions.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Philip Hopley
Philip Hopley
Special Counsel
+61 2 9225 5988
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160
Sky Kim
Sky Kim
Solicitor
+61 2 9225 5573

ASIC continues its focus on advertising and disclosure

Yesterday, ASIC provided an update on its surveillance activity on advertising and disclosure by investment funds, emphasising the importance of investment fund disclosure not being misleading and adequately addressing risk.

It is important for licensees to bear in mind that the stance and views taken by ASIC can be applied equally to other products, such as superannuation products (particularly on platforms) and insurance products. Accuracy of disclosure and advertising materials continue to be a key focus area for ASIC, particularly during COVID-19, where market conditions are rapidly evolving.

In particular, there is a very important provision contained in the PDS disclosure regime in section 1013D of the Corporations Act, which is relevant in this regard. This is section 1013D(1)(c), which requires disclosure of significant risks associated with holding the product. In the current market, COVID-19 has created new risks.

The PDS disclosure regime is not static. Rather, it is a dynamic one that requires product issuers to reflect on the dynamic content of their PDSs. The requirement of section 1013D is subject to the overriding requirement expressed in the preamble to section 1013D(1), which is to disclose such information that a retail client would reasonably require for the purposes of making a decision on whether to acquire the financial product. In the present circumstances, prima facie, changing risks in relation to illiquidity, other withdrawal restrictions and investment all seem relevant to a client’s acquisition decision.

It may be that some of these developments may fall within the exception to disclosure contained in section 1013F of the Corporations Act, which provides an exclusion from disclosure where it would not be reasonable for a retail client considering whether to acquire the product to find the information in the PDS and in this case, “the kinds of things such persons may reasonably be expected to know.” It is probable that while clients may be expected to know, in general terms, issues of illiquidity, there will be specific product aspects of general market conditions that will not be within the assumed knowledge of a client and therefore, will require specific disclosure.

This then reverts to the issue of whether ASIC Instrument relief can be utilised, or whether an SPDS or new PDS is required.

For more commentary on disclosure obligations and reliance on ASIC Instrument relief, see our articles here and here.

In addition to the above risks which materialise more frequently during COVID-19, it is important to note that there is always a degree of risk associated with product comparisons, which should be undertaken on a whole of product basis (rather than simply focusing on particular features).

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Tamanna Islam
Tamanna Islam
Senior Associate
+61 2 9225 5160

ASIC’s 2020/21 timetable released

Today, ASIC published its Interim Corporate Plan for the 2020–2021 financial year and an updated timetable of its ongoing work up to the second quarter of 2021.

Key dates with respect to legal and regulatory reform in the financial and credit services industries are set out in the table below:

Project Indicative timing
Product intervention power – regulatory guidance

ASIC will publish a regulatory guide in June 2020 on how it will use the product intervention power.

June 2020
Mortgage brokers best interest duty – regulatory guidance

ASIC will publish a new regulatory guide on how ASIC will assess compliance with the best interest obligations in National Consumer Credit Protection Act 2009 (Cth) Part 3-5A.

June/July 2020
Internal dispute resolution (IDR) – updated requirements

ASIC will publish an update to Regulatory Guide 271 Internal dispute resolution, outlining revised updated IDR standards and requirements for financial services and credit licensees.

RG to be published July 2020

New requirements to commence from 5 October 2021

Design and distribution obligations (DDO) – regulatory guidance

ASIC will publish its regulatory guide on DDO, following consultation on its draft regulatory guide that was released in December 2019.

RG to be published in Q3 2020

ASIC plans to respond to industry requests for guidance ‘as soon as possible’

Regulatory guidance on client review and remediation – consultation

ASIC will consult on extending Regulatory Guide 256 Client review and remediation conducted by advice licensees (RG 256) beyond financial advice.

ASIC’s timetable also states that it started an internal review of RG 256 in 2019, with a focus on ‘extending the application of the policy, including greater transparency on the progress and outcomes of remediation, and providing best practice guidance for designing and conducting consumer-centred remediation’.

Q3 2020
PDS disclosure requirements for managed funds and superannuation – commencement

As we mentioned in an earlier update, ASIC will amend the transitional arrangements PDSs to ‘allow entities to come into the new disclosure regime from 30 September 2020 and require any PDS given on or after 30 September 2022 to comply with the new disclosure regime’.

No changes have been announced to commencement of the new regime for periodic statements.

