Chapter 2: The Problem and Objective

This Chapter discusses the problem. It also considers whether government action is needed to correct it and the objective of government action.

A: What is the problem to be addressed?

34. Put at its most simple, the problem is that financial services licensees do not always have assets to meet claims arising from clients' losses which result from misconduct in the course of providing financial services ¾ for example, defrauding clients of their funds or financial products.8

Concepts: Financial services licensees, financial service, financial products

35. A person who operates a financial services business in Australia must be licensed to do so under the new Chapter 7 (unless exempt) and, when licensed, is referred to as a financial services licensee.

36. The term `financial service', which is used in paragraph 34, includes dealing and advising on financial products. It is explained further in paragraph 124.

37. At the heart of the definition of providing a financial service is the concept of `financial product'. The term `financial product' includes securities, derivatives, superannuation, general and life insurance policies (with certain limited exceptions) and deposit-taking facilities (but not credit products).9

What is the nature and size of the problem? ¾ Evidence of wrongdoing and losses

Evidence from ASIC

38. In its annual reports ASIC reported that:

  • in 1999-2000:
    • 8 investment advisers who had defrauded their clients were jailed following prosecutions brought by ASIC;
        • the amounts involved ranged from $114,000 to $4 million;
    • 16 investment advisers were banned for life;
        • one adviser banned had been involved in unauthorised transactions worth $17 million;
    • the registration of 2 insurance brokers was cancelled;
  • in 2000-01:
    • 5 investment advisers who had defrauded their clients were jailed following prosecutions brought by ASIC;
    • 17 people were banned for life from advising investors and another 13 advisers were banned for shorter periods of time;
        • one of the incidents triggering this action involved unauthorised investments resulting in client losses of more than $10 million;
    • 7 insurance brokers were deregistered or suspended.

39. ASIC's records indicate that the rate of insurance brokers going into external administration in recent years is significantly higher than for securities dealers. (Only three securities dealers have gone into external administration in the last 10 years.)

40. Action initiated by ASIC has, over the years, assisted in the recovery of significant funds. In one case of improper advice in 2000-01, ASIC's action resulted in payment of approximately $10.6 million by the principal to the clients.

Claims on the National Guarantee Fund

41. The second source of information is the Securities Exchanges Guarantee Corporation (SEGC) Annual Report for 2000-01.10 This indicates that:

  • the SEGC has received 5,554 claims since its establishment in 1987, most of them in the period 1988-1991;
  • in the period 1988-1993, 8 stockbrokers became insolvent (resulting in 5,333 claims);
  • since 1993, there has only been one broker insolvency but there has been an increase in the claims for unauthorised transfer of securities;
    • 95 per cent of claims received in the 5 years preceding the report were in relation to unauthorised transfers ¾ typically involving fraud by a person who was not necessarily within the broker effecting the transfer;
  • since the National Guarantee Fund was formed, $21.4 million has been paid from it in claims and $13.4 million recovered.

The potential impact on Australians

42. Virtually all adult Australians have financial products covered by the new Chapter 7, and hence an interest in the compensation arrangements required.

43. Statistics on the value of several types of financial products per household indicate that the value is significant and has risen in recent years:

  • superannuation and life policies account for 20 per cent of household assets, with an increase of around 10 per cent per annum, on average over the five years to 2001;
  • directly-held shares and investments in managed investment schemes account for around 9 per cent of household assets, with an increase of around 24 per cent per annum on average over the same period.11

44. It is estimated that 40 per cent of Australian adults have direct ownership of shares.12 If this estimation is correct, then at least 5.7 million adults have an interest in the future of the current National Guarantee Fund as an investor protection fund, and any alternative to it which is proposed.

45. The number of financial service providers is also relevant: in 2000-01, ASIC recorded around 2,500 securities dealers and advisers (and about 37,500 authorised representatives) as well as around 1,200 insurance brokers and 190 futures brokers and advisers.13

The need for better evidence about the problem

46. In summary, despite indications above that the problem described in paragraph 34 is significant, at this stage the evidence we have of consumers of financial services suffering loss is patchy. We would therefore welcome any evidence you may have which will help us to form a more complete picture of the problem.

