Chapter 1: Introduction

The purpose of this Chapter is to introduce the reader to the compensation review.

It includes brief consideration of the purpose of the review, its ambit and origins, and proposed `next steps'.

The structure of the discussion in the paper as a whole is included in the Overview.

A: The compensation review

What is the purpose of this review?

1. The purpose of this review is to consider the need for and requirements of compensation arrangements in the financial services sector. The aim is to ensure that Australia has a comprehensible and efficient compensation regime that provides appropriate protection for investors and does not impose an unjustified burden on participants in the sector. Any proposed changes arising from this review will need to meet with a broad consensus, and be consistent with the Australian regulatory regime, while taking due account of international models.

2. By `compensation arrangements', we mean mechanisms for providing the clients of financial services licensees with compensation for loss suffered as a result of, for example, a breach of the licensee's specific obligations under new Chapter 7. This review includes consideration of the rationale for compensation arrangements, the extent of the conduct that should be covered, the mechanisms to provide compensation and who should be eligible to claim it.

What triggered the review?

3. While not forming part of the Corporate Law Economic Reform Program, this review follows the enactment of the Financial Services Reform Act (CLERP 6). That Act harmonised the regulation of financial markets, and of financial service providers in a new Chapter 7 of the Corporations Act, but wholesale review of compensation arrangements was not part of the CLERP 6 agenda.

4. During consultation on the exposure draft of the Financial Services Reform Bill, some basic difficulties with the then current and proposed compensation arrangements were brought forward. We were asked whether continuing to require market licensees to have compensation arrangements was justifiable. It was suggested that the obligation to have compensation arrangements should instead rest on financial services licensees.

5. Since time did not allow a considered review of compensation arrangements as a whole before the proposed introduction of the Financial Services Reform Bill, only modest amendments were included in the expectation that a thorough review would be undertaken subsequently.

What is the purpose of this paper?

6. The purpose of this paper is to raise issues and options for discussion, to progress the review. It is not based on a Government `position' and no option put currently has any Government endorsement.

What does this review address and what is outside its ambit?

7. The area of discussion in this paper is, in general terms, loss to a client suffered as a consequence of the misconduct of a financial services licensee or its representative in the course of providing financial services.

8. The discussion is not about loss suffered as a result of an investment which provides a poor return, whatever the cause, or the collapse of the issuer of a financial product. It therefore does not cover:

  • the loss of insurance cover if the insurance company which issued your policy becomes insolvent;
  • any loss on the sale of interests purchased in a managed investment scheme due, for example, to the scheme being unable to sell the product it produced;
  • any loss on the sale of a quoted investment caused by a drop in the market price;
  • any loss which you, as an investor, may suffer if the superannuation fund in which you have invested is mismanaged or fails;

and it does not involve consideration of guaranteeing money placed on deposit with banks.2

9. On the other hand, it is about losses suffered, for example:

  • when a financial planner, or his representative, steals money which should have been held on trust on behalf of a client who has given instructions for the purchase of superannuation, securities or other financial products with that money;
  • as a consequence of accepting a licensee's financial product advice which was not reasonable in the circumstances (for example, reasonable inquiries into the personal circumstances of the client had not been made);
  • when the licensee (whether the supplying institution or an intermediary), while holding the purchase money, becomes insolvent before the financial product is issued or purchased; or
  • as a consequence of the unauthorised transfer of securities.

10. In terms of legislative provisions:

  • the review is about the area currently covered by section 912B (the obligation on financial services licensees to have compensation arrangements) and Part 7.5 of the new Chapter 7 (the obligation on market licensees to have compensation arrangements);
  • it is not about:
    • the remainder of new Chapter 7, including the requirement for ASIC-approved external dispute resolution schemes;3
    • the order of priority in distributing assets on the winding up of a company.

11. Being within the area of discussion does not, of course, mean that the compensation arrangements eventually chosen will cover that particular situation. The appropriate coverage of compensation arrangements is a matter for discussion — see Chapter 5.

B: Origins of the review

The Corporate Law Economic Reform Program, CLERP 6 and the Financial Services Reform Act 2001

12. The Commonwealth Government initiated the Corporate Law Economic Reform Program (CLERP) in 1997.

13. The sixth paper in the CLERP series was entitled Financial Markets and Investment Products and was released in 1997. It was subsequently developed into a consultation paper entitled Financial Products, Service Providers and Markets — an integrated framework, and the Financial Services Reform Bill. This Bill was enacted as the Financial Services Reform Act 2001 (the Financial Services Reform Act), which commenced on 11 March 2002. The Financial Services Reform Act amends the Corporations Act 2001 (the Corporations Act) by inserting a new Chapter 7 which provides:

  • uniform regulation of dealing and advising in relation to all financial
    products — including securities, derivatives, superannuation, life and general insurance, bank deposit products and foreign exchange (but not credit products);
  • a harmonised financial product disclosure regime;
  • harmonised regimes for the licensing of:
    • financial service providers (replacing the widely diverging regulatory arrangements which include the licensing of securities dealers and advisers, futures brokers and dealers, the registration of insurance brokers and foreign exchange dealers as well as the arrangements governing insurance agents); and
    • financial markets and clearing and settlement facilities.