Opt-in from 30 September 2020

Required for PDSs given on or after 30 September 2022

Removal of claims handling exemption – consultation

ASIC may engage in targeted consultation on a new information sheet for entities involved in claims handling, on ‘how to apply for an Australian financial services licence and comply with licence obligations’.

September 2020 or upon the introduction of legislation into Parliament (whichever is later)
Review of the ePayments Code – consultation

ASIC will consult on the ePayments Code as part of its review to assess its ‘its fitness for purpose, noting significant developments in financial technological innovation and the need to ensure the Code is simple to apply and easy to understand’.

Q4 2020
Royal Commission law reform for mortgage brokers – consultation

ASIC intends to consult on:

  • a draft legislative instrument and information sheet on a reference checking protocol for mortgage brokers and financial advisers;
  • updates to Regulatory Guide 104 Licensing: Meeting the general obligations; and
  • updates to Regulatory Guide 205 Applying for and varying a credit licence.
October 2020 or upon the introduction of legislation into Parliament (whichever is later)
Insurance in superannuation report – publication

ASIC states that its review is focused on ‘industry’s progress on improving insurance outcomes for consumers’.

December 2020
Royal Commission law reform on hawking – consultation

ASIC intends to consult in late 2020 on changes to Regulatory Guide 38 The hawking prohibitions (RG 38) to account for the legislative amendments recommended by the Royal Commission.

December 2020
Royal Commission law reform on a deferred sales model for add-on insurance – consultation

ASIC intends to consult on an information sheet about the deferred sales model for add-on insurance.

December 2020
Royal Commission law reform relating to financial advice – regulatory guidance and legislative instruments

ASIC will release an update to Regulatory Guide 245 Fee disclosure statements (RG 245) and make the relevant legislative instruments in December 2020, subject to the passage of legislation, in relation to the following Royal Commission recommendations:

  • Recommendation 2.1: Annual renewal and payment
  • Recommendation 2.2: Disclosure of lack of independence
  • Recommendation 3.2: No deducting of advice fees from MySuper accounts
  • Recommendation 3.3: Limitations on deducting advice fees from choice accounts
December 2020
Royal Commission law reform for breach reporting – regulatory guidance

ASIC intends to consult on:

  • an update to Regulatory Guide 78 Breach reporting by AFS licensees (RG 79) on the proposed breach reporting requirements; and
  • a new information sheet about new requirements for financial advisers and mortgage brokers to investigate misconduct and notify and remediate affected clients.
February 2021
Royal Commission law reform for enforceable code provisions – regulatory guidance

ASIC intends to consult on a draft update to Regulatory Guide 183 Approval of financial services sector codes of conduct (RG 183), in the context of the proposed law reform to facilitate enforceable code provisions.

Q2 2021, with an intention to commence targeted consultation at an earlier stage

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828

Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444

Operational disruption in financial services in the age of COVID-19

Written by Michael VrisakisTamanna Islam and Sky Kim

COVID-19 has clearly had wide-ranging impacts on how financial services institutions conduct their businesses, ranging from the need for additional disclosure (dealt with in our previous disclosure module) to marketing and distribution, investment, valuation, administration and supply chain, and reporting in respect of financial products.

This module looks at how COVID-19 has impacted on these operational aspects, with particular focus on how institutions can overcome or mitigate the additional burden introduced by COVID-19.

 

Marketing and distribution
In circumstances where potential investors are largely house-bound, there has been a pronounced need to explore and utilise electronic commerce in financial services marketing and distribution.
In this context, it is useful to examine the extent to which applications for financial products have to be made and processed using traditional paper means with wet signature or alternatively, if and how non-paper forms of applications can be utilised.

A useful starting point is the application procedure provided for in the Corporations Act. The following requirements are set down by section 1016A of the Corporations Act, relevantly:

  1. a restricted issue or sale of a financial product is effectively an issue of such a financial product where a PDS is required to be given in relation to the product sale. A relevant financial product is, for present purposes, a managed investment product, a superannuation product, an investment life insurance product, an RSA product, or a margin lending facility; and
  2. for such issue, an eligible application is required. This is defined as an application which is made using an application form.

The application form must be included in or accompany the product disclosure statement or be copied or directly derived from such a form.

Importantly,

  1. the requirements do not stipulate that the form must be signed; and
  2. for certain products such as life risk products, there is no requirement for an eligible application form.

