MOTIVOS DE LOS CONFLICTOS
6. DISCUSIONES, CONCLUSIONES Y LIMITACIONES
APRA Australian Prudential Regulation Authority
ASIC Australian Securities and Investments Commission
ASX Australian Stock Exchange Limited
CIPF Canadian Investor Protection Fund
CFR Council of Financial Regulators
CRF Consolidated Revenue Fund
DMF Discretionary Mutual Fund
DOFI Direct Offshore Foreign Insurer
EDR External Dispute Resolution
FICS Financial Industry Complaints Services
FIDA Financial Industry Development Account
FSA Financial Services Authority, United Kingdom
FSCS Financial Services Compensation Scheme
FTE Full time employee
HBWI Home Builders Warranty Insurance
HCSL HIH Claims Support Limited
IBNR Incurred But Not Reported
LPLC Legal Practitioners’ Liability Committee
MDO Medical Defence Organisation
NGF National Guarantee Fund
PII Professional Indemnity Insurance
SEGC Securities Exchanges Guarantee Corporation Limited
SFE Sydney Futures Exchange Limited
SIPC Securities Investor Protection Corporation, United States
SMIF Solicitors’ Mutual Indemnity Fund
SPR Superannuation Protection Reserve
SRO Self regulatory organisation
RETAIL CLIENT COMPENSATION
FOR FINANCIAL SERVICES
LICENSEES
OPTIONS PAPER
Paper 3
July 2007
Melzan Pty Ltd
ABN 14 398 003 119 Telephone: 0412 228 495 Facsimile: (02) 9979 1791 Email: [email protected] PO Box 732, Mona Vale NSW 1660Retail Client Compensation For Financial Services Licensees – Options Paper 2
Executive Summary
Financial services accounts for 8 per cent of GDP or $52 billion dollars. It is the third largest sector in the economy. The industry includes over 4500 licensees, including fund managers, stockbrokers, insurance brokers and other financial advisors.
However, if a licensee becomes insolvent, ceases trading, loses their license, disappears or does not have sufficient Professional Indemnity insurance (PI), then there is a good chance that the client will not get compensated for a breach of the licensee’s legal obligations, as the recent Westpoint, Fincorp, Bridgecorp and Australian Capital Reserve collapses have demonstrated. Similarly, if the licensee is fraudulent or misappropriates funds, then the chances of a client recovering their money are low.
Unlike doctors, lawyers and even builders, there is currently no scheme in financial services which protects consumers from the possibility of these kinds of losses.
Although there is no reliable data on how many people may be affected by the gaps left by PI, we do know that the impact on individual retail clients can be devastating when the investments are life savings.
This Options Paper has been prepared to assist the Financial Industry Complaints Service (FICS) to assess:
What method of compensation provides the best outcomes for retail clients and other
stakeholders;
What design features an effective compensation scheme would have; and
Next steps for progressing a compensation scheme.
This Options Paper assesses four options for addressing the gap in consumer protection and providing a compensation scheme which provides the best outcomes for retail clients and other stakeholders:
Option A: compulsory PI combined with a Government-supported centralized fund;
Option B: compulsory PI combined with an industry-run centralized fund;
Option C: a centralized fund with no requirement for PI; and
Option D: Group insurance arrangements.
Compulsory PI combined with a Government-supported centralized fund (Option A) provides the best option as it offers a sufficient scope of cover, is accessible and efficient for retail clients, provides adequate financial cover, is affordable for licensees and Government, promotes risk management and meets the objectives of key stakeholders.
Retail Client Compensation For Financial Services Licensees – Options Paper 3 Designing a scheme necessarily involves tradeoffs between multiple objectives. The challenge is to balance concerns about consumer protection with objectives such as efficiency, equity, minimum complexity and minimum cost.
We recommend that a centralized fund have the following key design features:
Coverage of fidelity (fraud and misappropriation of funds) and last resort (insolvency,
cease trading, disappearance and loss of license);
Caps that are on par with External Dispute Resolution (EDR) scheme financial
jurisdiction;
Operation by an independent body jointly governed by EDR schemes, consumer
representatives, Government and industry representatives;
Multi-source funding from Government for establishment costs, ASIC for ongoing
operating expenses, a borrowing facility combined with post-event levies on licensees;
Direct access by retail clients to the centralized fund;
Supported by Federal legislation which ties the obligation on licensees to have
adequate compensation arrangements to compliance with their funding obligations to the centralized fund; and
Prospective application ideally commencing on the same date that the obligation on
licensees to have PI commences, currently being 1 July 2008.
