Publications / Financial Services
The collapse of Storm Financial and Opes Prime attracted substantial public and media interest and raised significant concern about the operation of financial advisers and the industry as a whole. The Government’s response, including a Senate Inquiry and comprehensive review of financial services regulation, has culminated in legislative reform.
Last week (31 August 2011), the Government released an exposure draft of the legislation for the first raft of proposed reforms to the Corporations Act 2001 (Corporations Act) to implement its ‘Future of Financial Advice’ (FOFA) program. The FOFA reforms aim to improve the quality of financial advice and align the interests of the adviser with their client to reduce conflicts of interest, and build confidence in the financial planning industry. The reforms are also designed to facilitate improved access to financial advice. Partner at McCullough Robertson, Tim Wiedman has prepared this comprehensive advisory detailing the proposed changes to the draft legislation.
The Government has imposed a very short exposure period with any comments to be provided by Friday 16 September 2011. This time frame suggests the Government intends to introduce the draft Corporations Amendment (Future of Financial Advice) Bill 2011 (Bill) to Parliament in its current form and does not propose to make substantive changes as a result of the consultation process.
The draft Bill contains the legislative framework for the following FOFA reforms:
- the creation of statutory obligations for financial advisers to act in the best interests of their clients and to place their clients’ interests ahead of their own in providing personal advice
- requiring financial advisers to provide regular disclosure of ongoing fees and to obtain client agreement to the continued charging of ongoing fees, and
- enhancing ASIC’s power to refuse to grant, and to suspend or cancel, an AFSL and to ban financial advisers.
Draft legislation addressing other FOFA reforms, such as banning conflicted remuneration, is expected to be released for public comment later this year.
This article summarises the key changes to be implemented by the draft Bill and provides comment on the practical effect of these proposed changes.
Best interest obligations
The Bill proposes to amend the Corporations Act to require individuals who provide personal advice to retail clients to:
- act in the best interests of the client when providing the advice, and
- give priority to the interests of the client in the event of a conflict between those interests and the interests of the adviser, licencee or authorised representative.
These obligations will only apply to personal advice given to retail clients. They will not apply to:
- general advice, or
- personal advice given to wholesale clients.
How are these reforms different from current obligations
The Corporations Act does not currently impose a statutory duty on advisers to act in the best interests of clients or to give priority to the interests of the client where there is a conflict of interest.
The draft Bill imposes obligations (including the best interest obligations) on the adviser, rather than licensee or authorised representative. However, penalties and liability for breaching the statutory obligations to act in best interests, give priority to client interests, ensure personal advice is appropriate and warn retail clients where advice is based on incomplete or inaccurate information will rest with the licensee or authorised representative (consistent with the current regime), even though these obligations will be imposed on the adviser.
The licensee will remain potentially liable to compensate a retail client who suffers loss or damage because of a breach of a statutory obligation by the adviser (regardless of whether the adviser is an employee, authorised representative or employee of the authorised representative). Similarly, it is the licensee or authorised representative who will contravene the Corporations Act if an adviser breaches the statutory obligations.
The extension of these statutory obligations to individual advisers is designed to overcome the difficulties ASIC has faced in taking administrative action against individuals who provide poor or inappropriate advice. Currently, ASIC can only use the administrative enforcement mechanisms available to it (for example, banning orders) against the licensee or authorised representative only and not the person who actually provided advice.
The proposed amendments will enable ASIC to take administrative action to stop individual advisers, who are not licencees or authorised representatives, who give poor quality advice from providing advice in the future.
Steps to take in discharging ‘best interests’ obligation
The draft Bill includes a non-exhaustive list of steps an adviser must take into account to discharge the obligation to act in the best interests of the client. The steps listed include:
- identifying the objectives, financial situation and needs of the client, that are disclosed to the adviser by the client
- identifying the subject matter of the advice requested by the client
- where it is reasonably apparent that information relating to the client’s objectives, financial situation and needs is either incomplete for the purposes of providing the advice requested or inaccurate, making reasonable inquiries to obtain complete and accurate information
- if it is reasonably apparent that a client’s objectives could be better achieved, or their needs better met, if the client obtained advice on another subject matter, advising the client in writing of that fact
- assessing whether the adviser has the expertise to provide the advice requested and, if not, declining to provide the advice
- assessing whether the client’s objectives could be achieved and needs met through means other than the acquisition of financial products
- conducting reasonable investigation into financial products that might achieve the objectives and meet the client’s needs of which the adviser is aware and assessing the information gathered in the investigation, and
- basing all judgments made in advising the client on their objectives, financial situation and needs.
