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Attachment B: Current Compensation Mechanisms in the Financial Services Sector in Australia

This attachment provides a summary of the Australian requirements for financial markets and financial service providers to have compensation arrangements, both before and after application of the Financial Services Reform regime.

A: Requirements imposed on exchanges/financial markets

(i) Before the Financial Services Reform Act 2001

(a) The Australian Stock Exchange Limited and the National Guarantee Fund

The National Guarantee Fund, established in 1987,87 provides a clearing guarantee88 and investor protection in relation to transactions on the Australian Stock Exchange (ASX). Its origins are summarised in Attachment C.

The situations in which clients of a stockbroker may claim on the National Guarantee Fund are:89

  • where the broker has failed to complete a sale or purchase of securities entered into on the ASX's equities and debt market or where those transactions are required to be reported to the ASX by the stockbroker (`contract guarantee');
  • an unauthorised transfer of securities;
  • contravention by a stockbroker of the certificate cancellation provisions (which relate to the ASX's uncertificated securities system);
  • where a person has entrusted property to a stockbroker who subsequently becomes insolvent and therefore cannot meet its obligations to that person.

Only the head of claim relating to insolvency involves a `cap'. It is 14 per cent of the minimum amount of the National Guarantee Fund — that is, $11.2 million. In relation to any of the other grounds for claiming, there is no limit on the payment, if the head of claim is satisfied.

There is no requirement that the claimant be `retail'. All who satisfy the requirements are equally entitled to claim.

The National Guarantee Fund holds about $160 million and is administered by the Securities Exchanges Guarantee Corporation Limited, a subsidiary of the ASX. The basis of the fund was a proportion of the fidelity funds previously held by the capital city exchanges. To this has been added interest from broker accounts and investment income. While the power exists, no levies have been imposed to support the Fund. Payments have been made from the Fund for claims, administration and securities industry development purposes.

The relevant provisions were Part 7.10 of the Corporations Act 2001.

(b) Other stock exchanges, and futures exchanges

Other stock exchanges (in practice, Newcastle and Bendigo), and futures exchanges are required to have a fidelity fund.90 Such a fund, on which clients of stock/futures brokers may claim, is required to cover only defalcation91 and fraud of money and other property held in connection with the broker's business of dealing in securities/futures contracts. In addition, there is a discretion to pay an official receiver or trustee in bankruptcy/liquidator in cases of insolvency.

Claims are capped at $500,000 per broker. These schemes extend to brokers that have ceased to participate on the relevant exchange.

They do not, however, provide any guarantee that losses of clients following insolvency, when the risk to the client is most acute, will be covered.

The relevant provisions were Parts 7.9 and 8.6 of the Corporations Act 2001.

The grounds for claiming against the National Guarantee Fund have differed from those required under this heading since its establishment in 1987. At the time of its introduction, attention was drawn to the Fund's benefits as a `no fault' scheme, over certain other professional schemes. This means that it is easier for the claimant to gain access to it because they do not have to prove, for example, fraud.

(ii) After the Financial Services Reform Act 2001

(a) The Australian Stock Exchange Limited and the National Guarantee Fund

The function of the National Guarantee Fund, and the grounds for claiming against it, remain, with few changes in the short term.

However, the Financial Services Reform Act92 empowers the Minister to direct the payment out of the fund the element referable to clearing guarantee (leaving the Fund with only its `investor protection' functions).

To facilitate any future changes in ASX procedure, the grounds for claiming have been moved into the Corporations Regulations.93

The relevant provisions are Division 4 of Part 7.5 of the amended Corporations Act, and Division 4 of Part 7.5 of the Corporations Regulations.

(b) Other financial markets

A number of changes were made to the requirements for compensation arrangements for financial markets other than the ASX on which the trades of retail clients are executed.94 The new provisions:

  • require coverage only for retail clients (whereas the previous provisions did not distinguish between wholesale and retail clients);
  • tie the loss to a transaction on the market, not to the firm's business of dealing in securities or futures contracts (as the previous provisions did);
  • do not require a fidelity fund, instead anticipating that a range of mechanisms would be acceptable, and it is up to the market operator as to how these are funded.

However, the new arrangements still only require coverage for loss arising from fraud or defalcation (although greater coverage can be provided at the discretion of the market operator).

`Run-off' provision is still required and caps are anticipated. In addition, the provisions give greater flexibility to the market operator to design the scheme that then must be approved by the Minister.

Market licensees other than the ASX remain subject to the compensation requirements that applied prior to the commencement of the Financial Services Reform Act. They will be subject to the compensation requirements in the new Chapter 7 when their transition period ends.