Principal Issue 1

Can you provide any evidence of the nature and extent of losses suffered by consumers of financial services to assist us to understand the extent of the problem?

B: Why is government action needed to correct the problem?

What protection and redress is available (apart from compensation arrangements)?

47. It has been argued that, as with other products and services, the main protection for clients of financial services lies in a combination of competition, information disclosure, reputation and legal redress.14

48. It is not clear that competition and reputation alone will address the problem in paragraph 34.

49. Do information disclosure and legal redress do so? To answer this, it is necessary to examine the protection and avenues for redress provided to consumers of financial services by the law. These include:

  • for bodies regulated by APRA and new entrants after 11 March 2002, the qualifications to become a financial services licensee, and, for all financial services licensees, the obligations flowing from being a licensee (see Attachment A), including:
    • the requirement to provide a Financial Services Guide and to be a member of an external dispute resolution scheme;
    • the requirements for handling client assets;15
  • the other avenues for redress included in the new Chapter 7 — for example:
    • compensation orders in relation to financial services civil penalty provisions;16
    • civil action in relation to provision of the required disclosure document;17
    • civil action for loss or damage consequential on contravention of the provisions relating to false
      or misleading statements, inducing a person to deal, dishonest conduct or misleading or deceptive conduct;18
    • payment of money from `frozen' accounts;19
    • through the cooling-off provisions and provisions for choosing not to proceed with agreements with unlicensed persons, clients may be in a position to retreat from some inappropriate arrangements;20
  • the other mechanisms for redress which may be available including:
    • private legal action — for example, in contract or tort;
    • action under Part 2, Division 2 of the ASIC Act — for example, an action for damages under section 12GF or enforcement of the warranties implied by section 12ED;
    • ASIC initiating a representative action under section 50 of the ASIC Act;
    • making a claim in the insolvency of a financial services licensee, or taking action for the loss or damage against a director for insolvent trading;21
  • funds and property are held on trust by a financial services licensee and will not be available for the general creditors of the failed intermediary;22
    • equity provides personal remedies for a breach of trust (compensation and account for profits) and remedies directed at the property (tracing, and recovery of the trust property or having a charge over it).23

Current avenues for redress — some limitations

50. Do these provide sufficient protection for clients? The avenues for redress summarised in paragraph 49 above do not guarantee that assets will be available to satisfy any judgment or determination a client obtains in relation to the financial services licensee's conduct as such. They may also involve significant cost to the claimant and delay in being paid.

51. Licensing schemes are not infallible. In general, they focus on characteristics at the time of application and, no matter how thorough, will allow some incompetent or fraudulent operators to be licensed. Licence suspension or cancellation may occur only after a default or loss has been suffered.

52. Despite this, the very existence of a licensing regime may encourage consumers to assume a level of protection that the regulatory framework cannot guarantee.

53. Where the financial services licensee is insolvent, the avenues are more limited. If a winding up order has been made:

  • those claimants with debts will be able to prove in the winding up but are unlikely to receive the full amount of their claim;
  • claims for unliquidated damages or compensation, whether in tort, contract or another cause of action, can also be proved (the liquidator must make an estimate of the value of the claim, or refer the question of value to the court);
  • unsecured creditors are prevented from enforcing debts directly against the company's property;
  • proceedings against the company cannot be commenced or proceeded with except with leave of the court.

54. In addition, a failing financial services licensee may not comply with its obligations, for example to keep its client money in a trust account, and tracing the funds or financial products held on trust, where the remedy is available, will be expensive.

C: What is the objective of government action?

55. The objective is to ensure that consumers, particularly retail consumers, of financial services have appropriate remedies so that they maintain confidence in the financial marketplace and continue to participate in it.

D: Will compensation arrangements help to achieve this objective?

