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Duty to Manage Conflicts of Interests: Analysis of the Law

Info: 11507 words (46 pages) Dissertation
Published: 9th Dec 2019

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Tagged: LawBusiness Law

Duty to Manage CONFLICTS — is the law clear to Comply?


In January 2018, Australian Securities and Investments Commission (ASIC) issued Report 562 Financial advice: Vertically integrated institutions and conflicts of interest (REP 562).[1] REP 562 looked into how the financial advice arms of Australia’s largest banking and financial services institutions manage the conflicts of interest that arise as a result of providing advice to retail clients and also manufacturing financial products under a vertically integrated business model.[2]

The result suggested that “the advice licensees reviewed may not be appropriately managing the conflict of interest associated with a vertically integrated business model”.[3] Specifically, in examining a sample of files to test whether advice to switch to in-house products satisfied the “best interests” requirements, ASIC found that in 75% of the files reviewed, the advisers failed to demonstrate compliance with the duty to “act in the best interests of their clients”[4]. Further, 10% of the advice reviewed was likely to leave the customer in a “significantly worse financial position”.[5]

The review identifies areas where improvements are needed in the management of conflicts of interest, identifies the steps being taken to address shortcomings and flags that ASIC will consult on plans to introduce more transparent public reporting on approved product lists, including where client funds are invested, for all “vertically integrated firms”.[6]

The methodology adopted in Report 562 is rather interesting with regard to its review of case files. As examined later, ASIC appears to have fused the analysis of s 961B, 961G and 961J and creates a (although unintended) broader procedural defence for advisors in satisfying the “best-interests duty”. This is not to blame ASIC for attempting to offer a concise summary and set standards for measuring compliance with statutory best-interests obligation, rather, the article considers the difficulty and confusion root in the fundamental design of the legislation.

This article consists of four parts. Part I outlines the financial advice landscape in Australia, introducing the key participants and the common practice adopted by the industry. Examining the benefits and risks presented by “vertically integrated business model”, Part I presents the government authorities stance for the start.

Part II has two components. First, it traces the historical development of “conflicts management” obligation in Australia, comparing and contrasting the statutory proscription against equitable concept of fiduciary. Then it focuses more narrowly on the statutory obligations imposed upon financial advisor in the provision of personal advice to retail clients, and the licensee’s associated liability. Noted on the discretions inherently allowed from the wording of the provisions, it is argued the statutory obligation to manage conflict has been constructed rather commercial-friendly.

Part III examines REP 562. Looking closely into ASIC’s formulation of standard of conduct required for compliance of best-interest obligations, the article considers the possible fusion of the statutory requirements might justify a reform to seek a unified principle.

Part IV offers some observations of the current enforcement regime and propose for a “purpose driven” formula of the definition of “conflicts”.

I         The Financial Advice Landscape

With some limited exceptions[7], anyone who carries on a financial services business in Australia must hold an Australian Financial Services (AFS) licence issued by ASIC under Ch 7 of the Corporations Act.[8] This includes the business of providing “financial product advice” as defined.[9] Financial product advice comes in two types – personal and general. Personal advice is defined in s 766B(3), as advice that is given or directed to a person in circumstances where the provider of the advice has considered one or more of the person’s objectives, financial situation and needs, or a reasonable person might expect the provider to have considered one or more of those matters.[10] All other financial product advice is general advice.[11]

As at 30 June 2017 there were 4,185 AFS licensees authorised to provide personal advice and a further 1,653 licensees authorised to provide general advice.[12] Over 25,379 individual advisers were registered as providing personal advice to retail clients[13]as representatives of those licensees.[14]

Although the number of advisors authorised to provide personal financial advice to retail clients seems high, the advice industry is quite concentrated, as financial advisers generally fall into two categories:

  • affiliated with a financial institution (often referred to as aligned advisers); or
  • non-institutional operators (known as independent or non-aligned financial advisers).[15]

A common means of alignment in the financial advice sector is through vertical integration of business activities.[16]

A vertically integrated financial advice business occurs where a wealth management entity engages in both the delivery of personal financial advice services as well as manufacturing the financial investment products. It is a model widely adopted by financial service industry.[17] For example, the four major banks, AMP and IOOF (who manufacture their own financial investment products as well as provide advice) account for around 35% of the financial advice market, as measured by the number of advisers operating under a licence they control.[18]

The vertical integration of product manufacture with product sale and financial advice is a ‘one stop shop’ vision in which retail customers’ investment needs can be provided alongside traditional banking facilities such as loan and deposit services. It promises the virtue of efficiency, which is then passed on to consumers in the form of lower costs and greater access to financial advice. Customers may also enjoy the simplicity of dealing with just one institution.[19]

But the internal efficiency of the ‘one stop shop’ does not necessarily produce efficiency in outcomes for customers.[20] The one-stop shop has an incentive to promote the owner’s (or related parties’) products above others, even where they may not be ideal for the consumer.[21]

Thus, a vertically integrated business model creates an inherent conflict of interest.[22] The conflict arises as there are potentially competing priorities between the financial advisers providing advice that is in the best interest of the client while at the same time selling products that the aligned financial institution has manufactured.[23] Vertically-integrated advice (where an adviser recommends purchase of a financial product (including life insurance) from entities with which they are associated) is prevalent[24] in these institutions, which has been and remains a root cause of poor advice outcomes.[25]

Refrained from interfering with the market choice, the legislature permits such conflict to exist,[26] but requires the related AFS licensee and the authorised advisor to manage[27] it through a range of obligations (“duty to manage conflict of interest”[28] and “best-interest duty”[29])[30]

II       Managing Conflicts as an AFS Licensee

The widely adopted vertical integration business model in financial service sector means that the interests of AFS licensees and their representatives are not always aligned with those of their clients when they are advising on or arranging financial transactions.[31] But integration is not a problem per se, rather, it is a commercial decision which sometimes allow consumers to benefit from greater choice and boost economy efficiency[32]. Accordingly, regulatory authorities view it unnecessary and inappropriate to impose restrictions on the adoption of such business model.[33]

Instead, the legislature responded by imposing a statutory obligation (s 912A(1)(aa) on an AFS licensee to:

… have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative…[34]