We recommend that data collection, economic/actuarial modelling and stakeholder engagement are important ‘next steps’ to progressing a compensation scheme.
Retail Client Compensation For Financial Services Licensees – Options Paper 4
TABLE OF CONTENTS
Executive Summary... 2 Introduction ... 5 1 Options for a compensation scheme ... 8
1.1 Option A: Compulsory PI combined with a Government-supported centralized fund 8
1.2 Option B: Compulsory PI combined with an industry fund...11 1.3 Option C: Government-run centralized fund, no requirement for PI...14 1.4 Option D: Group insurance scheme...16 1.5 Recommended option: Option A ...18
2 Possible design features of Option A: compulsory PI combined with a Government-supported centralized fund ...19
2.1 What level of benefit should consumers receive? ...19 2.2 How should a retail client be able to access the fund?...21 2.3 Who should operate the fund? ...25 2.4 What level and nature of funding should the Government provide? ...27 2.5 What arrangements should be made for levying licensees? ...28 2.6 What legislative support should be put in place?...30 2.7 What time limitations should apply?...31 2.8 What transitional arrangements should be put in place?...31 2.9 Summary of recommended design features ...32
3 Next Steps ...32
3.1 EDR scheme jurisdiction ...32 3.2 Data collection and analysis ...33 3.3 Economic modelling...33 3.4 Stakeholder consultation ...33
Conclusion...34 Appendix A...35
Retail Client Compensation For Financial Services Licensees – Options Paper 5
Introduction
The financial services industry comprises a broad range of licensees. The industry regulator, the Australian Securities and Investments Commission (ASIC) counts over 4500 licensees, 69% of which are financial advisors such as fund managers, financial planners, stockbrokers and insurance brokers, as well as financial institutions such as banks, general and life insurance firms.
In providing financial advice, financial advisors have a number of legal obligations. At common law, they have fiduciary obligations to their clients. They also have a number of statutory obligations under the Corporations Act (Act), including the obligations to provide advice that has a reasonable basis, to meet the disclosure requirements, and not to engage in dishonest, misleading or deceptive conduct.1 Claims against financial services licensees are most typically for inappropriate advice, although they can also be for misappropriation of funds and breaches of trade practices provisions.
Licensees are required to have ‘adequate’ arrangements in place to compensate retail clients,
should such liabilities arise.2 New regulations, commencing on 1 July 2007 and applying to
licensees from 1 July 2008, provide that the obligation to have ‘adequate’ compensation arrangements will be satisfied if licensees have PI in place, unless they are prudentially
regulated by the Australian Prudential Regulatory Authority (APRA).3 References to
‘licensee’ in this Options Paper are to non-exempt (that is, not APRA-regulated entities), unless the context indicates otherwise.
However, the steps taken by the Federal Government to date are market-based and are not intended to be a comprehensive consumer safety net. PI is a competitive market in which insurers choose to cover certain risks at an affordable premium, but PI leaves licensees to pay some parts of their liability themselves.
As Figure 1 demonstrates, although there are schemes in place to protect the clients of lawyers in all States (for example, LawCover and Fidelity Fund in NSW), doctors (Health Care Liability schemes in NSW and Federal levels), builders (Home Warranty Insurance), stockbrokers (National Guarantee Fund) and the members of Superannuation Funds (Federal Superannuation Protection Reserve), there is no scheme in place to protect the retail clients of financial services licensees such as financial advisors.
1 The Study of Financial System Guarantees defines agent risk as “where a trusted party fails to act in the principal’s best interest by making poor investment decisions, providing poor or negligent advice, failing to handle an investor’s funds honestly (for example, fraudulent conduct and theft) or having inadequate systems and controls which create the possibility of loss due to operational risk”: Study of Financial System Guarantees, March 2004, Professor Kevin Davis.
2Corporations Act s 912B.