It follows from the above that an application for a relevant financial product could be set up on the basis that it is signed electronically by the applicant. In this regard, electronic transactions facilitation legislation is not necessary as a signature is not required. However, other legislation may require wet signatures.

COVID-19 also presents opportunities for financial services providers to pivot marketing and distribution to electronic and other digital channels, such as website, call centre and digital tools such as calculators and product comparison tools. In particular, there has been a shift towards self-directed channels, where customers are able to navigate the application process with minimal to no intervention from the licensee. This is particularly relevant as the parameters of “no advice” and “general advice” models continue to be explored and tested by financial institutions, ASIC and the courts.

 

Call centres
One of the inevitable consequences of COVID-19 has been the fact that many call centres have not been able to be staffed in the usual manner. Rather, call centre operations have been forced to become remote, with many call centre operations now being exclusively conducted by frontline staff working from home.

This has had implications in terms of ways in which call centre operations have been supervised, and the compliance framework governing call centre operations. In particular, recording of calls, which is a fairly ubiquitous compliance control, has been curtailed, given operational difficulties associated with call recording in circumstances where the call centre is operating remotely.

Importantly, the obligations of an Australian financial services licensee to ensure compliance with financial services law under section 912A of the Corporations Act 2001 (Cth) (Corporations Act) continue during COVID-19 and similar disruptions. However, it is crucial to bear in mind that the Corporations Act is not prescriptive in this regard. Rather, it is up to the licensee to determine its compliance framework, having regard to its business operations and prevailing circumstances. For example, monitoring of call centre interactions via call recording may not be possible but other alternative compliance measures such as detailed scripts, FAQ documents, training, telephone mystery shopping and monitoring of sales data (eg cancellation or lapse rates) may be substitutes.

In changing circumstances, legislative standards of conduct, such as the obligation of an Australian financial services licensee to carry out financial services efficiently, honestly and fairly, can be affected. What is reasonable, for example, may well be at least partly affected by these changed circumstances. This topic will be explored in more detail in our following module dealing with Compliance and Governance.

 

Administration and supply chain
COVID-19 has caused major disruption to the administration and supply chain of many financial services providers, with significant impacts on back office operations. Offshore and onshore administration have, in many cases, been disrupted by shifts in working protocols. The impact is made more complex by varying government restrictions during the COVID-19 lockdown across the globe.

This in itself may cause delays or breaks in usual administration processes and time horizons. In turn, this may create disruptions in customer outcomes or issues with service providers. These disruptions can give rise to considerable uncertainty, increased costs and legal risks, particularly associated with an inability to perform under service contracts (either on time or at all). For APRA-regulated entities, this is a particular area of risk given the impact on prudential requirements, such as business continuity, liquidity, stress testing and governance.

In this context, contractual liabilities under services and supply agreements may arise due to such disruption, with contracting parties seeking modification of existing obligations that have become impractical or impossible to perform. Modifications can include delays or pauses in performance or payment obligations.

This is an area where the doctrine of force majeure may play a role. The application of force majeure will depend on the governing law of the contract and the terms of the contract itself. The key questions that arise in this context are:

  1. whether COVID-19 appropriately falls within the concept of force majeure under the relevant contract (eg coverage for pandemics, Government-imposed quarantine or “Acts of God”);
  2. whether the force majeure clause applies to obligations that are only impossible to perform, or whether it extends to other obligations that have become impractical or uncommercial to perform;
  3. what is the effect of the force majeure clause (eg is performance suspended)?

It may also be that contractual provisions may provide some relief or flexibility under the relevant service contract to renegotiate the material service standards or outcomes during the affected period. The doctrine of frustration may also provide some relief where the contract is incapable of being performed.

It is important to bear in mind that in the context of new administration or supply contracts being entered into, COVID-19 from now on is a foreseeable event that will not likely fall within the concepts of force majeure or frustration. As a result, new contracts should contemplate specific arrangements in the context of COVID-19, where applicable (eg expressly include it as a force majeure event). For more information on contracting during COVID-19, see our resources and tips available here and here.

The longer term impacts of this disruption are yet to be seen. However, we are seeing a shift, in some cases, towards less reliance on outsourcing and offshoring. A number of industry participants have been forced, or otherwise determined, to onshore their operations, as well as recruit additional staff to insource certain back office operations.