56. If the current avenues for redress and ensuring adequate funds to pay proved claims are considered insufficient, are compensation arrangements the only response? Are there alternatives that should be considered?

57. The following alternatives to the compensation arrangements proposed by CASAC were put in submissions to the Committee:

  • applicants for a financial services licence should satisfy a high solvency threshold, with mechanisms to ensure that those persons continue to satisfy it once they have been licensed;
  • there should be a strong regulatory focus on reducing the possibility of intermediaries becoming insolvent, rather than reliance on a compensation scheme.

58. While the first appears to be a means of achieving the second, its adoption could have an adverse effect on the entry of small financial service providers into the sector. Both suggestions may be seen as implying that the Government guarantees the solvency of financial services licensees. Obviously, solvency cannot be guaranteed; yet the suggested alternatives do not address what happens on insolvency. Adoption of the proposals would, however, involve ASIC in prudential regulation and impose increased costs on industry.

E: Should compensation arrangements be required by legislation?

59. What is so special about financial services that further regulatory interference in the market is warranted? Generally, the consumer probably has greater difficulty assessing services being purchased, than goods. Looking at services generally, what distinguishes financial services?

Reasons for compensation arrangements

60. The following have been put forward in various contexts as reasons for requiring compensation arrangements.

Providing for retirement ¾ consumer confidence

61. In the light of the expected increase in the proportion of retired persons to the working population in the years to come, Australian governments have sought to encourage reduced dependence by retirees on the age pension through superannuation initiatives. While a minimum level of superannuation is now mandatory, households may also choose to change their spending patterns in anticipation of their future needs by increasing the proportion of their assets in superannuation and other investments. Owning shares has also been encouraged by the major privatisations of recent years.

62. It is desirable that investors continue to have confidence in the financial services licensees through whom such products are purchased and sold.


63. Financial service providers linked to banks or insurance companies provide a wide range of financial services. The possibility of such a provider providing poor service or failing financially may have implications for confidence in the related banking and insurance group. Compensation arrangements in relation to financial services may assist with this confidence. However, in practice, if such a licensee breaches significant obligations to clients or deprives them of property, there is significant and immediate pressure on the relevant bank or insurance group to right the wrongs done as soon as possible.

Incomplete information ¾ assessment of risk

64. In particular cases, the consumer will have incomplete information about the financial services they are obtaining and the creditworthiness of the financial service provider. If they are aware of that lack of information (and the risk entailed in not having it) and are averse to taking such risks, then they may not obtain the financial service.

65. For example, in the United Kingdom, there is evidence that suggests that part of the reason for the substantial fall in the sales of life assurance and personal pension products in 1994 and 1995 was the lack of consumer confidence in the industry following a series of scandals and hazardous selling practices.24

66. Alternatively, they may not be aware of the lack, or the extent of the lack, of information.

67. In addition, for many, financial services may n
ot be used frequently and hence the consumer has little experience or ability to learn from experience. This is particularly so in relation to major investment decisions such as superannuation.

68. Even if the risk involved could be assessed, some insurance policies, for example, are entered into for the benefit of third parties who are not in a position to make such an assessment.

69. Further, the complexity of financial products increases the probability that financially unsophisticated consumers can misunderstand or be misled about the nature of the products, particularly their obligations and risks.

70. Finally, it is difficult to verify any advice being given by a financial services licensee and faults frequently cannot be rectified.

71. It is arguable that a compensation framework provides an independent assurance to consumers about the terms on which financial services are offered and their quality. On the other hand, it has been argued that the problems of incomplete information and the assessment of risk in purchasing financial products is no greater than in the purchase of, say, a horse or a car.

Court action

72. If easily accessible, compensation arrangements may provide a cheaper, easier and quicker avenue for redress than the range of legal action outlined in paragraph 49, a number of which require action in a superior court.

73. On insolvency, many of the remedies referred to in that paragraph cease to be available, and any compensation arrangements provide both the route for determining the claim and the source of funds.