Note as a general obligation owed by all AFS licensees, s 912 A(1)(aa) applies in circumstances of both fiduciary and non-fiduciary relationships. This is important because in Australia, financial product issuers and financial intermediaries that provide personal advice to a client may owe fiduciary duties to that client, depending on the nature and circumstances of their interaction.[35]

The exact operation of s 912A(1)(aa) in fiduciary and nonfiduciary relationship is not settled, although it was suggested that:

  • “To the extent or in the areas that the relationship is not fiduciary, the statutory obligation to manage conflicts requires the AFS licensee to ensure the existence of the conflict is fully and candidly disclosed to the client.  Once the conflict is disclosed, the licensee or representative can pursue its own interests, within the bounds of commercial standards of honesty, careful conduct and promise keeping[36].
  • Where the relationship is fiduciary, the statutory obligation to manage conflicts accommodates but does not displace the fiduciary proscriptions. This means that the AFS licensee cannot act (or allow the representative to act) in circumstances where there is a real and sensible possibility that the licensee’s or representative’s personal interest, or duty to another person, may conflict with its duty to act in the best interests of the client, unless that would be permitted under fiduciary principles (for example because effective Chinese wall arrangements are in place or where the client has given its fully informed consent)”[37].

Many considers that a financial adviser providing personal advice to a client (whether retail or wholesale) will owe fiduciary duties to the client in connection with that advice[38]— especially where the client places trust and confidence in the advisor and acted upon the advice.[39] In contrast, an AFS licensee or its representative who is a “mere salesman” of financial products will not sit as fiduciary to the customer. The dividing line between the two is not always clear; especially in large institutions where vertically-integrated advices are prevalent and advisors normally take up multiple roles simultaneously.[40]

A      Statutory conflicts management obligation – in general

Section 912A (1) (aa) was introduced into the Corporations Act three years after the enactment of the Financial Services Reform Act 2001 (Cth) (‘FSR’), by the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (Cth). The view at the time was that the “efficient, honest and fair” standard introduced by FSR included a requirement to manage conflicts,[41] but industry developments meant it should be made more explicit.[42]

The Explanatory Memorandum to the Bill envisaged two categories of conflicts that must be managed:

  • “conflicts within the financial services business (Category 1): examples are conflicts within one area of the financial services business, such as dealing on behalf of various clients, or across different areas of the business, such as between publishing research in a client newsletter and market making;
  • conflicts between something within the financial services business and something outside the financial services business (Category 2): examples are where outside factors give rise to conflicts within the financial services business, such as a conflict of interest between the financial services licensee lending (as principal) to a particular enterprise and the financial services licensee underwriting a public offer for the same enterprise. Alternatively, a conflict may arise where the objectivity of research is compromised by the analyst’s personal interests or relationships”.[43]

The Memorandum also asked ASIC to “develop guidance and take enforcement action, while being consistent with a principles-based approach”[44], as “ASIC guidance on the management of conflicts of interest will assist licensees to comply with their legal obligations”[45].

In August 2004, ASIC issued RG 181 Licensing: Managing conflicts of interest[46], explaining its approach to monitor Licensees’ compliance with the statutory obligation in s912A(1)(aa) (the conflicts management obligation). RG 181 defined conflicts of interest as “circumstances where some or all of the interests of people (clients) to whom a licensee (or its representative) provides financial services are inconsistent with, or diverge from, some or all of the interests of the licensee or its representatives. This includes actual, apparent and potential conflicts of interest”.[47] Although “the obligation to have adequate arrangements to manage conflicts of interests does not prohibit all conflicts of interest…it does require arrangements to ensure that all conflicts are “adequately managed”[48]. ASIC observed “three mechanisms that licensees would generally use to manage conflicts of interest:

a)      controlling conflicts of interest;

b)     avoiding conflicts of interest; and

c)      disclosing conflicts of interest.”[49]

RG 181 has not been revised since issue, the strength of proposed mechanisms for licensees to “manage conflict” is arguably ineffective to reach the statutory purpose. Judging from REP 562 (discussed below) and widespread misconducts prevalent in financial service industry, a new definition and standard for measuring conflict management effectiveness is needed.

The nature of the statutory conflicts management obligation was considered by Jacobson J in obiter in Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty Ltd (No 4).[50]  In that case, the relationship between the investment bank and its client was found not to be fiduciary, and the investment banking services were not ‘financial services’ for the purposes of the statutory requirement.[51] His Honour’s observations were adopted by Beach J in Australian Securities and Investments Commission v Avestra Asset Management Ltd (in liq), a case concerning the responsible entity of a registered Managed Investment Scheme:

In Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty Ltd … Jacobson J made the following observations (at [423]), albeit by way of obiter, which I accept. First, the effective management of conflicts of interest does not require that every possible conflict of interest must be eliminated, although that course is open to a financial services licensee. The reference to ‘management’ of conflicts of interests assumes that some potential conflicts may be managed through implementing adequate arrangements that stop short of eliminating the conflict of interest (at [444] and [445]). And even in a fiduciary situation, adequate arrangements for the management of conflicts of interest does not always require the elimination of conflicts of interest for which the beneficiaries’ express consent has not been obtained (at [443]). Second, whether particular arrangements are adequate is to be determined as a question of fact in each case (at [446]). Third, adequate arrangements require more than a raft of written policies and procedures. They require a thorough understanding of the procedures by all employees and a willingness and ability to apply them to a host of possible conflicts (at [454]).[52]

To this, his Honour added the following observations:

(a) First, whether arrangements are adequate will depend upon the nature, scale and complexity of the licensee’s business. Moreover, although s 912A(1)(aa) does not import the full stringency of equitable constraints upon a fiduciary acting in a conflict of interest situation, the fact that a financial services licensee is in a fiduciary position (see also s 601FC(2)) will inform what arrangements are adequate.

(b) Second, the obligation to manage conflicts of interest is more than simply an obligation of disclosure to clients or beneficiaries.

(c) Third, the effective management of conflicts of interest will involve a combination of avoiding, controlling and disclosing conflicts of interest.

(d) Fourth, controlling a conflict of interest requires a licensee to first identify, assess and evaluate a conflict of interest and then to decide on and implement an appropriate response. Moreover, any arrangement in response must be regularly monitored to ensure that its implementation is effective.

