Chapter 6: Financial Services Licensees

The purpose of this Chapter is to discuss whether financial services licensees should be made responsible for, and pay for, compensation relevant to their own and their representatives misconduct.

It also explores the advantages and disadvantages of surety bonds and professional indemnity insurance, and asks whether there are other mechanisms which should be considered.

Finally, it asks what risks should the required mechanisms cover.

A: Responsibility

157. As indicated above, the subject of this paper is loss suffered by clients as the result of financial services licensees' breach of their legal obligations as licensees or where licensees have deprived clients of funds or financial products.39 The actor in this context is the financial services licensee (or its representative, for whose relevant conduct it is responsible).

158. It therefore follows that, all other things being equal, the obligation to make the compensation arrangements should be on the financial service provider (the principal).

159. This would also provide an incentive to behave if the premium or other payment due reflects accurately the risk involved in covering a particular licensee.

160. The advantages of such an approach are:

  • it imposes liability on the body responsible for the regulated conduct;
    • if the risk involved in the particular operations and the cost to the financial services licensee are aligned, cross-subsidisation will be minimised;
  • it underlines the message that the main responsibility for risk management lies with internal supervision. External regulation is not an alternative to robust and effective internal supervision processes and responsibilities;40
  • it is consistent with the approach of the Financial Services Reform Act of a harmonised regime applying across the financial services sector, while allowing for variations to take account of different products and ways of doing business.

161. The difficulties with such a conclusion are:

  • any problems inherent in or currently being experienced with the available mechanisms;
  • the degree to which `confidence in the market' (particularly if this is construed as the formal market or clearing and settlement facility) is the justification for requiring compensation arrangements.
    • It is arguable that all who benefit from such confidence should contribute. This may lead to the conclusion that some obligation should rest on the market operator or, perhaps in the context of uncertificated financial products, the prescribed CS (clearing and settlement) facility.

B: Mechanisms

162. There are several devices which can be used to make financial services licensees primarily responsible for compensation arrangements:

  • surety bonds;
  • professional indemnity insurance;
  • other means.

163. Each would involve a measure of discipline on the licensee because it would form a requirement for the continuation of the licence. The merits of each mechanism are considered briefly below.

Surety bonds41

164. Securities dealers and advisers, under the pre-Financial Services Reform regime, were required to lodge a $20,000 surety bond with ASIC (see Attachment B).

165. ASIC can apply the bond `to compensate a person who has suffered pecuniary loss due to the failure of the licensee or an agent of the licensee to carry on business under the licence adequately and properly'.42

166. Approximately 2,000 bonds are held by ASIC. Usually fewer than 10 bonds per year are called on, although the number of claimants for the one bond varies from one to 40.

167. The advantages of a surety bond requirement are:

  • the client has ready access to the funds through ASIC, and access to review mechanisms in relation to ASIC's decisions;
  • they are limited in the range of risks covered by the relevant legislative provisions, not the terms of an insurance contract;
  • at least while solvent, it is the individual licensee which faces the loss.

168. The disadvantages of the current surety bond requirement are:

  • they provide a very limited source of compensation following any significant losses covered by it (and, in this situation depending on the security provided, the provider of the bond may be `out of pocket', rather than the ex-licensee);
    • the current Australian bond, $20,000, is too small for many events in which compensation is sought - it is not proportional to the risk, the size of the business or the funds held on behalf of clients;
    • investors frequently receive only a few cents in the dollar;
    • it thus provides little compensation, and probably its potential loss provides little deterrence;
  • a substantial bond may prove an impediment to those wanting to start in the financial services sector in a small way;
  • it is not clear that the existence of security bonds under the current Corporations Act is widely known;
  • administration of the bond imposes some costs on ASIC, such as ensuring lodgment and assessing claims;
    • overwhelmingly, ASIC does not handle the funds - instead performance bonds/bank guarantees are used - although the bank may require deposit of the actual amount;
  • the threshold question of who can claim on the deposit is considered by one commentator to be unclear currently - for example, is negligence covered?43
  • the claimant will be left to private legal action (with its legal costs) or external dispute resolution to the extent that his claim is unpaid (and if it is worthwhile).

169. Noting the disadvantages above, we have taken the preliminary view that surety bonds do not provide adequate protection or, if markedly increased, involve a possible impediment to becoming a financial services licensee and potentially a significant cost on business.

Professional indemnity insurance

What is professional indemnity insurance?

170. Traditionally, professional indemnity/professional liability insurance covered a professional against liability in respect of loss caused by his negligence to other persons, including clients.