The new Chapter 7 also includes a power to exempt a person or class of persons, or market or class of financial market from the compensation requirements or to modify them in their application to a particular person or class.95 It was anticipated that this power may be used where:

  • a particular market was nearing the end of its transition period (and hence obliged to change its compensation arrangements to fit the new Chapter 7); and
  • meanwhile the Government had announced it would, following the review, implement an inconsistent compensation regime.

The compensation requirements for market licensees which are described above relate only to risk associated with the conduct of brokers, not any risk arising from the market licensee's conduct or that of any of its employees in conducting that market. There is no separate requirement for compensation arrangements to be made by clearing and settlement facilities.

B: Requirements imposed on financial services providers

(i) Requirements before the Financial Services Reform Act 2001

As indicated above, the Financial Services Reform Act provides for a harmonised licensing regime for financial services providers who were previously regulated under a series of Commonwealth Acts, each with their own requirements.

The following points summarise the compensation arrangements and financial requirements applying to some individual segments of the industry before they transition into the Financial Services Reform licensing regime.

  • Securities dealers and advisers :
    • are
      required under the Corporations Act96 to provide a security bond of $20,000 to ASIC;
      • this is used to compensate persons (whether retail or wholesale) who have suffered `pecuniary loss due to the failure of the licensee, or an agent or employee of the licensee, to carry on business under the licence adequately and properly';97
    • in addition, ASIC imposes financial conditions, including net tangible assets and surplus liquid fund requirements.

      The requirements imposed by the Australian Stock Exchange on its participants are also relevant.

  • responsible entities of registered schemes:
    • ASIC Policy Statement 131 Managed Investments: Financial Requirements requires, as a licensing condition, that responsible entities maintain appropriate professional indemnity insurance and insurance against fraud. This should cover claims up to, in aggregate $5 million, or the value of scheme assets, whichever is less, unless it is demonstrated to ASIC that such insurance is not reasonably obtainable. This Policy Statement also requires certain levels of net tangible assets.
  • operators of investor directed portfolio services:
    • ASIC Policy Statement 148 Investor Directed Portfolio Services requires persons operating Investor Directed Portfolio Services to maintain appropriate professional indemnity insurance and insurance against fraud of officers and agents. It also requires certain levels of net tangible assets - when acting as the custodian of assets, the operator must have net tangible assets of at least $5m.
  • Under the Insurance (Agents and Brokers) Act,98 insurance brokers are required to have `acceptable' professional indemnity insurance.
    • To be acceptable, the contract must:
      • be accepted by ASIC;
      • cover liabilities incurred as a result of a breach of professional duty by the broker in the course of carrying on business as an insurance intermediary up to an amount specified in the regulations;
      • include a local jurisdiction clause.99
    • The amount of any excess is limited and the insurer is prevented from avoiding the contract or reducing liability under it on the ground of non-disclosure by the broker.
    • It is an offence for the insurer to cancel the policy without giving ASIC three days written notice including the reason.

      Bodies regulated by APRA have been subject to capital and solvency requirements:

  • in the case of authorised deposit-taking institutions:
    • APRA sets stringent capital adequacy requirements under the Banking Act 1959;
    • its prudential standards also address, among other things, liquidity, credit quality and large exposures.
  • in the case of insurance companies:
    • the general insurance industry has been governed by the Insurance Act 1973 which includes a capital requirement and prescribes a solvency margin;
    • new prudential standards issued by APRA relate to minimum capital requirements and a Liability Valuation Standard;
    • a regime that is similar in structure applies to life insurers.

(ii) Requirements after the Financial Services Reform Act 2001

The purpose of this section of the paper is to summarise the requirement on financial services licensees (those who have transitioned into the new Chapter 7 regime) to have compensation arrangements (section 912B), relevant transitional arrangements and ASIC Policy Statements.

The new regime for licensing financial service providers is described briefly in Attachment A.

Section 912B — compensation arrangements

A financial services licensee that provides financial services to retail clients must have arrangements for compensating those persons for loss or damage suffered because of breaches of the obligations imposed by new Chapter 7 on the licensee and its representatives (section 912B). The arrangements must be in accordance with the regulations or be approved in writing by ASIC.

Thus a wider range of financial service providers are required to have compensation arrangements than were required to do so prior to the Financial Services Reform Act - for example, insurance companies.

Section 912B is discussed further in Chapter 6 of this paper.

The new Chapter 7 of the Corporations Act also imposes a separate requirement on financial services licensees and product issuers, who provide services to retail clients, to be a member of one or more external dispute resolution schemes approved by ASIC.100

Transitional arrangements

The transitional regulations provide that section 912B does not apply in relation to a financial services licensee for the period of 2 years commencing on 11 March 2002101 (the commencement of the Financial Services Reform Act).