(e) Fifth, in some cases, the potential impact on a licensee or third parties will be so serious that a conflict of interest cannot effectively be managed by disclosing it and imposing effective internal controls. In such cases, the only way to adequately manage such a conflict of interest may be to avoid it.

(f) Sixth, where disclosure is used as a means of managing a conflict of interest, the disclosure must be made to the affected persons in a timely, prominent, specific and meaningful way. The concept of ‘meaningful’ connotes something comprehensible to the expected reasonable reader or audience. It also connotes something targeted in terms of its usefulness to the reasonable reader or audience. Further, its informational content ought to cover the probability of the conflict occurring and the likely magnitude of its consequences if it does occur in terms of the potential advantages and disadvantages to those who generated the conflict or are participants or beneficiaries therein, or those to whom the disclosure is made. And for those to whom the disclosure is being made, reference should be made to any realistic steps that such a person can take (if any) to ameliorate the conflict’s effects.[53]

This suggests that, even outside the fiduciary context, an AFS licensee cannot meet its statutory conflicts management obligations simply by providing the disclosure required (for retail clients) in the Financial Service Guide or Product Disclosure Statement.[54] But the statutory conflicts management obligation does not of itself require the AFS licensee to give up (or ensure its representative gives up) its own interest, or to prioritise the client’s interests, unless it has a prior legal obligation to do so.[55]  Such an obligation may arise under fiduciary principles or from a specific statutory ‘best interests’ obligation as imposed upon financial advice providers.[56]

B       Statutory conflicts management obligations in providing personal advice to retail investors

1        Background

During the global financial crisis of 2007-8, some retail clients who had been advised to make unsuitable financial choices, including with their retirement savings, suffered significant losses.[57] To understand the causes and consequences of these losses, the Parliamentary Joint Committee on Corporations and Financial Services (PJC)[58] chaired by Bernie Ripoll MP conducted a wide-ranging inquiry into financial products and services in Australia.[59] PJC observed that “disclosure had not been effective to address conflicts of interest” and recommended that the Corporations Act be amended to “explicitly include a fiduciary duty for financial advisers operating under an AFS Licence, requiring them to place their clients’ interests ahead of their own”[60]. This approach reflects a policy view that individuals consulting a regulated adviser ought to be entitled to expect disinterested and objective advice[61] about what is best for them in the circumstances disclosed to the adviser,[62] given the information asymmetry[63], financial illiteracy[64] and power imbalance[65] experienced by the individual.

In response, Corporations Amendment (Future of Financial Advice) Act 2012 introduced the “best-interests” obligations upon financial advisers to ensure the ‘provider’ of personal advice to retail clients adheres to (or at least having regard to) the client’s best interests[66] in providing service. The statutory best-interests obligation spreads across four operative provisions (ss 961B, 961G, 961H, and 961J), and applies directly to the individual advisor. This differs from the previous regime where the suitability requirement under former s 945A was imposed upon AFS Licensees or their authorised representatives.

More counterintuitive is the possibility that an individual advisor is not necessarily liable for a failure to comply – responsibility for non-compliance with “best-interests duty” sits with the licensee unless the provider is an authorised representative.[67] A licensee must “take reasonable steps to ensure” that its representatives comply with the statutory obligation[68], and is subject to civil penalty liability for representatives’ noncompliance in circumstances specified in ss 961K, 961Q and 961L. Such allocation of liabilities may be justified when consider the underlying aim to promote AFS licensees’ management and control of institutionalised conflicts of interest, however, as examined later, the convoluted[69] liability and enforcement regime creates unnecessary uncertainty for the enforcement in reality.[70]

2        “Best-interests duty and other related obligations”

(a)   S 961 B – Statutory “best-interests duty”

Section 961B (1) says that the provider “must act in the best interests of the client in relation to the advice”[71]. This requirement is distinct from general fiduciary duties as it appears to require positive conduct on the part of the provider to discharge the obligation, thus offering wider protection to the retail client. It echoes the “fairness” concept in s 912A(1)(a) which requires AFS Licensees to ensure “efficient, honest and fair” provision of financial services[72]. The intent of s 961B (1) is that the meeting of the client’s objectives, financial situation and needs must be the paramount consideration when providing financial advice to retail clients.[73] However, the statutory best-interests duty under s 961B (1) may have been affected, and to some extent displaced, by s 961B (2), so far as taking the steps specified in s 961B (2) is treated as compliance with the “best-interests duty” specified in s 961B (1)[74].

S 961B(2) specifies steps that a provider must take in “acting in the client’s best interest”, including requirements to obtain instructions and conduct inquiries, as well as to take “any other step” that would reasonably be regarded as being in the client’s best interest.[75] None of the steps expressly requires the provider to identify or resolve interest-duty or duty-duty conflicts, although perhaps this is contemplated by s 961B(2)(g).

Steps in s 961B(2) are directed at the process or procedure by which a provider arrives at the advice, and not at the end to which the provider’s efforts must be directed. They reflect “the notion that good process will improve the quality of advice that is provided”[76] and are intended to set out the minimum required to establish that a provider has acted in the best interests of the client. Section 961B(2) “may be treated as providing a ‘safe harbour’ for providers accused of breaching the best interests duty. If the provider can prove that he or she has done each of the seven things in s 961B(2), he or she will have satisfied the best interests duty.”[77]

However, s 961B(2) does not require the advisor to “act in good faith” in taking the steps prescribed, the criteria would be more recognisably related to the adviser’s duty of care. Duty of care is but one element of the equitable “best-interests duty”, it should not be the whole of it.[78]

(b)   S 961 G – Appropriateness

The second operative provision is s 961G, which says that the provider “must only provide the advice to the client if it would be reasonable to conclude that the advice is appropriate to the client, had the provider satisfied the duty under section 961B to act in the best interests of the client”[79].  S 961G appears to impose two obligations, first to comply with s 961B, by taking steps specified in s 961B(2); second, after compliance with s 961B is satisfied, the advice must be evaluated as  reasonably appropriate to client.

It is worth comparing the wording of s 961G with the application of former s 945A(1). As Edelman J pointed out, to satisfy the suitability test under s 945A(1), the adviser must not give the advice unless it is “appropriate having regard to an investigation and consideration of the subject matter of the advice as was reasonable in all of the circumstance”[80]. There appears to be no material distinction between the former suitability test and the current appropriateness test.