171. While the traditional policy was confined to negligence, the `professional indemnity' policy in recent years has evolved to a broader range of civil liability and is available to a wider range of occupations. Depending on the wording, the policy may extend the basic negligence cover to a claim arising from a breach of contract, tort and statute (such as misleading and deceptive conduct provisions in the corporations legislation).44

172. Extensions could include loss of documents, dishonesty of employees, retroactive cover, run-off cover and legal defence costs.

173. The circumstances in which professional indemnity insurance is currently required in the financial services sector are described in Attachment B of this paper.

What are the advantages and disadvantages of professional indemnity insurance as a means of providing compensation?

174. The advantages are:

  • insurance is considered more effective and efficient than surety bonds;
  • it provides substantial funds to pay accepted claims and greater certainty that they will be available (in defined circumstances);
    • access could be following a direct approach to the licensee, court action (or the threat of it) or following an external dispute resolution determination;
  • provided it is risk-weighted, the burden falls on those responsible for the relevant conduct;
  • professional indemnity insurance is standard business practice and most licensees are expected to have it, whatever the regulatory requirements (although the exact coverage will vary);
  • it does not involve the establishment of new infrastructure and the cost of running it;
  • it assists in discipline to the extent that it involves surveillance provided by insurers, and to the extent that the insurer makes a rational assessment of the risk inherent in the business of the particular licensee.

175. The disadvantages are:

  • it requires prescription as to the coverage, the minimum level of coverage, the excess etc provided by the policy which will suffice for regulatory purposes;
    • this may be by regulations (as in the case of the Insurance (Agents and Brokers) Act) or by a combination of regulation and discretion to the regulator (as in paragraph 912B(2)(b)); and
    • regulatory oversight is then necessary to ensure that the cover has been obtained and maintained, and that the policy does not have inappropriate limitations and exclusions;
        • a contract of professional indemnity required to be held by insurance brokers needs to be accepted by ASIC45 - would such a requirement be justified more generally?
  • there may be difficulty in the regulator or client establishing that cover is in place and not voided by, for example, misrepresentation,46 admissions to the claimant or failure to report a claim;
  • while the client's rights are against the insured, the processing of claims and payment of successful claimants is dependent on the insurance company, and any decision it makes to contest the claim;
    • if litigation results, there is likely to be an imbalance in the resources and expertise of the claimant and the insurer;
    • however, if the claim is within external dispute resolution limits and the professional indemnity policy covers determinations of the scheme, then access is facilitated.

Other mechanisms?

176. Are there other mechanisms which should be considered as alternatives to professional indemnity insurance or surety bonds? An industry fidelity fund has been suggested as one alternative. If there are appropriate alternatives, should financial services licensees be allowed to choose which suits their circumstances?

177. Relevant in this context is the question whether membership of a market compensation arrangement would, to some extent, satisfy the obligation on a financial services licensee to have compensation arrangements.

Should all licensees be treated the same way in any requirement for compensation arrangements?

178. Should APRA-regulated bodies, those with high financial requirements imposed by other means or those with high market capitalisation be treated differently in any requirement for compensation arrangements?

179. This is discussed in paragraphs 265 to 269 below.

Principal issue 6

What compensation requirements should be imposed on financial services licensees?

(a) Should financial services licensees be required to have professional indemnity insurance? Are there other appropriate mechanisms which could be alternatives at the option of the licensee?

(b) (See below) What should the mechanism be required to cover?

The current professional indemnity insurance market

180. Before the Government develops policy in this area, we need further information about the current state of the market for professional indemnity insurance in the financial services sector.

181. The issues on which we would like your views and experience include the following:

  • reinstatement of cover, excesses and the availability of `run off' cover;
  • the availability of coverage for fraud of licensees and their representatives, legal expenses and cover for licensees licensed to engage in a range of activities cutting across established segments of the financial services sector;
  • whether insurers provide cover in respect of determinations of external dispute resolution schemes.

182. You may be aware of other issues of relevance. If so, we would appreciate your advice.

183. Some background on the current state of the professional indemnity insurance market is provided in Attachment E.

184. We also need to understand whether clients have had difficulty obtaining the benefit of such policies.

Principal issue 7

(a) What, if any, difficulties are being experienced in the financial services sector with the cost and availability of professional indemnity insurance? For example, is run-off cover available?

(b) What, if any, difficulties have consumers had in being compensated from professional indemnity insurance policies?

C: What should the mechanism adopted be required to cover?