However, the requirements under the Insurance (Agents and Brokers) Act for persons carrying on business as an insurance broker, or as a foreign insurance agent, to have acceptable professional indemnity insurance will continue to apply during the two year transitional period to:

  • persons who remain under the Insurance (Agents and Brokers) Act; and
  • those who hold Australian financial services licences authorising them to carry on such an insurance business.102

Similarly, securities dealers while they remain regulated under Part 7.3 of the previous Chapter 7, will continue to be required to have a security bond with ASIC.

In accordance with Corporations Regulation 10.2.45, ASIC has indicated103 that it will continue, during the transitional period, to impose the `approved security requirements' to those which would have been required to be licensed under Part 7.3 of the previous Chapter 7 and provide financial services to retail clients.

ASIC `Pro Forma 209': Australian Financial Services Licence Conditions

ASIC has indicated in `Pro Forma 209' that a condition relating to `Professional Indemnity Compensation Requirements' may be imposed on financial services licensees. It will be imposed having regard to the transitional arrangements for compensation, depending on the role the licensee plays in providing financial services or in individual circumstances where ASIC requires the licensee to have professional indemnity arrangements in place.

The two scenarios included in `Pro Forma 209' which are given to provide guidance on the type of conditions that will be imposed are:

(a) Where the licensee is authorised to operate a registered managed investment scheme in the capacity of a Responsible Entity and/or operate an Investor Directed Portfolio Service as an operator of such service, the following conditions will be imposed:

The licensee must maintain an insurance policy covering professional indemnity and fraud by officers that:

    • is adequate having regard to the nature of the activities carried out by the licensee under the licence; and
    • covers claims amounting in aggregate to whichever is the lesser of:
      • $5 million; or
      • the sum of the value of all scheme property of all Investor Directed Portfolio Services for which it is the operator and registered schemes for which it is the responsible entity.

(b) Where the licensee is required to have professional indemnity requirements in place as a result of individual circumstances, the following condition may be imposed:

The licensee must where so required by the ASIC in writing, mai
ntain a policy of professional indemnity insurance which conforms with the specifications set out in that notice.

ASIC Policy Statement 166 — Licensing: Financial requirements

ASIC Policy Statement 166 applies to holders of Australian financial services licences other than those which are regulated by APRA. It indicates various financial requirements, depending on the particular class of licensee.104 ASIC is not a prudential regulator and takes the view that this policy statement is not intended to ensure that a licensee will meet its financial commitments (including to clients and market counterparties).

The purpose of these requirements is not to provide compensation. ASIC states that it imposes the financial requirements to help ensure that:

  • the licensee has sufficient financial resources to conduct its financial services business in compliance with the Corporations Act;
  • there is a financial buffer that decreases the risk of a disorderly or non-compliant wind-up if the business fails; and
  • there are incentives for the owners of the business to comply through risk of financial loss.

87 By the Australian Stock Exchange and National Guarantee Fund Act 1987.

88 This aspect of its functions is outside the scope of this paper.

89 Subdivisions 4.3, 4.7, 4.8 and 4.9 of Part 7.5 of the Corporations Regulations.

90 See `Abbreviations and terms used' above.

91 `Defalcation' is not defined in the legislation. However, Gibbs CJ, Wilson and Dawson JJ indicated in
Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371 that `defalcation' in the comparable provision in the Securities Industry Act 1975 (NSW) was not limited to dishonest dealings. A person who had suffered loss as a result of a failure to account for funds entrusted to a firm as trustee should be able to recover from the fund even if the failure was due, eg to negligence, rather than dishonesty.

92 Section 891A.

93 See Part 7.5 of the Corporations Regulations, especially Division 4.

94 Division 3 of Part 7.5.

95 See section 893A.

96 See paragraph 786(2)(d) and Corporations Regulation 7.3.03.

97 Corporations Regulation 7.3.04, prior to the Financial Services Reform amendments.

98 See section 9B and the Regulations.

99 We understand that the requirement for `run-off cover' in effect never commenced.

100 Subsections 912A(1)(g) and (2)(b), and subsections 1017G(1) and (2)(b).

101 See Corporations Regulation 10.2.44(1).

102 See Corporations Regulation 10.2.44(2).

103 ASIC Policy Statement 167.39.

104 Thus:

    • responsible entities of registered schemes, Investor Directed Portfolio Services operators and custodial or depository service providers will be required to have net tangible assets of up to $5 million;
    • market makers and underwriters will be required to have $50,000 to $100 million;
    • foreign exchange dealers will be required to have $10 million `tier one capital'.