(c)   S 961H – Warning

The third operative provision is s 961H, which contains the obligation (similar to the old s 945B) to warn the client if the advice is based on incomplete or inaccurate information.

(d)   S 961J – Priority

The fourth operative provision s 961 J, also known as “priority” provision, requires a provider must give priority to the interests of a retail client when giving advice where he/she knows or reasonably ought to know, of existence of any conflicts.

While there are superficial echoes of fiduciary concepts in s 961J, the obligation clearly falls short of the fiduciary standard at general law. In fact,

…[I]t only applies if the provider knew or ought reasonably to know of the existence of the conflict. It does not require the adviser to avoid the conflict or to obtain the client’s fully informed consent to it acting as the client’s adviser despite the existence of the conflict. It does not require client’s fully informed consent before the adviser or any other person (including the associates listed in the section) profits from the relationship between the client and the adviser. Unlike the fiduciary proscriptions at general law, the statutory provision does not perform a prophylactic function; instead it allows the adviser to proceed despite the conflict and leaves it to the adviser to ‘prioritise’ the interests of the client in the advice relationship.[81]

As such, an advisor would not be prevented from receiving remuneration from a person other than a client, provided he or she does not give priority to maximising remuneration over the clients’ interests. The “open textured” language of this section, although offers flexibility to suit a range of commercial circumstances, is too uncertain to supervise or enforce – there will always be room for factual debate as to whether conduct gave “priority” to a client’s interest in any particular case.[82]

C       A few remarks

It should be clear even in the provision of financial advice to retail clients, the statutory conflicts management obligations are not fiduciary duties in the strict sense, and do not reflect orthodox equitable understandings of best-interests obligations. Instead they may be related to a different and emerging standard of “fairness” that is required in dealings between financial services providers and their retail clients – something less than a strict fiduciary standard (which is probably irreconcilable with the current economic structure[83] and purpose of the financial advice sector[84]) but more than what is expected of both parties in ordinary arm’s length commercial dealings.[85] This approach is arguably more consistent with the commercial realities of an advice sector that sits (at least in significant part) inside vertically integrated financial institutions, and may reflect a pragmatic adjustment to the fiduciary approach advocated in 2009 by the PJC.[86]

Given the rather relaxing standard of the statutory best-interests obligation, one would expect financial advisors (with proper training as/with an AFS Licensee(s)) to appreciate the flexibility and leeway offered, and at least, follow the steps prescribed in s 961B(2) to discharge “best-interests” duty. Yet as demonstrated in REP 562, we might be expecting too much from the financial industry.

III    REP 562 – Financial Advice and Conflicts Management

On 24 January 2018, ASIC released Report 562 Financial advice: Vertically integrated institutions and conflicts of interest (REP 562)[87] covering ASIC’s recent review of financial advice provided by the five biggest vertically integrated financial institutions. The report followed ASIC’s investigation into the make-up of approved product lists by licensees owned by AMP, ANZ, CBA, NAB and Westpac and the quality of advice provided to 200 clients who were advised to move their superannuation to the in-house superannuation platform.

A      Methodology

REP 562 focused on five of the largest banking and financial services institutions with vertical integration, requesting information from the two largest advice licensees controlled or owned by each of the five institutions, where these licensees were authorised to provide personal advice to retail clients. The information covered the periods from 1 July 2014 to 28 February 2015 (first relevant period) and from 1 January 2017 to 31 March 2017 (second relevant period)[88].

The project had two components:

  1. Review of the “approved product list”[89] (APL) composition and product sales;
  2. Review of the quality of advices recommending an inhouse superannuation platform to new customers, testing whether advisors had demonstrated compliance with the obligations under the Corporations Act 2001 (Cth) to:
  1. act in the best interests of the customer (s961B);
  2. provide the customer with appropriate advice (s961G); and
  3. prioritise the customer’s interests over their own interests or those of a related party (s961J).

B       Key findings and Analysis

1        APL Construction and Product Sales

ASIC found “a clear weighting”[90] in the products recommended by advisers towards inhouse products: The report found that overall, 79% of the financial products on the firms’ approved products lists (APL) were external products and 21% were internal or ‘inhouse’ products. However, 78% (by value) of the investments made by clients were made in in-house products. (At the level of individual licensees, the proportion varied from 31% to 88% invested in in-house products. By product type, the proportions invested in in-house products varied: 91% for platforms; 69% for superannuation and pensions; 65% for insurance; and 53% for investments[91]. Taken as a whole, the report shows that advisers favour in-house products.)

It appears that APLs are less effective in managing conflicts than previously perceived. A balanced APLs do not, of themselves, drive out “conflicted” advice. Advisers may be expected to know more about the products manufactured by the licensee with which the advisers are associated than they know about a rival licensee’s products. Advisers will often be readily persuaded that the products ‘their’ licensee offers are as good as, if not better than, those of a rival. And when those views align with the adviser’s personal financial interests, recommending the client to use an in-house product seems quite a natural choice.

2        Case File Review

ASIC reviewed 40 customer files (full record) from each institution to examine the quality of advice provided to 200 clients who were advised to move their superannuation to the in-house superannuation platform[92].

In ASIC’s view, 75% of the advice provided was “non-compliant” as they did not comply with the “best-interests duty and related obligations”, although “all of the advisors relied on the framework of the safe harbour steps in s 961B(2)(a)-(g) of the Corporations Act in providing the advice”[93]. ASIC said that in 10% of cases the client was “likely to be significantly worse off as a result of following the advice” and that in “65% of cases the files did not demonstrate the customer would be in a better position following the advice”[94].

(a)   Satisfying “best-interests duty” according to ASIC

In reviewing the 200 files ASIC (and an external reviewer) considered first whether the adviser was able to rely on the safe harbour provisions (s 961B(2)). An adviser who is able to demonstrate (from contents recorded in the case file) that they have taken each of the steps in s961B(2) is deemed to have provided advice that was in the best interests of the client. ASIC acknowledged that each step taken would be scaled narrowly or extensively, based on the advice being given. As ASIC advised elsewhere, where the advice is limited, it is often (but not always) possible that the inquiries required by the safe harbour steps are also limited.[95]

Given the protection offered by the safe harbour and the procedural-oriented nature of s 961B(2) (explained earlier), it is surprising that providers of advice do not step carefully through them. But they do not.

