Allens

Funds Management

Focus: The Future of Financial Advice reforms – what product issuers should know

17 july 2012

In brief: The Future of Financial Advice reforms are finally upon us and their impact beyond the personal advice sector may well be more significant than anticipated. Partner Marc Kemp (view CV) and Senior Associates Frances Dunn, Larissa Macpherson and Simon Lewis discuss some aspects of the reform package that trustees of superannuation funds and responsible entities of retail managed investment schemes may need to consider.

How does it affect you?

  • The bans on conflicted remuneration in relation both to general and personal advice may be broader than some industry participants expect. In particular, trustees of super funds who outsource the provision of financial product advice should carefully scrutinise their remuneration arrangements, to ensure that they do not fall foul of the new prohibitions.
  • Some product issuers who have assumed they are unaffected by the new prohibitions on paying volume-based shelf space fees may need to take a closer look. The broad definition of 'platform operators' and the uncertain scope of the prohibited conduct and onerous burden of proof to discharge statutory presumptions present significant challenges to compliance.
  • Super fund trustees who are looking to offer personal 'intra-fund superannuation advice' to their members after 1 July 2013 will need to engage with the controversial subject of 'scaled advice' and its interplay with the new Future of Financial Advice (FoFA) best interests obligations. They will also need to be mindful of the new charging rules for intra-fund advice expected to be introduced into superannuation legislation by the Stronger Super/MySuper reforms.
  • Although the amendments to the powers of the Australian Securities and Investments Commission (ASIC) are principally directed at ASIC's ability to take action against individuals within the financial services industry, all Australian Financial Service (AFS) licence holders should be aware of ASIC's expanded powers to take anticipatory action if it considers a licensee is likely to contravene their financial services obligations, and to make banning orders against a person it considers is not of good fame or character.
  • Amendments were made in the Senate that effectively defer mandatory compliance with most of the FoFA reforms until 1 July 2013. However, relevant persons will be able to voluntarily 'opt in' to these new obligations and prohibitions between 1 July 2012 and 30 June 2013, by giving notice to ASIC.
  • Certain entitlements to benefits, fees and commissions in place before 1 July 2013 (or an earlier 'opt in' date, if applicable) will be grandfathered from the new prohibitions on conflicted remuneration, volume-based shelf-space fees and asset-based fees on borrowed amounts. However, the grandfathering provisions are limited in scope and subject to modification by regulations, so product issuers should not assume that all conflicted remuneration payable under existing arrangements will be covered. Issuers also need to be mindful of the anti-avoidance rules (which commenced on 1 July 2012) when entering into or varying any fee arrangements during the FoFA transition period.

Background

Assent was given in late June to the Corporations Amendment (Future of Financial Advice) Act 2012 (Cth), and the Corporations Amendment (Further Future of Financial Advice Measures) Act 2012 (Cth). While the prolonged and vociferous public debate concerning the FoFA reform package has tended to focus on either flagship measures, such as the ban on adviser commissions or the finer points of the new adviser charging rules, the impact of the reforms beyond the personal advice sector may be more significant than some product issuers anticipate.

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Conflicted remuneration

The prohibition framework

The general prohibitions on the payment of 'conflicted remuneration' to financial services licensees (or their representatives) who provide financial product advice to retail clients are contained in Division 4 Part 7.7A of the Corporations Act 2001 (Cth) (the Act). There are prohibitions covering licensees who accept conflicted remuneration and product issuers, or employers who pay conflicted remuneration to licensees or their representatives.

The general bans on conflicted remuneration are accompanied by specific prohibitions contained in a new Division 5 of Part 7.7A that:

  • prohibit advisers charging asset-based fees to retail clients on geared amounts; and
  • prohibit platform operators receiving volume-based shelf space fees from fund managers (discussed further below).
Scope of prohibited conduct

'Conflicted remuneration' is defined broadly, to mean any benefit (monetary or non-monetary) that could reasonably be expected to influence the advice given by a licensee (or representative) or the choice of financial product being recommended by the licensee (or representative). The definition is not confined to personal advice and, therefore, may cover benefits that are capable of influencing general advice given by a licensee or representative.

This general definition is augmented by a new section 963L, which creates a statutory presumption that certain kinds of volume-based benefits will be conflicted remuneration unless the contrary is proved. The Explanatory Memorandum justifies this on the basis of legislative impracticality and the fact that volume-based payments carry inherent conflicts.