The above impacts are also compounded by the announcement of Government measures such as the early release of funds from superannuation schemes, and market demands for financial hardship arrangements (for example, in insurance). These measures are requiring licensees to ensure adequate resourcing (including reallocation of resources) to service these issues.

 

Reporting
Similar to the area of pre-sale disclosure and ongoing significant event reporting as discussed earlier, ongoing investor reporting may well be affected by COVID-19.
In particular:

  1. delays may be experienced in the communication process due to administration disruption discussed above;
  2. related resultant data issues involving delays in obtaining data or inaccessibility of data.

Such delays may cause regulatory issues in terms of inability to comply with statutory reporting requirements or delays in being able to comply with such reporting requirements.

These potential compliance issues cause prospects and potential for seeking regulatory relief.

This relief might be formal or might be more informal. It may involve the relevant regulator being prepared to grant certain leniency in compliance timeframes or in the requirements which would otherwise apply.

It follows that financial institutions who are experiencing such issues should be alert to the prospects of and potential to engage with the relevant regulator to obtain concessions and/or relief from such normal compliance requirements.

This might be at an individual level or at an industry level.

 

Investment
Clearly COVID-19 has caused disruption of many aspects of funds’ investment. While investments have obviously continued to be made, markets have been disrupted, in many cases severely. This has led to the need for additional disclosure but also in many cases, adjustments to the investment options offered through the product.

It may have also meant investment options are being closed or being otherwise modified. In many cases, underlying fund managers are imposing redemption restrictions on investors (such as partial or complete suspension). In some cases, we have seen the source of the fund manager’s power to activate such restrictions is not immediately obvious.

This process often needs to be implemented and disclosed quickly.

Where existing disclosures do not cover these matters, disclosure implications arise often under:

  1. section 1017B of the Corporations Act, which requires disclosure of material changes and significant events; or
  2. in relation to managed investment schemes that have 100 or more members who acquired interests under a PDS, section 675 of the Corporations Act. This continuous disclosure obligation requires disclosure of information that is not generally available and which a reasonable person would expect, if it were generally available, to have a material effect on the price or value of the interests in the scheme.
    Timing requirements under section 1017B vary, from advance disclosure in the case of fee increases to disclosure before the change or event or as soon as practicable after that but not more than three months after the change or event. The timing requirement under section 675 is “as soon as practicable”.

Typically product issuers will want to initiate changes quickly. This usually means:

  1. quick form of disclosure; and
  2. effecting the change before it is disclosed.

The Corporations Act allows for electronic disclosure which is potentially the quickest means of disclosure.

This could involve disclosure viz the website by relying on ASIC Corporations (Updated Product Disclosure Statements) Instrument 2016/1055 (Instrument 2016/1055) which allows product issuers to update information in a product disclosure statement (PDS) without issuing a supplementary PDS, provided that the updated information does not include any materially adverse information and the issuer discloses upfront that updated information can be found elsewhere (eg on the website). You can read further about the use of Instrument 2016/1055 in our first module here.

ASIC Corporations (Removing Barriers to Electronic Disclosure) Instrument 2015/649) can also be relied upon to give an electronic PDS where there is no PDS that is capable of being printed. Similarly, ASIC Corporations (Facilitating Electronic Delivery of Financial Services Disclosure) Instrument 2015/647 allows providers to make disclosures such as PDSs available digitally (eg on a website), and notify the client the disclosure is available, without the need for client agreement to receive the disclosure in that manner as long as clients have the ability to opt for the disclosure to be delivered in full to either an electronic address or to a postal address.

As far as implementation is concerned, implementing the change before disclosure is possible, although care has to be taken in terms of whether the change could render the PDS misleading or deceptive or otherwise mean it is not up to date.

 

Valuation
Similar issues arise in the context of valuation.

Clearly changes to valuations must be made consistently with any procedures stipulated in the relevant product disclosure statement or trust deed.

Again, the timing of the valuation changes versus disclosure of the changes needs to be considered as canvassed above.

In relation to superannuation, a special feature of the legislative regime is that section 155 of the Superannuation Industry (Supervision) Act 1993 (Cth) imposes not just an ability of a trustee to put a halt on redemptions but actually require a trustee to put a halt on redemptions if certain prescribed circumstances exist.

In particular the trustee is prohibited from redeeming interests in the superannuation entity where:

  1. the trustee believes that the redemption price would not be fair and reasonable as between the redeemer and the other beneficiaries of the entity; or
  2. the trustee cannot for whatever reason work out the price at which the interest should be redeemed under the governing rules of the entity,
    except at a fair and reasonable price as between the redeemer and the other beneficiaries of the entity.