Retail Client Compensation For Financial Services Licensees – Options Paper 6
Figure 1
Melzan’s research on retail client compensation
Melzan Pty Limited (Melzan) has been retained by FICS to identify deficiencies in PI cover, research other schemes in Australia and overseas, and to develop options for going forward. In its May 2007 paper ‘Gaps in the Professional Indemnity Insurance Market’ (Gaps Paper), Melzan identified that there is patchwork coverage of some key areas that may leave retail clients exposed. Mandatory PI is a market-based solution which leaves gaps in consumer protection because:
It does not cover losses sustained by retail clients where the principal of a licensee has
been fraudulent or dishonest, or misappropriated the funds of client;
The availability of ‘run-off’ cover is limited. If a licensee is retired, they may not have sufficient assets themselves to compensate a former client;
May not assist where a licensee disappears, has their license withdrawn by ASIC, is
wound up or ceases to be a going concern. In such instances, the client may have an award made in their favour but the award is of little use to them because the defendant does not exist;
Even with PI, a licensee may become insolvent. Reasons include:
o Liability to clients exceeds indemnity provided by PI so the licensee becomes
insolvent (for example, the quantum of the loss exceeds the limit of indemnity, sum of multiple losses exceeds the limit of indemnity including any reinstatements under the policy);
o Excesses are so high that the licensee becomes insolvent (for example, having
to pay multiple excesses may make a licensee insolvent); Consumer compensation schemes Lawyers
Doctors Builders Super Funds Banks and insurers?
CFR proposal Financial advisorsRetail Client Compensation For Financial Services Licensees – Options Paper 7
o Standard exclusions in PI require such high levels of self-insurance that the
licensee becomes insolvent (for example, authorized representatives acting outside the scope of their authority, conflicts of interest claims, and claims relating to products not on an ‘approved product list’); and
o The licensee is unprofitable for reasons which do not relate to claims made by
clients (such as economic downturn, failure to properly manage business). In its June 2007 paper ‘Research on Group Insurance and Compensation Schemes’ (Research Paper), Melzan identified that:
There are compensation schemes in place to protect consumers who deal with
financial planners, insurance brokers and other financial advisors in the United Kingdom, Canada and the United States.
The Financial Services Compensation Scheme (FSCS) which is in place in the United
Kingdom provides the best model for a compensation scheme in Australia. This is a scheme which has a statutory requirement for licensees to hold PI, a centralized fund established with legislative backing and funded on an ongoing basis through levies on
licensees. It covers some gaps left by PI that arise when licensee is unable, or likely to
be unable, to pay claims against it.
This Options Paper
This third and final paper is an Options Paper. This Options Paper has been prepared to assist FICS to assess:
What method of compensation provides the best outcomes for retail clients, and other
stakeholders
What design features an effective compensation scheme would have.
Next steps for progressing a compensation scheme.
This Options Paper comprises three Parts.
Part 1 assesses four options for addressing the gap in consumer protection: compulsory PI combined with a Government-supported centralized fund; compulsory PI combined with an industry-run centralized fund; a Government-run centralized fund with no requirement for PI; and Group insurance arrangements. It then recommends which of these options provides the best outcomes for retail clients and meets many of the objectives of other stakeholders.
Part 2 outlines a number of different possible design features of a centralized fund, by balancing concerns about consumer protection with objectives such as efficiency, equity, minimum complexity and minimum cost. It then recommends a set of key design features. Part 3 identifies some ‘next steps’ that could be taken to progress the introduction of a compensation scheme in Australia.
Retail Client Compensation For Financial Services Licensees – Options Paper 8
1
Options for a compensation scheme
There are four broad options for a compensation scheme:
Option A: Compulsory PI combined with a Government-supported centralized fund Option B: Compulsory PI combined with an industry-run fund
Option C: Government-run centralized fund, no requirement for PI Option D: Group insurance scheme
In this Part, each of these options is assessed against the criteria set out in the Research Paper:4
A sufficient scope of cover for effective consumer protection
Accessibility to consumers
Adequate financial cover for consumers
Affordability for whoever funds the scheme, whether that be industry, Government or
consumers
Efficiency
Provides an incentive for industry, regulators and consumers to manage risk
effectively
Acceptability to stakeholders
1.1
Option A: Compulsory PI combined with a Government-supported
centralized fund
Option A is a combination of PI insurance and a centralized fund supported by Government.5
Based on the model which is currently in place in the United Kingdom,6 its basic elements are:
A statutory requirement for licensees to hold PI.
A centralized fund established with the assistance of Government funding and
predominantly post-event funded through levies on licensees.
4 Research Paper Part 1.2.
5 This Option A is similar to Option 4 sub-option C in the Compensation Arrangements for Financial Services
Licensees Regulation Impact Statement April 2007 (released 29 July 2007). 6 See Research Paper Parts 3.1; 3.2.