While the rationale for this statutory presumption reflects legitimate concerns, s963L casts a rather wide net that encompasses most benefits that are in any way affected by the volume (by number or value) of products recommended or acquired. Moreover, although the Explanatory Memorandum contemplates hypothetical scenarios where this statutory presumption could be rebutted, it does not answer more pragmatic questions concerning the process for parties who wish to do this.

The breadth of these prohibitions and the fact that they extend to general advice is of justifiable concern to a number of product issuers. For instance, issuers who regularly provide general advice to members in the form of brochures or through telephone-based inquiry services may need to examine any trustee or management fees they receive that are calculated by reference to member account balances or funds under management.

Similarly, remuneration arrangements with super fund administrators that are (as is typically the case) set by reference to the size of the fund and/or the volume of members may need to be revisited by trustees who have also outsourced to their fund administrator the provision of fund-related general or personal advisory services to fund members.

Exceptions

There are a number of important exceptions to the characterisation of monetary benefits as conflicted remuneration, which are contained in ss 963B to 963D.

Monetary benefits provided in relation to a general insurance product are excepted, meaning that commissions may continue to be paid. Monetary benefits provided in relation to life risk insurance are also excepted, other than for group life risk products issued to superannuation trustees for the benefit of a class of members, and life risk products issued to a superannuation trustee of a default fund. This means that commissions may be paid on individual life risk products issued both outside of superannuation and within a 'choice' superannuation fund. Concerns have been expressed that the differential treatment of life risk products, depending upon whether they are issued in the superannuation environment (and what part of it), may lead to a distortion in the market for risk insurance and, in particular, the type of advice given. It has been suggested that ASIC 'shadow-shop' to assess whether this becomes a real problem.

Benefits that relate to the issue or sale of financial products, rather than the provision of financial product advice (ie 'execution-only' non-advice services) are also exempt, as are incentives provided to bank employees for advice on basic banking products, under s963C. A monetary threshold of $300 will apply to non-recurring soft dollar benefits and there are exemptions for non-monetary benefits that involve education, training or IT support.

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Volume-based shelf space fees

Are you a platform operator?

The new prohibition on platform operators receiving volume-based shelf space fees (contained in Subdivision 5A of Part 7.7A of the Act) will cover licensees who are generally recognised as investment platform operators, such as IDPS operators and product issuers of multi-product or wrap offerings that administer extensive investment menus through IT-based platforms. However, other product issuers may be surprised to learn that their arrangements with underlying fund managers could also be subject to this new prohibition.

Any AFS licensee who offers a custodial arrangement within the meaning of s1012IA will be a platform operator to whom this prohibition potentially applies. Broadly, this covers circumstances where the licensee acquires underlying financial products upon the instructions of the investor or member, and holds these interests on their behalf under a trust or similar arrangement.

Likewise, any super fund trustee licensed by the Australian Prudential Regulation Authority (APRA) who offers investment choice and makes particular underlying financial products available to members will be a platform operator to whom this prohibition potentially applies.

Scope of the prohibition

The new prohibition is concerned with platform operators who receive benefits (monetary or non-monetary) from underlying fund managers in circumstances where the fund manager's product is made available by the operator to its investors or members. Platform operators who may receive such benefits will be in the unenviable position of being required to assess whether the benefits are 'volume-based shelf space fees'.

The legislation does not purport to provide an exhaustive definition of these fees. Instead, volume-based shelf space fees are defined as having 'a meaning affected by s964A' (ie the provision containing the prohibition), leaving the interpretation of this expression (and, therefore, the scope of the prohibition) open to future expansion by the courts or via regulatory policy.

Although the Explanatory Memorandum characterises this ban as one that will apply to benefits whose purpose is for the fund manager to secure placement on an administration platform (ie 'shelf space') or a preferential position on the platform, the prohibition itself does not take into account these or any other factors relevant to the purpose of the benefit.