The draft Bill specifies that a reasonable investigation into financial products does not require an investigation into every financial product available. However, if the client has requested the adviser consider a specific financial product or class of financial product, then the adviser will need to consider that product or class.
These provisions are intended to facilitate ‘scaleable’ or ‘limited advice by only requiring advisers to consider those issues which the client has requested advice on. It is not necessary for advisers to obtain every piece of information about a client, only the information necessary for the subject matter of the advice. The draft explanatory memorandum, which was released with the draft Bill, explains that where the needs and objectives of the client relate to a specific aspect or financial product, only a limited assessment is required.
Interaction with the approved product list
The draft Bill specifies that if the adviser has an approved product list and finds that no product on the list would meet the objectives and needs of the client, then the adviser does not have to consider financial products beyond those on the approved product list. However, in this circumstance, the adviser must not recommend a product from the approved product list to the client and must inform the client they are unable to recommend a product from the approved product list which would meet the client’s needs or objectives.
Advising the client to obtain advice on another subject matter
We are concerned that some of the items which advisers are required to consider in discharging their ‘best interest’ obligation are unduly onerous and may require advisers to consider products or strategies both beyond those they are authorised to advise on and in areas in which they have no expertise.
The draft Bill will require advisers to:
- recommend clients obtain advice on another ‘subject matter’, where it is reasonably apparent that a client’s objectives or needs could be better satisfied by doing so, and
- assess whether the client’s objectives or needs could be satisfied through means other than the acquisition of financial products.
This appears contrary to the general premise of the financial services regime which requires advisers to only advise on products they are competent to do so. Generally, advisers can only advise on financial products covered by their, or their employer’s, AFSL or, if an authorised representative, covered by their authorisation. Further, to provide advice on financial products to retail clients, advisers must meet the competency standards set by ASIC as contained in Regulatory Guide 146.
Conversely, the draft Bill apparently requires advisers to potentially consider financial products beyond those the adviser is authorised and competent to advise on and also consider products which are not financial products. For example, if a client was seeking an investment which provides income returns and the potential for capital growth over the medium to long-term, an adviser may need to recommend, in addition to equities, that a client consider direct property investment even though the adviser may not understand the property market, lending requirements for property or the taxation issues associated with property investment.
We believe this requirement is likely to result in the use of ‘boilerplate’ disclosure or recommendations in statements of advice as advisers seek to discharge their obligations by ‘considering’ products or strategies of which they have a limited knowledge, understanding or experience. A recommendation that a client consider, for example, property investment in circumstances where the adviser is unable to provide any further context or recommendation will be so general in nature that it will be of little or no use to the client and potentially detract from the substantive advice given.
We are concerned with a legislative framework which encourages advisers to consider and, potentially, make recommendations about products they are not competent or experienced to provide advice in and will simply result in advisers including a generic list of other potential products or strategies in a statement of advice.
Recommending products from the approved product list
The draft Bill deals with the circumstance where the adviser has an approved product list and there are no suitable products on the list. However, the draft Bill fails to deal with an adviser’s obligations where there is an approved product list and it includes a product with does meet the client’s objectives and needs.
In this circumstance, is there an obligation on an adviser to consider other products not on the approved product list? Or is an adviser only ‘aware’ of products on their approved product list? If a client asks the adviser to consider a particular product which is not on the approved product list, does the adviser have to decline to provide advice? What if the adviser is an employee of a product issuer who only considers and, if appropriate, recommends the issuer’s products - a scenario common in the funds management, banking or timeshare industries? The draft explanatory memorandum indicates an adviser may be able to comply with the reasonable investigation obligation even though they limit their investigation to products on the list. However, this is likely to depend on the number and type of products on the list (in particular, the number of potentially suitable products).
