Compensation arrangements 
for consumers of financial services
Future of financial advice

© Commonwealth of Australia 2012
ISBN 978‑0‑642‑74797‑6
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Manager
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The Treasury
Langton Crescent Parkes ACT 2600
Email: medialiaison@treasury.gov.au 

5 April 2012

The Hon Bill Shorten MP
Minister for Financial Services and Superannuation
Parliament House
CANBERRA ACT 2600

Dear Minister	
I present my report on compensation arrangements for consumers of financial services.
Those arrangements are designed to reduce the risk that compensation claims by retail clients cannot be met by licensed providers of financial services due to their lack of available financial resources. The current arrangements call for licensees, other than relatively well resourced categories such as APRA‑regulated banks and insurers, to hold professional indemnity insurance cover as a means of enhancing their ability to meet claims.
Retail clients are generally able to recover compensation for losses attributable to misconduct by licensees with whom they have dealt. In some cases however this is not so as the licensees in question lack the resources to meet claims by clients. These cases mostly involve claims for inappropriate investment advice and are commonly associated with losses incurred by clients following the failure of a managed investment scheme. Uncompensated losses of this kind can have serious consequences for affected retail clients. They may also detract from confidence in the financial services sector.
I have considered the need for a statutory scheme to provide additional protection for retail clients in circumstances where they do not have recourse to the last resort arrangements which are already in place in key areas such as bank deposits and general insurance. 
I have concluded that it would be inappropriate, and possibly counter‑productive, to introduce a more comprehensive last resort compensation scheme to underpin the current relatively light compensation regime for financial advisers and other providers of financial services. Given the limited regulatory measures to protect retail clients from the risk of licensee insolvency, it would be inappropriate to require more responsible and financially secure licensees to underwrite the ability of other licensees to meet claims against them for compensation. There would also be an element of regulatory moral hazard should a last resort scheme be introduced without a greater effort first to put licensees in a position where they can meet compensation claims from retail clients. It would reduce the incentive for stringent regulation or rigorous administration of the compensation arrangements. 

Priority should be given, in any move to bolster the protection of retail clients, to a more rigorous approach to compliance by licensees to provide greater assurance that they will be in a position to compensate their own clients through their insurance arrangements and the capital resources they have at risk. 
To put it another way, the regulatory platform for financial advisers and other licensees needs to be made more robust and stable before a safety net, funded by all licensees, is suspended beneath it. I see this as a necessary step before further consideration is given to a scheme under which the cost of uncompensated claims against one firm would be passed on to other firms who are not so remiss. This would be consistent too with the more robust regulatory approach to the providers of services elsewhere in the financial system, including prudential regulation, where last resort protection is offered to consumers. 
It needs to be recognised that a more stringent approach to licensing may itself have consequences for the cost of, and access to, the market for the provision of financial services. The proposed remedial measures are designed to give more substance to the compensation arrangements that are already in place. They would be focused on those licensees who are seen to pose most risk. They would not impose a significant regulatory burden across the board. 
I point out also that as a practical matter there is some disparity between the obligations towards retail clients borne by issuers of financial products and by financial advisers, with consequential limits to the protection offered and recourse open to those clients who acquire products direct from issuers. As a matter of strategic approach, it would be timely to review the current relatively light‑handed regulatory regime for the issue of certain financial products into the market, in particular managed investment schemes, and the possible need for some tightening of that regime. 
If the current compensation arrangements are reinforced along the lines proposed it would be open to round them out in due course with a more comprehensive scheme of last resort. The report goes on to consider the scope for, design and limits of any such scheme. 
Yours sincerely

Contents
Chapter 1: Introduction
Terms of reference
Background and scope
Review process
Chapter 2: Consumer protection in financial services
Regulatory approach
Licensing regime for financial service providers
Grounds for compensation claims
Avenues for consumer redress
Scope of compensation arrangements
Nature of compensation arrangements
Insurance as a basis for compensation
Limitations of professional indemnity insurance
Compensation arrangements in practice
Consequences where insurance not available
Shortfall for consumers
Phoenix activity by some licensees
Operation of EDR schemes
Assessment
Chapter 3: Compensation following recent licensee failures
Circumstances of recent failures
Trio Capital
Retail client test
Assessment
Chapter 4: Strengthening current arrangements
Introduction
Administration of insurance requirement
Assurance from licensees
Financial adequacy of licensees
Enforcement powers
Other issues
Recommendations

Chapter 5: Rebalancing responsibilities of licensees
Licensee conduct and compensation obligations
Access to EDR schemes
Scope to rectify imbalance
Underlying regulatory approach to product issuers
Product issuer responsibility to consumers
Standardise key product labels
Allocation of cost of compensation between licensees
Role of gatekeepers in protecting consumers
Recommendations
Chapter 6: Observations on a last resort scheme
Purpose of scheme
Liability standard
Eligible claims
Capping of payments
Membership of scheme
Scheme funding
Authority for scheme
Governance
Systemic improvements
Relationship to EDR schemes
Relationship to existing schemes of last resort
UK compensation arrangements
Chapter 7: Conclusions
Regulatory framework
Default compensation arrangements
Uncompensated claims
Limits of compensation arrangements
Enhancement of consumer protection
Last resort scheme
Further measures
Recommendations
Appendix A:	Summary of consultation paper
Appendix B:	Overview of submissions
Appendix C:	Other financial sector compensation arrangements
Appendix D:	Compensation arrangements in other countries
Appendix E:	Corporations Regulations
Glossary

Outline of report
The report covers the following matters:
•	Chapter 1 outlines the scope of the review and the review process, and provides background.
•	Chapter 2 describes and assesses the current arrangements for the protection of retail clients who deal with providers of financial services.
•	Chapter 3 looks at the scope for retail clients to obtain compensation for licensee misconduct in the context of recent collapses of financial services providers.
•	Chapter 4 considers possible legislative and administrative measures to bolster the current compensation arrangements and make licensees responsible for the consequences of their own misconduct.
•	Chapter 5 considers possible measures to redress an apparent imbalance between the responsibilities borne by financial advisers compared to the issuers of products given that financial product failure generally underlies claims against advisers.
•	Chapter 6 addresses the possible design and governance of a scheme of last resort, if one were to be introduced, to provide compensation in circumstances where a licensee does not have the financial resources to meet a claim for compensation by a retail client.
•	Chapter 7 provides an overview of the report and its findings and conclusions on the need to strengthen the current arrangements for compensation of retail clients. It sets out a number of recommendations for further action.