Section 964A creates a very broad statutory presumption that benefits paid to a platform operator that are in any way dependent on the volume (by number or value) of the find manager's products made available to members or investors via the platform will constitute 'volume-based shelf space fees'. This presumption can be displaced, but only if it is proved that the benefit either:

  • represents a reasonable fee for services provided to the fund manager (whether by the platform operator or another person); or
  • is a discount or rebate given to the platform operator, whose value does not exceed the reasonable value of scale efficiencies achieved by the fund manager because of the volume of the fund manager's products involved.

The question of how a platform operator could successfully displace this statutory presumption (by 'proving' that the benefit meets either of these requirements) is problematic. It also raises timing issues, given that the statutory presumption under s 964A is apparently not displaced under the legislation until and unless the relevant benefit is proved to be a reasonable fee for services, or a legitimate discount or rebate referable to scale efficiencies.

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'Best interests' obligations

New personal advice obligations

The FoFA reforms replace the existing 'suitability rule', and other requirements applicable to personal financial product advice under ss 945A and 945B, with a more comprehensive set of obligations under a new Division 2 of Part 7.7A, to:

  • act in the best interests of the client in relation to the advice (s961B);
  • ensure that the advice provided is appropriate to the client (s961G);
  • warn the client if the advice is based on incomplete or inaccurate information (s961H); and
  • give priority to the interests of the client in the event of a conflict of interest (s961J).

These new statutory obligations are imposed directly on the individual advisers who provide personal advice to retail clients, rather than simply on the relevant licensee or authorised representative, as under ss 945A and 945B.

Notwithstanding this, civil penalties and damages resulting from advisers' non-compliance with the new best interests obligations are imposed on the relevant licensee or authorised representative (unless the authorised representative can demonstrate that the breach resulted from reasonable reliance on information or instructions provided by the licensee).

Concept of 'best interests'

The general 'best interests' obligation in the new s961B is supplemented by a list of seven steps preparatory to the provision of the advice, which, if carried out by the adviser, will result in the adviser being taken to have met this obligation. Although the Explanatory Memorandum observes that an adviser may be able to demonstrate that they have met the general obligation without having recourse to these seven preparatory steps, the extent to which the advice sector will have the confidence to do so remains to be seen. Advisers will need to adhere to a cut-down list of three steps, in order to satisfy the 'best interest' obligation for general insurance (but not life insurance) and basic banking products under sub-sections 961B(3) and (4), reflecting a belief that such products are more simple and better understood by consumers, which lessens the adverse impact of poor advice.

The new s961B statutory best interests obligation and list of preparatory procedural steps should not be confused with the very different concepts of best interests duties, either at general law or under existing statutory best interests duties, such as that imposed on superannuation trustees by s52 of the Superannuation Industry (Supervision) Act 1993 (the SIS Act).

Notwithstanding this, many of the preparatory steps listed in the legislation are qualitative, and dependent upon the client and adviser interaction in each particular case. Licensees will face a challenge in devising organisation-wide compliance systems and controls that are capable of adequately testing their advisers' and representatives' compliance with the new statutory best interests obligations in individual circumstances.

Scaled advice

In April 2010, the Federal Government advanced a new policy objective to be pursued as part of the FoFA reform package of removing regulatory barriers and improving access to low-cost simple or limited advice. Personal advice that is confined to a specific area of a retail client's financial needs or a limited range of issues (rather than a traditional 'holistic' advice that relates to all aspects of the client's financial circumstances) is generally referred to as 'scaled advice'.

During both of the parliamentary committee reviews into the FoFA Bills, some industry participants raised significant doubts as to whether the particular formulation of the new statutory best interests obligation in s961B would adequately allow for the provision of scaled advice. Although these concerns were not universally shared, more than one industry body called for s961B to either explicitly permit or make reference to the concept of scaled advice.

In response to these concerns, fairly minor changes were made to the legislation, in the form of an explanatory note added to s961B that refers briefly to the concept of scaled advice and some corrections made to language used in the Explanatory Memorandum. Although these changes will assist in the interpretation of the new statutory obligations, they fall short of providing the explicit legislative comfort sought by some industry participants during the parliamentary committee review process.

Instead, ASIC has been tasked to provide specific regulatory guidance about how the provision of limited, scaled advice can be accommodated within the best interests obligation under s961B. This guidance is expected to build on ASIC's Consultation Paper 164 Additional guidance about how to scale advice and Regulatory Guide 200 Advice for super fund members (RG 200). Released in 2009, RG 200 provides guidance for superannuation trustees that (among other things) confirms ASIC's view that the existing suitability rule in s945A is compatible with the provision of 'scaleable' advice, whereby clients and advisers agree to confine the scope of the advice to a single issue or a limited range of products, arrangements or issues.