In 75% of case files examined, the advisers had not taken ALL of the safe harbour steps. This was commonly because the adviser failed to demonstrate that they had sufficiently researched and considered the customer’s existing financial products (s961B(2)(b)(ii) ‘the client’s relevant circumstances’) and based all judgments on the customer’s relevant circumstances (s 961B(2)(f)).

ASIC considers (as we all do) that investigating a client’s existing financial products and assessing whether they could meet the client’s needs are “very important considerations”[96] when recommending a replacement product. To strengthen its stance, ASIC points to a standalone obligation under s947D (“switching advice”) of the Corporations Act, requiring the advisor to include certain information about the costs of switching, any benefits a customer may lose, and any other significant consequences of switching products “when recommending the replacement of one product with another”[97].

Some advisors say that they cannot consider a client’s existing product because it does not appear on the approved product list. But it is hard not to be slightly suspicious of this. Per ASIC, all the advice licensees had a process by which an adviser could seek approval to recommend a customer’s existing financial products if these products were not already on the licensee’s approved product list.[98] Second, the investigation of a client’s existing product does not need to be as extensive as the review of a product for replacement.

It is worth noting that ASIC did not appear to expect any further step to be taken under the last limb of the safe harbour – “to take any other step reasonably necessary”[99] – to act in the best interests of the client. This limb of the safe harbour has been roundly criticised as “it could undo the usefulness of the safe harbour itself”[100]. Judged from the REP 562, such criticism seems unwarranted.

In each case where the adviser could not rely on the safe harbour, ASIC said that it then went on to consider whether the adviser “nevertheless provided advice that was in the client’s best interests under s961B(1)”[101]. It concluded “In each case where the adviser could not rely on the safe harbour, we also found that the advice provided was not in the customer’s best interests under s961B(1)”[102], but refrained from saying what it considered in forming its conclusion.

It seems likely the other criteria adopted by ASIC in analysing compliance with “best-interests” duty without satisfying s 961B(2) is that “the advice would leave the customer in a better position”[103]. However, s 961B does not impose a duty on an adviser to give advice that will, or is likely to, put the client in a better position. It is not about justifying the quality of the advice by retrospective testing against financial outcomes. The timing for evaluating “better position” is critical to form a conclusion, but it would fail to recognise the inherent uncertainty in investment decisions, and may sometimes justify high risk advice which happens to generate “short term” profit (“fishing” & “layering”[104]).

(b)   Satisfying “appropriate advice” according to ASIC

ASIC then looked at whether the adviser had complied with their duty under s961G to only give advice if it is reasonable to assume that the advice is appropriate.

This is an interesting obligation, where some suggested that the reference to reasonableness would help an adviser whose advice was being tested.[105] But it is apparent from REP 562 that “test of reasonableness” will only be available for an adviser who brings themselves within the safe harbour. As advised earlier, it would not be possible to satisfy s 961G without complying with s 961B. But does it necessarily mean that advice compliant with s 961B is “appropriate”?

ASIC stated that 75% of the customer files reviewed failed the appropriateness test, and “often the reason for a file to “fail” under 961G stemmed from failing to comply with s 961B(2)”[106]. However, ASIC did not clarify if there were case files that passed s 961B yet were “inappropriate”. The fusion of s 961B and 961G arguably offer greater certainty for advisors – knowing that compliance with s 961B(2) would potentially save them from liability of providing “inappropriate” advice.

It should be noted that, in Australian Securities and Investments Commission v NSG Services Pty Ltd, the first civil penalty action taken by ASIC alleging breaches of the best-interests obligations, Moshinsky J found:

“It was common ground that, while s 961B is concerned with the process or procedure involved in providing advice that is in the best interests of the client, s 961G is concerned with the content or substance of that advice. At first blush, the text of s 961B does not appear to support the proposition that s 961B is concerned with the process or procedure involved in providing advice that is in the best interests of the client. However, support for this way of viewing the focus of s 961B is provided by the context in which it appears, including the language of s 961G, the legislative history, and the legislative materials (see, in particular, the revised explanatory memorandum to the Corporations Amendment (Further Future of Financial Advice Measures) Bill 2011 (Cth) at [1.23], [1.24], [1.57]). It is unnecessary for present purposes to reach a concluded view on this issue.”[107]

(c)   Satisfying “duty of priority” according to ASIC

Finally, ASIC considered whether the adviser satisfied the duty “to prioritise the clients’ interest” (s 961J). In this review, the product manufacturers and advice licensees were related entities. ASIC contended that as these businesses were vertically integrated, there was a conflict between what was in the product manufacturer’s interests and the client’s interests. Thus, where an advisor recommends a customer to switch into an inhouse product, s961J would only be satisfied where the advice demonstrated “benefit” to the customer[108].

The specific subject matter (switching advice) arguably justified ASIC’s adoption of “benefit” or “better position” in evaluating compliance with s 961J, as there was a benchmark (existing product) preceding the switching advice.

However, where there was no existing product that meet client’s need (i.e. no bench mark to demonstrate “benefit’), ASIC seemed to be (once again) fusing “best-interest” and “appropriateness” into concluding its “priority” analysis: “Given the number of files that were rated as a “fail” when testing advisers’ compliance with the best interest duty (s 961B(1)) and the appropriate advice requirement (s 961G), it was perhaps not unexpected that, in a large number of files, advisers did not demonstrate how they had prioritised the needs of the customer (s961J).”[109] Coincidentally, ASIC found 75% of the files reviewed failed to satisfy s 961J.

ASIC did not specify any case file which passed “best-interests” duty yet failed to “prioritise client’s interest”. Whether this indicates that “S 961J is no more than a restatement of the duty imposed by S961B to act in the best interests of the client”[110] remains to be examined in the future.

C       Fusion of “best-interests duty”

Apparently, ASIC accepts that an adviser can recommend an in-house product consistently with their best-interests duty. In fact, REP562 attempted to provides a concise roadmap for advisors to achieve this.