14. Further details of the regime for the licensing of financial service providers under the new Chapter 7 are provided in Attachment A.

15. As indicated above, while wholesale reform of the market compensation requirements was not a part of CLERP 6, participants in the consultation sessions on the draft Financial Services Reform Bill raised basic questions about the compensation regime.

16. Since time did not allow a review of the area prior to the Bill's proposed introduction, only modest reforms were included in the r
elevant provisions. In his second reading speech, the Hon Joe Hockey MP, who was then the Minister for Financial Services and Regulation, indicated that the reforms in the Bill were not the Government's final position and that more detailed research and consultation was needed in this area.4

Request to the Companies and Securities Advisory Committee (CASAC)

17. Following the introduction of the Bill, Mr Hockey asked the Companies and Securities Advisory Committee (CASAC) on 26 April 2001 to consider issues relating to compensation in the financial services sector and report on them within nine months. The issues referred to the Committee included whether there was a need for compensation arrangements, as well as the structure and coverage of any such arrangements required by legislation.

CASAC's Consultation Paper

18. In September 2001 CASAC issued a Consultation Paper that proposed for discussion a scheme to compensate retail clients of insolvent financial services licensees who were intermediaries.5 The scheme, which was limited to certain investments, would apply only when the intermediary was insolvent or unable to pay, and would cover the return of client property held by the licensee and losses to retail clients arising from any improper conduct by the licensee.

Responses to CASAC's Consultation Paper

19. The CASAC Consultation Paper received only limited circulation, given the time restraints for reporting. The nine responses received were mixed. A number of submissions supported the proposed scheme. On the other hand, some raised concerns about possible `moral hazard', and the methods and implications of financing the scheme.

20. One asked whether there was evidence of such a lack of consumer confidence as to justify the scheme. Others asked whether the proposal was consistent with the recommendations in the Report of the Financial System Inquiry (the Wallis Committee) on risk management and financial safety, and the harmonised approach to regulation reflected in the Financial Services Reform Act.

21. The scope, in terms of the liabilities covered, was questioned and it was suggested that possible alternatives, such as reforming and improving the current schemes, should be considered.

CASAC's interim report

22. The Convenor of CASAC conveyed the Committee's preliminary thinking and a summary of the comments received on consultation to the Treasurer in December 2001. The Convenor advised that the Committee needed to consider ASIC's policy on approved retail client compensation arrangements before finalising its report.

23. Further details of the proposal in the CASAC Consultation Paper and responses to it are included in Chapters 8 to 10 of this paper. Paragraphs 233 to 234 summarise the proposed scheme.

Senator Campbell's announcement

24. On 28 February 2002, Senator Campbell, the Parliamentary Secretary to the Treasurer with responsibility for the Corporations Act, announced that he intended to release an issues paper for industry consultation on a framework for compensation arrangements in the financial services sector. Senator Campbell indicated that he had asked Treasury to prepare the issues paper in consultation with ASIC and CASAC,6 with the aim of seeking industry feedback on the issues.7 This process therefore subsumes the previous CASAC review.

C: This issues and options paper

25. This issues and options paper has been prepared in response to Senator Campbell's request. ASIC and the Corporations and Markets Advisory Committee have been consulted in its preparation, and it is now being released for public consultation.

26. The aim is to engage a wide cross-section of the public and industry in the debate, and to obtain the views of as many interested parties as possible.

27. Issues are highlighted throughout the paper and are reproduced together at the beginning of this paper. The inclusion of a particular issue should not be seen as implying that the Government has adopted a particular view on any of the preceding issues.

28. The structure of the discussion in the paper as a whole is included in the Overview.

D: The consultation process

29. As part of the consultation process, we envisage that one or more meetings will be held during the consultation period to discuss the issues raised in this paper.

30. In addition, we seek your written views. Information regarding submissions, including the deadline, is provided on the page of this paper immediately following the title page.

31. When making a submission, there is no need to address all the issues. You may decide that there are others, which we have not raised, or that only one segment of the paper interests you. However, if you take this approach you need to bear in mind that consideration of this subject must commence with the basic questions of justification for any compensation requirements, their purpose and the coverage of any scheme proposed.

32. You are encouraged to address, in your submission, the costs and benefits of possible solutions to consumers, business, Government and the community. Consumers should assess any proposed solution against their current compensation rights.

33. It is likely that, in the light of the comments and submissions received, a more detailed proposal will be formulated and that this, in turn, will be exposed for public comment. It is desirable that any legislative amendments required be enacted in good time before 10 March 2004, when the Financial Services Reform transition period ends.

2 Thus, the following Commonwealth legislation is not relevant to the current exercise because it relates to the safety of the financial product itself:

    • Part 23 of the Superannuation Industry (Supervision) Act 1993;
    • priority for depositors under subsection 13A(3) of the Banking Act 1959.

3 The relationship between compensation arrangements and external dispute resolution schemes is discussed at paragraphs 296 to 303.

4 The second reading speech on 5 April 2001 - Hansard pages 26524-5.

5 This paper is available on the Committee's website:

6 The Companies and Securities Advisory Committee was renamed the Corporations and Markets Advisory Committee with effect on 11 March 2002.

7 Senator Campbell's press release 008.