Intra-fund superannuation advice

Currently, ASIC class order CO 09/210 Intra-fund superannuation advice provides relief for superannuation trustees from the s945A suitability rule where the trustee holds an AFS licence that covers personal advice and the advice is confined to the member's interest in the fund. The class order does not apply to certain advice, including advice about investment options or superannuation pensions.

This relief will become redundant (and is expected to be revoked) when the FoFA reforms commence in full, from 1 July 2013, and the existing suitability rule is replaced with the new best interests obligations. It appears that, for the purposes of the Act, intra-fund superannuation advice will thereafter be just one of the various forms of limited or scaled personal advice that may be accommodated under (and will need to comply with) s961B.

However, the contemporaneous developments relating to intra-fund advice, as part of the Stronger Super (including MySuper) reforms to superannuation, deliver additional regulatory complexity not shared by other forms of scaled advice.

Although the rules relating to intra-fund advice are contained in different tranches of proposed legislation that are at different stages of the legislative process, it is likely that the Stronger Super/MySuper reforms will allow the costs of providing one-off or transactional intra-fund advice to fund members to be collectively charged across the fund's membership. The reforms will insert a definition of intra-fund advice into the SIS Act. As currently formulated, this definition is similar to the scope of advice currently permitted under CO 09/210, although this is still subject to change. The somewhat contradictory policy approach taken to costs transparency associated with personal advice under FoFA and with intra-fund advice under Stronger Super has been noted by a number of observers.

What is certain, though, is that superannuation trustees who intend to provide intra-fund advice to members after 1 July 2013 will need to grapple with an array of new legislation and regulatory policy.

After sufficient time has passed for the industry to bed down the implementation of the FoFA and Stronger Super reforms, it will be interesting to observe the extent to which these reform packages have, in fact, met the Government's original policy objective of facilitating access to simple, low-cost advice by retail clients, including superannuation members.

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Enhancements to ASIC's licensing and banning powers

As a result of the FoFA reforms, from 1 July 2012, ASIC can refuse a licence application, cancel or suspend a licence or make a banning order where it has reason to believe that the applicant or licensee 'is likely to' contravene the general duties of financial services licensees under s912A of the Act. Previously, ASIC could only do so where it had reason to believe the applicant or licensee 'will not' comply with these obligations.

These amendments seek to address past difficulties reported by ASIC in establishing a sufficiently certain belief that a person 'will not' comply with its obligations in future. In the case of AFS licence applicants, it can be difficult to form such a belief before the applicant has commenced operating a financial services business. In the case of existing licensees, the challenge of establishing as a matter of certainty, reasonable belief of future non-compliance with financial services law based on unrelated conduct or contraventions (such as breaches of internal policies or ASX listing rules) has apparently proved difficult outside of cases involving convictions for fraud.

Additional new grounds upon which ASIC may make a banning order include where:

  • ASIC has reason to believe the person is not of good fame and character;
  • ASIC has reason to believe the person is not adequately trained or competent to provide financial services; or
  • the person has been, or ASIC has reason to believe, they are likely to become involved in the contravention of a financial services law by another person.

ASIC will be able to consider any conviction for an offence involving dishonesty during the previous 10 years (provided the offence is punishable by at least three months' imprisonment) in determining whether it has reason to believe that an applicant or licensee is not of good fame and character, rather than only convictions for 'serious fraud', as previously provided.

These expanded grounds are largely intended to further ASIC's investor protection mandate, by allowing it to respond pre-emptively to a perceived likelihood, or probability, of future contraventions of financial services laws before investor losses being incurred, rather than effectively being required to await actual contravention before being able to remove questionable industry participants.

As noted in the Explanatory Memorandum, the enhancements to ASIC's licensing and banning powers remain subject to the ordinary principles of administrative law, and existing channels of review and appeal of ASIC decisions in the Administrative Appeals Tribunal are unchanged.