In ASIC’s view, an adviser who demonstrates that they have taken all of the steps in s 961B(2) (safe harbour) will not only be deemed to have complied with the “best interests duty” but also to have satisfied the “appropriate advice obligation”. Where advisor suggests the customer to “switch inhouse”, he/she must be able to show that the advice is going to provide some benefit to the client in order to satisfy the duty of priority. Where there is no need for the client to change existing investment, the advisor should simply advise so.

However, as examined above, the test adopted by ASIC in each duty analysis relied heavily on the subject matter and the nature of the advice. In formulating requirements for each duty, ASIC arguably welded different wordings prescribed in the statute into a general principle – “to look after the client’s best interest”. Such methodology, however, is contrary to the ordinary course of statutory interpretation. Although ASIC’s analysis is applaudable for offering simplicity in advice compliance check, its applicability awaits judicial scrutiny. Alternatively, the disparity between ASIC’s interpretation and the statutory prescriptions may be pointing to the unnecessarily complex construction of the current legislative regime and a need for reform.

IV    Observations and proposals

Despite the high level of non-compliant advice, combined with the high proportion of funds invested in in-house products, ASIC remained unwilling to take a firm stand against these large institutions and only concluded they “may not be appropriately managing the conflict of interest associated with a vertically integrated business model”.[111] Nor did ASIC taken any civil penalty proceedings against the licensees related to the advisors for those noncompliant advices identified.

ASIC fails to draw a definitive conclusion of the licensees’ noncompliance with s 912A(1)(aa) (“have adequate arrangements for the management of conflicts”) because it has no benchmark to evaluate against.  S 912 A(1)(aa) in effect hands over the power of identifying and categorising conflicts to the AFS Licensee, and expected the licensee to draw up a plan “appropriate (to the licensee)” to manage issues identified by the licensee.

Moreover, the definition of “conflicts of interest” in RG 181 is arguably no more than an umbrella term to cover a wide range of situations where conflict may arise, it does not point to the unfavourable consequences caused by having conflicts. A better view might be, as developed by the National Audit Office (NAO),

“A conflict of interest is a set of circumstances that creates a risk that an individual’s ability to apply judgement or act in one role is, or could be, impaired or influenced by a secondary interest. It can occur in any situation where an individual or organisation (private or government) can exploit a professional or official role for personal or other benefit. The perception of competing interests, impaired judgement or undue influence can also be a conflict of interest.”[112]

Identifying the sources of conflict has no material impact where the licensee has obligation to avoid/prevent that conflict from arising. If a principle-based approach is favoured for the flexibility offered, the principle should focus on the purpose of regulation: conflict should be managed because it impairs or influences individual’s ability to judge; conflict is managed only when it does not impair nor influence the individual’s ability to judge.

[1] Australian Securities and Investments Commission, ‘REP 562 Financial Advice: Vertically Integrated Institutions and Conflicts of Interest’ (report).

[2] Ibid 4–5, 17.

[3] Ibid 38.

[4] Corporations Act 2001 (Cth) s 961B.

[5] Commission, ‘REP 562 Financial Advice’, above n 1, 7–8.

[6] Ibid 11–12.

[7] Corporations Act 2001 (Cth) s 911A(2).

[8] Ibid s 911A(1).

[9] Ibid ss 761A, 766A, 766B,766C-D, 766E.

[10] Ibid s 766B(3).

[11] Australian Securities and Investments Commission, ‘RG 244 Giving Information, General Advice and Scaled Advice’ (Regulatory guide).

[12] Australian Securities and Investments Commission, ‘ASIC Annual Report 2016-17’ (June 2017) 21 <https://asic.gov.au/about-asic/corporate-publications/asic-annual-reports/>.

[13] Corporations Act 2001 (Cth) ss 761G and 761GA.

[14] Commission, ‘ASIC Annual Report 2016-17’, above n 12, 21.

[15] ‘Productivity Commission Inquiry Report-Competition in the Australian Financial System’ (Productivity Commission, June 2018) 282.

[16] Ibid 280.

[17] Commission, ‘REP 562 Financial Advice’, above n 1, 5.

[18] ‘Productivity Commission Inquiry Report-Competition in the Australian Financial System’, above n 15, 283.

[19] Ibid 9.

[20] Peter Malekas, ‘Focusing on Needs, Not Sales’, 1 April 2018 <https://www.ifa.com.au/opinion/25410-focusing-on-needs-not-sales>; Aleks Vickovich, ‘Death Throes of Vertical Integration’, 23 April 2018 <https://www.ifa.com.au/opinion/25438-death-throes-of-vertical-integration>; Georgia Wilkins, ‘Banks Begin to Unwind Vertical Integration, but Victims Continue to Fight’ The Sydney Morning Herald, 13 January 2017 <http://www.smh.com.au/business/banking-and-finance/banks-begin-to-unwind-vertical-integration-but-victims-continue-to-fight-20170105-gtm6kw.html>.

[21] ‘Productivity Commission Inquiry Report-Competition in the Australian Financial System’, above n 15, 82; Australian Lawyers Alliance, ‘An Inquiry into Consumer Protection in the Banking, Insurance and Financial Sector – Submission to Senate Standing Committees on Economics’ (7 March 2017); Gail Pearson, ‘Failure in Corporate Governance: Financial Planning and Greed’ in Chapters (Edward Elgar Publishing, 2016) 185.

[22] Commission, ‘REP 562 Financial Advice’, above n 1, 5.

[23] ‘Productivity Commission Inquiry Report-Competition in the Australian Financial System’, above n 15, 280.

[24] Commission, ‘REP 562 Financial Advice’, above n 1.

[25] Ibid 11–12.

[26] Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004; Corporations Act 2001 (Cth) s 912 A(1)(aa).

[27] Financial System Inquiry (Australia : 2014) et al, Final Report – Murray Report (The Treasury, 2014) <http://fsi.gov.au/publications/final-report>.

[28] Corporations Act 2001 (Cth) s 912A(1)(aa).

[29] Ibid Pt 7.7A Div 2.

[30] Commission, ‘REP 562 Financial Advice’, above n 1, 8.

[31] See, for example, Australian Securities and Investments Commission, Report 562: Financial advice: Vertically integrated institutions and conflicts of interest (January 2018).  See also Australian Securities and Investments Commission, Regulatory Guide 148 – Platforms that are managed investment schemes and nominee and custody services (December 2016) [RG 148-183] – [RG 148.187] (management of conflicts by platform operators), and Australian Securities and Investments Commission, Regulatory Guide 179 – Managed discretionary account services (September 2016) [RG 179.67] – [RG 179.87] (management of conflicts by MDA providers).