185. The next question is `What should the mechanism adopted be required to cover?' You need to consider this in the light of your answer to Principal Issue 4.

186. Some possibilities are discussed below. You may wish to suggest others.

All the obligations of the financial service provider under new Chapter 7

Current coverage of section 912B

187. The answer currently provided in section 912B,47 inserted by the Financial Services Reform Act, is loss or damage suffered because of breaches of the relevant obligations under new Chapter 7 by the licensee or its representatives.

188. This therefore encompasses, for example, loss suffered by a retail client:

  • which is caused by advice given by the licensee without a reasonable basis;
  • who has sought to return a product in accordance with the cooling-off provisions but the licensee has refused to comply with those provisions;
  • who has paid money to a licensee for the purchase of a financial product but the licensee has not dealt with it in accordance with Division 2 of Part 7.8 (for example, it has not been paid into a trust account, as required);
  • as a consequence of the failure by a licensee to issue a complying product disclosure statement.

189. Section 912B requires licensees to have compensation arrangements for losses suffered by retail clients as a consequence of breaches of the relevant obligations under `this Chapter' (that is, the new Chapter 7). In drafting the Bill, it was not the intention that this be read as requiring the compensation arrangements to cover compliance with other `financial services laws', one of the general obligations included in section 912A.48

190. Treasury officers envisaged that the details of the compensation arrangements required to meet section 912B would be prescribed by regulations but that ASIC would determine the amount of the cover in the light of the extent and nature of the financial services business carried on by the relevant licensee. Thus, in the case of general insurance brokers, the amount specified might be lower because premiums received by such a broker are deemed to have been received by the insurer. It was also envisaged that ASIC could review the amounts determined in the light of experience, but it was not envisaged that ASIC would consider the position of licensees individually in making determinations under this provision.

Questions about section 912B

191. This review does n
ot assume that section 912B should remain unchanged. The following issues arise in this context:

  • Should section 912B refer instead to:
    • specific obligations in Chapter 7?
    • specific liability provisions in Chapter 7?
    • some other set of obligations?
  • Should section 912B cover conduct in contravention of Part 7.9 (product disclosure) by financial services licensees?
    • clearly this is distinct from conduct of an intermediary, or comparable conduct (for example, advice or receipt of purchase money pending issue of a product) by an issuer.

Other possibilities

192. Although this issue can easily become a discussion in greater detail than is appropriate for this paper, the following models are worth considering:

  • The Technical Committee of the International Organisation of Securities Commissions49 suggested fraud, faulty execution, loss of documents or unauthorised trading by the firm's employees;
  • under the UK requirements,50 with limited exceptions, `Personal Investment Firms' are required to have adequate professional indemnity insurance cover for all the business activities which it carries on, or for which it is responsible;
    • the policy must cover negligence, legal defence costs, libel and slander, loss of documents, Ombudsman awards and representatives' conduct.

Principal issue 6(b)

What should the mechanism adopted be required to cover?

D: Conclusion

193. You need to consider whether the compensation arrangements which depend on financial services licensees are sufficient to meet your answer to Principal Issues 3 and 4. If not, are you suggesting a complementary market scheme or a broad statutory scheme?

39 The extent of the licensee's conduct giving rise to a compensable claim is discussed in Chapter 5.

40 David Llewellyn, op. cit., page 51.

41 This segment of the paper draws on points made by Paul Latimer in his article `Compensation of Investors for Failure of a Securities Industry Licensee', Company and Securities Law Journal Vol. 15, pages 495-503 (November 1997).

42 Corporations Regulation 7.3.04(1) prior to the Financial Services Reforms.

43 Paul Latimer, op. cit., page 498.

44 Rick Welsh, Professional Risk - traps for the unwary at Clayton Utz Risky Business II, 2-3 March 1999.

45 Section 9B of the Insurance (Agents and Brokers) Act.

46 Misrepresentation can be addressed in the relevant legislation- see s 9B(3) of Insurance (Agents and Brokers) Act.

47 Section 912B will, in effect, commence on 11 March 2004.

48 This reading has been suggested because one of the general obligations on financial services licensees in section 912A is to comply with `financial services laws' (a term which is defined in section 761A to include other relevant Commonwealth, State and Territory legislation).

49 The IOSCO Technical Committee, in a paper dated August 1996 entitled Client Asset Protection, discusses briefly the advantages and disadvantages of compensation schemes and insurance. See

50 The separate UK Financial Services Compensation Scheme is summarised in Attachment E.