This provision could provide relief to superannuation trustees where valuation difficulties are caused or contributed to by COVID-19. In particular, the redemption price for existing investors might prove to be artificially high, leaving remaining investors worse off.

 

Regulatory recalibration
The above-mentioned operational disruptions caused by COVID-19 present an opportunity for some industry-wide regulatory recalibration. While the financial services sector has been facing a number of types of disruption for many years, the impact of COVID-19 has been truly unique.

Some areas that would lend themselves to Government or regulatory intervention or relief include:

  1. the financial advice and disclosure space where Statements of Advice could be shortened and simplified by facilitating incorporation by reference of material from a website. While some scope already exists to do this, further peel-back would be extremely beneficial to both financial services licensees and consumers;
  2. the product disclosure space, which continues to be extremely onerous and inflexible. While short form product disclosure statements can be utilised, they are mostly not used because the regulatory requirements are less flexible compared to their long-form counterparts. For example, in the case of short-form PDSs, there is no ability to issue a supplementary PDS and so reliance on the website disclosure relief is the only alternative to reissuing the PDS (with such relief not being available for changes that are materially adverse);
  3. the digital calculator space. Regulatory concessions exist for financial calculator tools to allow their use without triggering personal advice. But the conditions attaching to the relief are somewhat restrictive and clunky as they don’t readily allow reference to specific financial products. If consumers are clearly informed that the information spitting out from the tool is not personal advice, this should be enough to allow tools to make more mention of specific financial products; and
  4. the circumstances in which APRA may exercise its modification powers. Sadly, a longstanding regulatory impediment has been statutory restrictions on the ability of APRA to modify key provisions of superannuation legislation. APRA cannot, for example, relax key provisions requiring members to make insurance elections on low balance accounts under the ‘Protecting Your Super’ and ‘Putting Members’ Interest First’ reforms, particularly in the context of members who need to remake elections once transferred to a new fund under a successor fund transfer.

Should readers have other examples where regulatory relief would be beneficial, we welcome your input.

 

Operational resilience
All of the above are set in the context of operational resilience more generally during COVID-19. All business continuity plans and crisis management plans will have been activated and while those plans will have been drafted to account for shorter and longer periods of disruption, most financial service providers we are speaking to are encountering a need to enhance their operational resilience. There are a number of areas where enhancements are occurring. Aside from enhancements to technology capability to improve their capacity to operate in a remote environment on an ongoing basis (which was a critical focus for financial service providers early in COVID-19), the other key ones are:

  1. effective monitoring of remote working staff both from an employment/HR perspective but also from a compliance monitoring and risk framework perspective. There has been an increased focus on enhancements to first and second line monitoring tools, particularly for those involved in the markets to monitor for insider dealing and market manipulation risks;
  2. updating policies and procedures in a number of respects including controls for maintaining information security and confidentiality in the remote working environment (which is proving particularly challenging) and disposing of confidential information, around personal mobile phone use and appropriate secure forums for conducting meetings/connections; and
  3. implementing alternative solutions for third party providers and others in the supply chain that are facing challenges with their business continuity programs or are unable to adapt to the changes that financial service providers are implementing.

In addition, financial service providers have needed to focus on capturing a wider set of information and new types of information, and to enhance their information flows in order to ensure appropriate oversight and governance during this time and in order to feed back into ensuring the ongoing business continuity plan is robust and tailored and stress tested.

 

Other issues
There will no doubt be a range of other operational issues and indeed, this note may just skim the surface.

In addition to the examples you might have where regulatory relief would be valuable, the HSF Financial Services team values your input and experience and encourage you to email our team with any particular issue you are experiencing.

 

Pythia’s wisdom: There is usually more regulatory flexibility than meets the eye and under COVID-19,part of any sensible organisation’s response plan should be to urgently evaluate where this flexibility can be found and relied on.

Who is Pythia?

Pythia is the official job title given to the original Delphic Oracle. She represents a strong female voice in Ancient Greek times in the role of dispenser of wisdom and sage advice to the population of Delphi. Our Pythia’s Wisdom feature is in part homage to the Pythia, as although the term has not entered the English language day to day lexicon, the phrase “Delphic Oracle’ has of course.

 

Michael Vrisakis
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