[32] ‘Productivity Commission Inquiry Report-Competition in the Australian Financial System’, above n 15, 249.

[33] Stan Wallis, ‘Financial System Inquiry (1996) Final Report’ (1997) <treasury.gov.au/publication/p1996-fsi-fr/>; Financial System Inquiry (Australia : 2014) et al, above n 27; ‘Future of Financial Advice: Best Interests Duty and Related Obligations’ 30.

[34] Corporations Act 2001 (Cth) 912A(1)(aa).

[35] Pamela F Hanrahan, ‘The Fiduciary Idea in Financial Services Law’ in Justin O’Brien and George Gilligan (eds), Integrity, Risk and Accountability in Capital Markets: Regulating Culture (Bloomsbury Publishing, 2013) 203; Pamela F Hanrahan, ‘ASIC v Citigroup: Investment Banks, Conflicts of Interest, and Chinese Walls’ in Private Equity, Corporate Governance and the Dynamics of Capital Market Regulation (2007) 117.

[36] See Lord Millett’s Foreword to J McGhee, Snell’s Equity (Sweet & Maxwell, London, 30th ed 2000), distinguishing between the core concerns of equity and the common law.

[37] Hanrahan, ‘The Fiduciary Idea in Financial Services Law’, above n 35.

[38] R Baxt, Ashley Black and Pamela F Hanrahan, Securities and Financial Services Law (Chatswood, NSW; LexisNexis Butterworths, 2017., 2017) 582.

[39] Ibid.

[40] Hanrahan, ‘The Fiduciary Idea in Financial Services Law’, above n 35.

[41] Australian Securities and Investments Commission v Avestra Asset Management Ltd (in liq) (2017) 120 ACSR 247; [2017] FCA 497 at [192] (Beach J).

[42] These developments can be traced back to the beginnings of financial deregulation in the 1980s.  As early as 1990 there was a reference to the UK Law Commission to inquire into the relationship between fiduciary duties and regulatory rules; the Commission noted that ‘Situations in which professionals and businesses appear to owe conflicting duties to different customers or in which there is a conflict between their own interests and those of their customers are not new. However, the potential for such conflicts increased as a result of the changes to the structure of the financial markets in the mid-l980s, in particular the abolition of the Stock Exchange’s single capacity requirement and the development of financial conglomerates offering a wide range of services.’  The Law Commission UK (Law Com No 236) Fiduciary Duties and Regulatory Rules (November 2995) [1.2].

[43] Explanatory Memorandum to the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003, para [5.599].  A third category was outside the scope of the requirements: ‘conflicts outside the financial services business (Category 3) – where a factor outside the financial services business gives rise to a conflict with another factor outside the same financial services business. Examples include where those conflicts might arise between two non-financial services businesses of a merchant bank (for example; corporate lending and dealing on the bank’s own behalf). Such conflicts are unrelated to the financial services businesses.

[44] Ibid.

[45] Ibid.

[46] Australian Securities and Investments Commission, ‘RG 181 Licensing: Managing Conflicts of Interest’ (Regulatory guide, 30 August 2004).

[47] Australian Securities and Investments Commission, Regulatory Guide 181 – Managing conflicts of interest (August 2004).   This is one of the few Regulatory Guides that has not been revised by ASIC since issue.

[48] Ibid, [181.27].

[49] Commission, ‘RG 181 Licensing’, above n 46.

[50] Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty Ltd (No 4) (2007) 160 FCR 35; 241 ALR 705; 62 ACSR 427; [2007] FCA 963.  See Pamela Hanrahan, “ASIC v Citigroup: Investment Banks, Conflicts of Interest and Chinese Walls” in Justin O’Brien (ed) Private Equity, Corporate Governance and the Dynamics of Capital Market Regulation (Imperial College Press, London, 2007).

[51] Because of the carve-out in Corporations Regulations 2001 (Cth) reg 7.1.29(3)(c).

[52] Australian Securities and Investments Commission v Avestra Asset Management Ltd (in liq) (2017) 120 ACSR 247; [2017] FCA 497 at [193].

[53] Australian Securities and Investments Commission v Avestra Asset Management Ltd (in liq) (2017) 120 ACSR 247; [2017] FCA 497 at [194].

[54] Commission, ‘RG 181 Licensing’, above n 46.

[55] Simone Degeling and Jessica Hudson, ‘Fiduciary Obligations, financial Advisers and FOFA’ 13; Hanrahan, ‘The Fiduciary Idea in Financial Services Law’, above n 35; Pamela F Hanrahan, ‘Fiduciary Duty and the Market: Private Law and the Public Good’ (ID 1184443, Social Science Research Network, 31 July 2008).

[56] Corporations Act 2001 (Cth) ss 961B, 961J.

[57] Warren McKeown, ‘Financial Advice Reform: Have We Learned Enough from Storm?’ The Conversation <http://theconversation.com/financial-advice-reform-have-we-learned-enough-from-storm-5299>.

[58] ‘Inquiry into Financial Products and Services in Australia’ (Parliamentary Joint Committee on Corporations and Financial Services, 2009) <https://www.aph.gov.au/binaries/senate/committee/corporations_ctte/fps/report/report.pdf>.

[59] ‘A Guide to the Ripoll Inquiry Recommendations and Their Likely Impact | Money Management’ (31 January 2010) <https://www.moneymanagement.com.au/features/editorial/guide-ripoll-inquiry-recommendations-and-their-likely-impact>.

[60] ‘Inquiry into Financial Products and Services in Australia’, above n 58, Recommendation 1.

[61] Dimity Kingsford Smith and Olivia Dixon, ‘What next for the Financial Consumer: More Disclosure? Caveat Vendor? FinTech Online?’ in Handbook of Research on International Consumer Law, Second Edition (Edward Elgar Publishing, 2018) <https://www.elgaronline.com/view/edcoll/9781785368202/9781785368202.xml>; M Scott Donald, ‘Whither Customer Protection in Financial Services?’ 2; Grant Holley, ‘What Does It Mean to Provide Financial Services Efficiently, Honestly and Fairly?’ (29 June 2012) <https://www.hnlaw.com.au/legal-updates/what-does-it-mean-to-provide-financial-services-efficiently->; Paul Ali et al, ‘The Fnancial Literacy of Young Australians: An Empirical Study and Implications for Consumer Protection and ASIC’s National Financial Literacy Strategy’ 19.