Financial ruin

74. There is a likelihood of the one financial services licensee dealing in, or providing advice about, a high percentage of an individual's savings. This exacerbates the consequences of fraud or inappropriate advice, even if a widespread portfolio is being chosen. This likelihood is increasing with trends in the financial services industry.25

75. While this point relates particularly to investments, there is a comparable point to be made in relation to insurance ¾ in the case of at least some insurance (for example, building, life and disability), there is a distinct possibility of the individual suffering substantial financial loss by being encouraged to purchase a product which does not fit the risk or by the licensee failing to execute the transaction as instructed.

76. Further, the same licensee may provide both investment and insurance advice to the one client.

Consistency with the Financial System Inquiry

77. The Financial System Inquiry (the Wallis Committee) recommended the development of a single set of requirements for investment sales and advice including `financial resources or insurance in cases of fraud or incompetence'.26

Keeping boards honest

78. It has been argued that a wide range of investors helps to keep the board of a company aware of its duties and the expectations of shareholders. It is only with compensation arrangements in place that retail investors will continue to have confidence to so invest and continue to perform this function.

Imperfections in the financial services market which are not removed by competition

79. From another perspective, inefficiencies in the performance of a market (in this case, the financial services market) can give rise to less than ideal outcomes. These inefficiencies can include the difficulty of obtaining information, buyers of services not having access to the same information as is available to sellers, and the behaviour that can arise in response to unequal access to information.

80. Other factors affecting the market may include events outside the financial services market that cannot necessarily be controlled or predicted but impact upon the delivery and price of services.

81. All of the above can add to the cost and risk to buyers and sellers in the market. Compensation can seek to address some of these inefficiencies by directly reducing the level of risk experienced by buyers and providing appropriate incentives for financial service providers to manage their risks prudently.

International comparisons

82. While not of itself a justification for mandating compensation arrangements, compensation regimes in various overseas countries lead to expectations of comparable protection in Australia.

Is mandating compensation arrangements consistent with the role of regulation?

83. From the discussion above, it appears that there are reasons to require compensation arrangements but that does not of itself necessitate regulatory intervention.

84. Regulation is necessary only to the extent that markets may fail, and then only where it can be demonstrated that the benefits of intervention outweigh the costs.27

85. The Wallis Committee concluded that:

      'the government should not provide an absolute guarantee in any area of the financial system (just as it does not do so in other areas). Primary responsibility should remain with those who make financial promises. It would be inequitable for the government to underwrite some financial promises but not other promises made by participants in the broader economy.'28

86. The Committee expressed the view that the intensity of financial safety regulation should be proportional to the intensity of financial promises, the most intense being payment services.

87. Even where regulation is justified, it is not the role of regulation to eliminate risk in the financial services sector (or elsewhere). Instead, the spectrum of risk should be preserved for reasons of economic efficiency.

What about the `moral hazard' involved in requiring compensation arrangements?

88. The phrase `moral hazard' refers to the notion that financial services licensees and clients will take less care because compensation for losses caused by the conduct which is the subject of the arrangements will be assured. Arguably, it could even induce consumers to gravitate towards risky licensees.

89. This may be justified in the situation where the consumer has reason to suspect a particular licensee ¾ for example, one whose prices are much lower than the `market rate' ¾ but didn't inquire.

90. However, `moral hazard' implies that the ordinary, retail consumer has access to, and is in a position to assess, information relating to, for example, the financial position of the licensee, or the competence and trustworthiness of particular staff members. It also assumes that the consumer is aware of the compensation arrangements.

91. Some schemes seek to address this aspect of `moral hazard' by:

  • ensuring that, say, 90 per cent of the loss of the retail consumer (up to a nominated cap) is paid ¾ so-called `co-insurance';
  • excluding those likely to be `in the know' (such as associates and close family of the wrongdoer) from obtaining compensation (the market compensation arrangements in the Corporations Act provide for this).