Retail Client Compensation For Financial Services Licensees – Options Paper 9
Coverage of some gaps currently left by PI, namely fraud and misappropriated funds,
and failure to pay in the event that a licensee ceases trading, loses license, disappears
or becomes insolvent.
Legislative support.
The objective of this Option A is to minimise gaps that are currently left by PI alone, but it
does not eliminate all gaps.
The gaps in cover left by standard exclusions (authorized representatives acting outside the scope of their authority, many conflicts of interest claims, and claims in respect of products not on an ‘approved product list’) would remain, as would the gaps in cover left by circumstances in which a loss exceeds indemnity provided by PI or where a PI policy is in place but excesses are high. In many cases, these gaps would continue to be borne by the licensee themselves (self-insurance). In the event that these gaps caused the licensee to become insolvent, then the centralized fund would compensate the retail client.
Appendix A contains a diagram demonstrating the gaps covered and left by Option A.
Criteria / Scheme Advantages Disadvantages
Sufficient scope of cover statutory obligations under the Act PI covers most common law and Fund fills some gaps currently left by PI, namely fraud and misappropriated funds
Fund covers gap left by PI, being failure to pay in the event that a licensee ceases trading, loses license, disappears or becomes insolvent.
Gaps in coverage of authorized representatives acting outside the scope of their authority, conflicts of interest claims, and claims in respect of products not on an ‘approved product list’ would probably continue
Accessibility for retail clients Direct access to centralized fund
Can be designed to be compatible with EDR schemes.7 Centralised fund could have a referral relationship (as in UK between FSCS and FSO).
Charges on retail client for accessing centralised fund may be kept to a nominal fee – depending on funding model
No direct access to PI by retail clients
Relationship between EDR scheme payments, PI and compensation fund can be confusing for retail clients – not a ‘one stop shop’
Retail Client Compensation For Financial Services Licensees – Options Paper 10
Criteria / Scheme Advantages Disadvantages
Adequate financial cover to cover client if licensee is Centralized fund can be designed
fraudulent, loses license, stops trading or becomes insolvent. PI covers most claims, compensation fund can be accessed for ‘last resort’ claims
Cushions consumers if PI market hardens and scope of cover contracts
No cover of gaps left by PI (eg a loss exceeds indemnity provided by PI or where a PI policy is in place but excesses are high).
Caps: compensation payable to a particular retail client may need to be capped, as in the UK and under other similar schemes, to ensure that it is affordable for Government and industry.
Affordability most risks are insured at market Use of PI market ensures that
rates and, ideally, at a premium level that reflects the risk profile of an individual licensee
Operation alongside PI market makes fund more affordable for both Government and licensees Affordability for licensees maximised as Government provides establishment costs
Centralized fund involves some subsidization: successful licensees pay for losses sustained by clients of failed licensees.
Industry levies likely to be passed on to consumers through increased costs of financial advice
Efficiency standard practice (eg the General PI responds in accordance with
Insurance Code of Practice) Possible to design centralized fund with claims handling deadlines and service standards that meet industry standards
May be some duplication if EDR schemes assess claims and centralized fund also assesses claims (as in overlap between FSCS and FOS in the UK)
Provides incentive for risk management
Encourages retail clients to exercise caution in selecting licensees because it does not ‘top up’ PI
PI market encourages licensees to manage risks in order to obtain PI at an affordable premium Centralized fund’s rights of recovery against licensee keep incentive to manage risks
Possible to design centralized fund so that compulsory membership is also tied to successful risk management (eg.
Existence of a centralized fund may create a moral hazard for regulators
Inclusion of risk management standards might contract the market of licensees
Retail Client Compensation For Financial Services Licensees – Options Paper 11
Criteria / Scheme Advantages Disadvantages
LawCover in NSW).
Acceptability to
stakeholders
Beneficial to EDR schemes as they avoid repeat of impecunious licensees arising from Westpoint, Fincorp, Bridgecorp and Australian Capital Reserve.
Beneficial to ASIC as it would avoid political scrutiny eg following the collapse of Westpoint, Fincorp, Bridgecorp and Australian Capital Reserve Beneficial to retail clients as it carries a ‘low-medium’ cost for them with a ‘medium-high’ benefit8 Beneficial to PI insurers as they continue to hold existing market and would be subject to less scrutiny for gaps in cover
Caution recently expressed by Government which has opted for PI- only and has noted that ‘establishment of an appropriate fund structure would take considerable time, research and negotiation’9
Caution of licensees: to date ‘a central fund has not received widespread industry support’.10 Support