We believe it is unreasonable to require an adviser to consider products beyond those listed on an approved product list. Licensees use approved product lists as a quality control and risk management tool. Licensees provide training to advisers on all products on the approved product list as a means of ensuring their advisers understand, and are competent to advise on, the products. Licensees prohibit advisers from recommending products not on the approved product list to remove the risk of advisers recommending products they do not understand or are not covered by the licensee’s AFSL.
Also, licensees may limit the recommended products to those issued by product issuers who are either reputable, known to the licensee or an entity on which the licensee has undertaken due diligence. Again, this is designed to minimise the risk of advisers recommending products to clients which they do not understand and, consequently, may not be appropriate for the client.
Further, where an adviser is employed by a product issuer and only advises on and, if appropriate, recommends the issuer’s products it is unreasonable to expect an adviser to consider other products, particularly the products of other issuers and competitors.
In our view, where an adviser has an approved product list and there is one product which meets the client’s needs or objectives, rather than requiring the adviser to consider other products that the adviser could simply disclose to the client that, as relevant, they only consider and recommend products offered by a single product issuer or products on an approved product list and there may be other products not considered by the adviser which may be as, or more, suitable for the client’s objectives and needs.
Alternatively, the explanatory memorandum or ASIC could clarify an adviser is only ‘aware’ of products contained on their approved product list, provided appropriate disclosure is made to the client.
Disclosure and payment of ongoing fees
Where an ongoing fee arrangement is in place, fee recipients will, in order to charge an ongoing fee, be required to:
- at least every 12 months, give a client a fee disclosure statement, and
- at least every two years, obtain the client’s consent to charge an ongoing fee. If the client does not consent to being charged an ongoing fee, the fee recipient will be unable to charge the fee.
The fee recipient is the person to whom the client is liable to pay the ongoing fee and will be either the licensee or representative.
Whilst designed to target ongoing trailing commissions, these provisions potentially have wider application.
What is an ongoing fee arrangement
An ongoing fee arrangement is an arrangement under which:
- a retail client to whom a financial services licensee or their representative provides financial product advice agrees to pay a fee (however described or structured), and
- the fee cannot reasonably be characterised as relating to advice that, at the time the arrangement is entered into, has already been given.
Unlike the best interest obligation, an ongoing fee arrangement may arise where the advice provided is general or personal. However, the obligation only applies to retail clients.
The drafting and scope of the definition is alarming. For example, if an employee of a responsible entity recommends a retail client acquire interests in the responsible entity’s scheme it is arguable the definition of ‘ongoing fee arrangement’ could potentially catch contribution and management fees charged by the responsible entity. This is because:
- financial product advice is provided to a retail client
- the retail client agrees to pay a fee (by subscribing for interests under the PDS and agreeing to be bound by the scheme constitution which includes the provisions for the charging of fees by the responsible entity)
- the management fee and contribution fee are paid by the retail client either directly from their application money or indirectly from the scheme’s funds, and
- the management fee and contribution fee are not related to the advice provided to the retail client.
In our view, the draft Bill should specifically acknowledge that the ongoing fee arrangement provisions do not apply to fees charged by a responsible entity pursuant to a scheme constitution.
Also, the requirement for the retail client to ‘agree to pay a fee’ may significantly limit the operation and effectiveness of the ongoing fee arrangement provisions. It is not unusual for a product issuer to pay a commission or other fee to the licensee or representative out of its own funds and not from the client. For example, a commission paid by an insurer to an insurance broker where a client renews their insurance is not deducted or paid from the premium (which is the same amount regardless of whether the client has an insurance broker or not) but by the insurer from their own funds.
It will be interesting to monitor ASIC’s interpretation of when a fee or commission is a fee which a retail clients has agreed to ‘pay’ and whether there are opportunities for the advising industry, or any segment of it, to restructure arrangements between product issuers and advisers.
Fee disclosure statement
If an ongoing fee arrangement is to operate for a period longer than 12 months, the fee recipient must give the client a fee disclosure statement at least 30 days before the 12 month anniversary of the day the arrangement was entered into or last disclosure statement provided.