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Transition and next steps

Commencement and transition

As foreshadowed by the Government in March 2012, amendments were made to the reform package in the Senate that effectively defer mandatory compliance with most of the FoFA reforms until 1 July 2013, including the new best interests obligations and the new prohibitions on conflicted remuneration, volume-based shelf space fees and asset-based fees on geared investments.

However, AFS licensees and other regulated persons will be able to 'opt in' to these new obligations and prohibitions during the transition period between 1 July 2012 and 30 June 2013, by issuing a notice to ASIC in the prescribed form.

The opt in mechanism applies on an 'all or nothing' basis, so if a licensee elects to opt in before 1 July 2013, the licensee and its representatives will become subject to all of the new obligations and prohibitions under Part 7.7A relevant to them. There is no opportunity to opt in voluntarily to some of the FoFA measures only, or for a licensee to opt in for some of its representatives only.

The practical consequence is that different industry participants involved in the same remuneration arrangements may have different commencement dates for the new Part 7.7A obligations and prohibitions. In particular, this may complicate the grandfathering of pre-commencement remuneration arrangements between licensees because, for example, the date from which the grandfathering of their existing remuneration arrangements is tested will be different for an early adopter of the FoFA reforms and a licensee who does not opt in to the FoFA reforms before 30 June 2013.

Those who elect to comply with the reforms during the transition period will be required to disclose this to any person affected by the resulting new obligations or prohibitions under Part 7.7A. ASIC must also publish details on its website of persons who have elected to comply early, including the relevant commencement date of compliance.

These transitional arrangements do not apply to the enhancements to ASIC's powers or the Part 7.7A anti-avoidance provision, both of which commenced from 1 July 2012. Therefore, persons are prohibited from entering into or carrying out any scheme after 1 July 2012 where the sole purpose (or for a purpose that is 'not incidental') of avoiding the application of any provision in Part 7.7A.

In addition, regulations have been made that delay the commencement of the conflicted remuneration bans for benefits relating to group life risk insurance policies for superannuation fund members and individual life risk insurance policies for default superannuation fund members until 1 July 2013, in line with the proposed commencement of the MySuper reforms. The MySuper reforms propose to separately prevent superannuation trustees from charging fees to members of a MySuper product that relate to the payment of conflicted remuneration to an AFS licensee.

Grandfathering of existing remuneration arrangements

The FoFA reforms include grandfathering provisions under which the new prohibitions in Division 4 (conflicted remuneration) and Division 5 (volume-based shelf space fees and asset-based fees on geared amounts) of Part 7.7A do not apply to benefits given under certain remuneration arrangements that were entered into before the commencement of those prohibitions (other than benefits given by a platform operator).

Interestingly, the grandfathering date for existing remuneration arrangements has also been deferred to 1 July 2013 (or an earlier 'opt in' date, if applicable). Although this may provide greater time for industry participants to put in place remuneration arrangements that are designed to take advantage of grandfathering, they should be mindful that any arrangements that are entered into or materially varied during the transition period will be subject to the anti-avoidance provision and may, therefore, be subject to regulatory scrutiny as to the purpose of such arrangements.

The regulations may prescribe circumstances in which this grandfathering does not apply. Treasury has released draft regulations relating to commissions payable under pre-existing arrangements between an adviser and a product issuer (rather than between the adviser and individual clients) that would exclude grandfathering for any new or additional financial products acquired by the adviser's clients under those arrangements.

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Next steps

ASIC has signalled its intention to issue specific regulatory guidance on a number of the FoFA reforms (in addition to amending existing guidance). The proposed timetable for new guidance is, currently, as follows:

  • ASIC's expanded suspension and banning powers: On 28 June 2012, an updated version of Regulatory Guide 98 Licensing: Administrative action against financial services providers was released, providing guidance on how ASIC expects to exercise its enhanced administrative powers against licensees.
  • Best interests obligations: Guidance on ASIC's expectations for meeting the new obligations on providers of personal advice is scheduled for release in August 2012.
  • Scaled advice: Guidance on providing information and advice (including scaled advice), taking into account the new best interests obligations, is due for release in August 2012. This is expected to build on ASIC's proposed guidance in Consultation Paper 164 Additional guidance about how to scale advice and the existing ASIC guidance in RG 200 concerning the provision of scaleable advice regarding superannuation.
  • Conflicted remuneration: Guidance on the practical operation of the ban, and how ASIC will administer it, is expected in September 2012.

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