[62] Erin Turner and Xavier O’Halloran, ‘CHOICE | Royal Commission: Misconduct in the Banking, Superannuation and Financial Services Industry’ 22.

[63] Peter kell Asic, ‘Improving Consumer and Investor Confidence’ 10.

[64] Paul Ali, Cosima Hay McRae and Ian Ramsay, ‘Financial Literacy and Financial Decision-Making of Australian Secondary School Students’ (SSRN Scholarly Paper ID 2490216, Social Science Research Network, 1 September 2014) <http://papers.ssrn.com/abstract=2490216>.

[65] Gail Pearson, ‘Risk and the Consumer in Australian Financial Services Reform’ (2006) 28(1) Sydney Law Review 99.

[66] Corporations Act 2001 (Cth) s 961.

[67] Ibid Pt 7.7A Div 2 Sub Div F, ss 961K-Q.

[68] Ibid s 961L.

[69] Pamela Hanrahan, ‘Background Paper 7 – Legal Framework for the Provision of Financial Advice and Sale of Financial Products to Australian Households’ (April 2018) <https://financialservices.royalcommission.gov.au/publications/Documents/legal-framework-for-the-provision-of-financial-advice-background-paper-7.pdf>.

[70] ‘ASIC’s Possible Flawed Interpretation of Responsible Lending Laws Faces Court Scrutiny’ <https://www-afr-com.ezp.lib.unimelb.edu.au/brand/chanticleer/asic-westpac-settlement-a-dogs-breakfast-20181024-h172gu>.

[71] Corporations Act 2001 (Cth) s 961B(1).

[72] Ibid s 912 A (1)(a).

[73] ‘Inquiry into Financial Products and Services in Australia’, above n 58; Financial System Inquiry (Australia : 2014) et al, above n 27.

[74] Commission, ‘REP 562 Financial Advice’, above n 1, 22.

[75] Corporations Act 2001 (Cth) s 961E.

[76] Financial System Inquiry (Australia : 2014) et al, above n 27.

[77] Australian Securities and Investments Commission, in the matter of NSG Services Pty Ltd v NSG Services Pty Ltd (Unreported, FCT, 2017) 345, 18.

[78] Pamela Hanrahan, ‘Conflicts of Duties in Statutory Contexts: Managed Investments, Superannuation and Financial Services’ 23.

[79] Corporations Act 2001 (Cth) s 961G.

[80] Australian Securities and Investments Commission v Cassimatis (No 8) (2016) 338 ALR 209; [2016] FCA 1023 at [673].

[81] Hanrahan, ‘The Fiduciary Idea in Financial Services Law’, above n 35.

[82] Professor Simone Degeling and Jessica Hudson, ‘Financial Robots as Instruments of Fiduciary Loyalty’ 21.

[83] FSRC Australia, ‘Background Paper 1: Some Features of the Australian Banking Industry’ 27.

[84] Hoon Chuah and James Devlin, ‘Research Note: Behavioural Economics and the Financial Services Consumer: A Review’ 8.

[85] Hanrahan, ‘The Fiduciary Idea in Financial Services Law’, above n 35.

[86] Hanrahan, ‘Conflicts of Duties in Statutory Contexts: Managed Investments, Superannuation and Financial Services’, above n 78.

[87] Commission, ‘REP 562 Financial Advice’, above n 1.

[88] Ibid 22.

[89]  A pre-selected list of financial products, determined by the AFS licensee, and considered suitable for potential investment by investors.Financial Products and Sales Incentives | ASIC’s MoneySmart <https://www.moneysmart.gov.au/investing/financial-advice/financial-products-and-sales-incentives>.

[90] Commission, ‘REP 562 Financial Advice’, above n 1, 45.

[91] Ibid 7.

[92] Ibid 24; ASIC chose to review these advices because customers commonly receive advice on superrnauation platforms.

[93] Ibid 33.

[94] Ibid 35.

[95] Australian Securities and Investments Commission, ‘REP 515 Financial Advice: Review of How Large Institutions Oversee Their Advisers’ (report).

[96] Commission, ‘REP 562 Financial Advice’, above n 1, 31.

[97] Corporations Act 2001 (Cth) s947D.

[98] Commission, ‘REP 562 Financial Advice’, above n 1, 26.

[99] Corporations Act 2001 (Cth) s 961B(2)(g).

[100] Sean Graham, ‘It’s an Uncertain Path to Safe Harbour on Best Interests’ Professional Planner, 8 January 2018 <https://www.professionalplanner.com.au/2018/01/its-an-uncertain-path-to-safe-harbour-on-best-interests/>.

[101] Commission, ‘REP 562 Financial Advice’, above n 1, 38.

[102] Ibid.

[103] Ibid 39.

[104] Australian Securities and Investments Commission v Camelot Derivatives Pty Limited (In Liquidation); In the Matter of Camelot Derivatives Pty Limited (In Liquidation) [2012] Federal Court of Australia 414 (23 April 2012).

[105] ‘Conflict of Interest in Financial Advice – ASIC’s Report’ on Aspire Financial Consulting Toowoomba (31 January 2018) <http://aspirefc.com.au/conflict-interest-financial-advice-asics-report/>.

[106] Commission, ‘REP 562 Financial Advice’, above n 1, 43.

[107] Australian Securities and Investments Commission, in the matter of NSG Services Pty Ltd v NSG Services Pty Ltd (Unreported, FCT, 2017) 345, 21.

[108] Commission, ‘REP 562 Financial Advice’, above n 1, 43.

[109] Ibid 42.

[110] ‘Financial Services Royal Commission Interim Report – Volume 1’ 89.

[111] Corporations Act 2001 (Cth) s 912A(1)(aa).

[112] ‘The Bank of England’s Approach to Conflicts of Interest – A Review by the Non-Executive Directors of the Bank’s Court’ [2017] The Bank of England 35, 15.

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