The draft Bill specifies the information to be set out in the fee disclosure statement which includes:
- the fees paid by the client in the previous 12 months and the fees anticipated to be paid in the next 12 months
- details of the services the client received and the services the client was entitled to receive in the previous 12 months, and
- details of the services the client is entitled to receive and the services the fee recipient anticipates the client will receive in the next 12 months.
If the fee disclosure statement is not complied with then the client is not required to pay the ongoing fee. The client is also entitled to a refund of any ongoing fee charged where the fee recipient was not entitled to do so (for example, they did not provide the client a fee disclosure statement as required).
A fee recipient must send the client a renewal notice at least 30 days before the 24 month anniversary of the day the arrangement was entered into or last renewal notice provided. A fee disclosure statement must also be sent to the client.
The draft Bill details the disclosure which must be contained in a renewal notice. However, essentially, the notice must state the client may renew the ongoing fee arrangement by notifying the fee recipient in writing and that if the client does not renew the ongoing fee arrangement the ongoing fee will cease to be charged and no further advice will be provided.
The client has 30 days to renew the ongoing fee arrangement. If the ongoing fee arrangement is not renewed within this period the fee recipient must cease charging the fee. Importantly, renewal of the ongoing fee arrangement requires positive action by the client, if the client does nothing it is treated as termination of the ongoing fee arrangement.
Termination of ongoing fee arrangement
A client can also terminate an ongoing fee arrangement at any time. A fee recipient can charge the client a fee for termination, provided the fee does not exceed the sum of:
- a liability owed by the client under the ongoing fee arrangement prior to termination, and
- the costs incurred solely and directly by the fee recipient because of the termination.
Will these ongoing fee arrangements apply to existing clients
No. These obligations will only apply to ongoing fee arrangements entered into or after the day the legislative amendments take effect, which is expected to be 1 July 2012.
What will be the practical effect of these changes
We expect the ongoing fee arrangement provisions to materially impact the price a licensee is willing to pay for another licensee’s or representative’s ‘book’ or ‘list’ of clients.
Currently, the purchase price of a licensee’s or representative’s ‘client list’ allocates significant value to the annual trailing commissions, as they are seen as an annuity stream. Moving forward, we anticipate a lower multiple or higher discount will be allocated to the ongoing fee revenue to take into account the uncertainty associated with the renewal of such fees.
The statutory obligations to act in best interests, give priority to client interests, ensure personal advice is appropriate and warn retail clients where advice is based on incomplete or inaccurate information, are civil penalty provisions. A licensee or authorised representative who contravenes these obligations may be subject to a penalty of $200,000 for individuals and $1 million for companies.
This represents a change to the current regime, where such a breach is a criminal offence.
The ongoing fee arrangement provisions are also civil penalty provisions, a breach of which may expose a licensee or authorised representative to a maximum penalty of $50,000 for an individual or $250,000 for companies.
Enhancement to ASIC’s licensing and banning powers
The draft Bill strengthens ASIC’s power to refuse to grant, and to suspend or cancel, an AFSL and to ban people from providing financial services. Specifically, the draft Bill will:
- enable ASIC to refuse or cancel/suspend an AFSL where a person is likely to contravene its obligations. Currently, ASIC can only take such action where a person will breach its obligations
- insert a new provision to allow ASIC to ban a person who is not of good fame and character or not adequately trained or competent to provide financial services
- permit ASIC to ban a person if they are likely to contravene a financial services law. Currently, ASIC can only ban a person if they will contravene a financial services law, and
- allow ASIC to ban a person who is involved, or is likely to be involved, in a contravention of obligations by another person. This will enable ASIC to ban an adviser who, for example, fails to act in the best interests of their client. This is because such breach will be a contravention by the licensee or authorised representative but, as the provider of the advice, the adviser is ‘involved’ in a contravention and potentially exposed to a banning order.
These changes will make it easier for ASIC to exclude people from the financial services industry.
Licensees and authorised representatives should immediately begin considering how these proposed changes will impact their business and implement a plan for updating their business practices, under the guidance of legal practitioners experienced in the area.
The proposed changes, if passed by the Federal Parliament (which appears likely), will become law on 1 July 2012, which may seem a long way off, but in reality will arrive very quickly if substantial changes need to be made to the way business is currently conducted.
Focus covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. Focus is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.