92. It is also desirable that the limitations of the scheme be well understood.

93. The notion of `moral hazard' also applies to financial services licensees. Where consumers suffer loss which is covered by compensation arrangements, the cost of the consumers' losses is borne by the wider financial services industry. This possibility may encourage licensees to behave badly. On the other hand, licensees presumably wish to retain their licences and maintain profitability. Other remedies in the Corporations Act (such as liability for insolvent trading, which can apply to directors) and, ultimately, subrogation of the compensation provider to the rights of the client against the licensee may also influence licensees.

94. Mandating any co
mpensation arrangements involves additional potential risk for the Commonwealth Government (and the taxpayer). Calls for government assistance can be expected if:

  • professional indemnity insurance is required by legislation but the insurance proves not to be available, or only at a cost considered exorbitant by industry; or
  • an approach involving a compensation fund is adopted and the fund, at some later stage, is mismanaged or proves to be inadequate.

F: Conclusion

95. In summary, while the arguments above do not lead to a particular model of compensation arrangements (let alone the details of that model), they indicate that, among other things:

  • consumers do not always have all the relevant information, and are not always in a position to assess the information or the worth of the particular financial service;
  • consumers can suffer severe financial hardship through losses suffered as a consequence of the conduct of financial services licensees;
  • this affects consumer confidence in obtaining financial advice and undertaking transactions in financial products;
  • consumers expect the level of comfort provided by a compensation regime and may be prepared to pay the additional cost.

96. There therefore appears to be a justification for requiring compensation arrangements for losses suffered as a consequence of conduct29 of financial services licensees.

97. The ambit and structure of the compensation model adopted (including the conduct covered) will be influenced by the experience of misconduct and financial failure in the jurisdiction, the values held and the perceived tolerance in the community for risk of financial loss.

98. However, the balance between financial risk and consumer protection, and between the costs and benefits of any proposed solution, need to be kept firmly in mind, especially in the light of the new measures included in the Financial Services Reform Act (and further ASIC licensing requirements) to promote consumer protection.

99. There is always the danger that schemes will be formulated by a government wishing to `do something' about a course of conduct or insolvency in which the public has a real concern. This can be seen in the brief description of the origins of the National Guarantee Fund in Attachment C. The aim of this review is to avoid such a situation by attempting to trigger a debate of the issues now.

Principal issue 2

Is requiring compensation arrangements in the financial services sector justified?

8 The particular conduct which compensation arrangements should cover is discussed in Chapter 5.

9 See particularly sections 763A to 763D, and the explicit inclusions and exclusions in sections 764A and 765A.

10 The SEGC administers the National Guarantee Fund - see Chapter 3 and Attachments B and C.

11 The household balance sheet in Australia', Treasury Economic Roundup - Spring 2001.

12 According to the ASX Shareownership Update of November 2000.

13 ASIC Annual Report 2000-01 page 60.

14 David Llewellyn, The Economic Rationale for Financial Regulation, Financial Services Authority Occasional Paper Series No. 1, page 36.

15 See Part 7.8.

16 Action is taken in a superior court under section 1317HA (or 1043L).

17 Under section 953B or 1022B.

18 Under section 1041I.

19 Under section 983E.

20 See Division 5 of Part 7.9 and Division 11 of Part 7.6.

21 See Subdivision B, Division 4 of Part 5.7B.

22 See sections 981A, 981E, 981H, 984B and Corporations Regulation 7.8.07.

23 Also see Corporations Regulation 7.8.04.

24 David Llewellyn, op cit, page 26.

25 Similarly, in the case of uncertificated `CHESS' securities, the broker may well have authority over all or a substantial proportion of a client's securities.

26 Financial System Inquiry (the Wallis Committee) Final Report (March 1997) Recommendation 15, pages 274-5.

27 Only a detailed proposal can be assessed in this way. It is anticipated that a cost/benefit analysis will be made of the proposal formulated following this consultation process.

28 Financial System Inquiry (the Wallis Committee) Final Report (March 1997), page 191.

29 Just what conduct of financial services licensees should be covered is considered in Chapter 5.