Chapter 3:	Compensation following recent licensee failures 
The ability of consumers to recover compensation for licensee misconduct is looked at in the context of recent high profile cases in which the collapse of a financial services issuer resulted in large scale consumer loss.  
The primary loss suffered by consumers in these cases is the loss of their investment following the failure of the product issuer.  Consumers are left in those circumstances with whatever rights they may have as unsecured creditors in an insolvency.  They generally do not have rights to compensation by reason of the failure of their investment as such.
In some circumstances however consumers may be able to attribute part of their loss to misconduct on the part of a licensee with whom they dealt, and to claim compensation on that basis.  This will typically be the case where they have invested through a financial adviser and where they are able to demonstrate that the advice was inappropriate to their circumstances. 
Consumers who invested in such products direct - as many do ‑ are less likely to have effective rights of recovery even where they can point to misconduct such as misrepresentation of the product by the product issuer. 
Following the recent collapse of Trio Capital, some but not all retail investors were able to access compensation.  APRA-regulated superannuation funds that had invested in Trio products were able to claim compensation under Part 23 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on the basis that fraud had substantially diminished the assets of their fund and its capacity to pay benefits. Other consumers who invested in Trio products direct or as trustees of self managed superannuation funds (SMSFs) did not have the same opportunity.  It is understood that some of those consumers are pursuing action against financial advisers for inappropriate advice.  Beyond claims of that kind it remains to be seen whether those consumers will be able to recover compensation from the product issuer where the loss in value of their investment resulted from fraud.  	
Circumstances of recent failures
3.1	Reference is made in this chapter to a number of recent collapses of managed investment schemes and other financial service providers.  There are some recurring features in these cases:
•	the financial services provider operated without a licence and/or failed to register the managed investment scheme;
•	flaws in the scheme’s business model, rather than licensee misconduct, resulting in liquidity problems and in turn the collapse of the product issuer;
•	some consumers who acquired an interest in financial products based on financial advice may not have been properly warned of the risks of investing in the products, or may have been induced to invest by misleading or deceptive statements about the features and risks of the products, or the financing of those investments.  In some cases, the advice given was standardised and may not have been appropriate for individual clients;  
•	some product issuers offered high commissions to financial advisers for the recommendation of their products.
In addition, in some cases consumers who invested direct with the product issuer may have received defective product disclosure statements.
3.2	In the wake of a product issuer’s collapse a distinction needs to be drawn between investment losses that result from the collapse and those that can be attributed to licensee misconduct.  The compensation arrangements under Chapter 7 are not intended to compensate for consumer loss following the collapse of a product issuer, nor for failures in investment or market performance of the product.  They are only intended to support the recovery of losses that can be attributed to licensee misconduct.  
3.3	Consumers who acquire an interest in a financial product on the recommendation of a financial adviser may be able to base a claim for compensation on inappropriate advice or some other misconduct if that can be established.  This might also be the case if inappropriate advice was given for an investment in an unlicensed or unregistered managed investment scheme.  
3.4	On the other hand consumers who invest in a financial product direct have little chance of compensation following the collapse of the product issuer other than as an unsecured creditor in the insolvency process.  As discussed in Chapter 5 this is likely to be the case even if the product disclosures made to investors were inadequate by licensing standards, because for example they did not disclose significant risks associated with holding the financial product.   
3.5	This highlights an apparent imbalance between the responsibilities borne by financial advisers for their part in the investment chain compared to the issuers of products whose failure underlies the consumer loss.  
3.6	Consumers who deal direct with unlicensed financial service providers (or unregistered managed investment scheme operators) have no recourse to compensation arrangements under the Corporations Act for loss suffered.    
3.7	In some instances, ASIC acting pursuant to section 50 has stepped in to take class actions on behalf of consumers against financial advisers, directors and/or auditors.  Such actions may lead to the partial recovery of consumer losses.
3.8	In the case of Westpoint, which operated an unregistered property development scheme without a licence, ASIC took action based on inappropriate advice against several financial advisers who had recommended Westpoint products to their clients. Table 3.1 provides information about those actions.  As far as ASIC is aware, the compensation agreed in the settlement of those actions has been paid, or will be paid, to affected clients.  ASIC has also taken or is pursuing action against auditors, directors and a trustee.  ASIC says the total amount recovered through its litigation is around $93 million and that in all it expects investors to see a return of around $160 ‑ 170 million of the $388 million in losses.
Table 3.1: ASIC recovery action against advisers for Westpoint investors 
Defendant financial adviser 	Insolvency of adviser	Number of investors	Damages claimed	Compensation agreed (a)(b)	
Masu Financial Management Pty Ltd 	No	85 (25 other investors took separate legal proceedings).	$12.6 million	Settlement not disclosed	
Professional Investment Services Pty Ltd (PIS) 	No	247	$22.8 million	$5.9 million 	
Bongiorno Financial Advisers Pty Ltd/Bongiorno Financial Advisers (Aust) Ltd 	One licensee is no longer licensed, and the other is still trading 	125	$8.5 million	$2.6 million	
Glenhurst Corporation Pty Ltd 	Yes	90 	$7.1 million	$2.5 million	
Brighton Hall Securities Pty Ltd	Yes	200	$14 million 	 Not yet resolved	
Dukes Financial Services Pty Ltd
(now known as Barzan Pty Ltd)	No	159	$12.2 million	$1 million	
Strategic Joint Partners Pty Ltd	No	80	$6.5 million	$1.39 million settlement awaits court approval	
Source: ASIC FIDO and Westpoint investor websites and ASIC Annual Report 2010-11.  
(a)	For cases where the settlement amount is publicly known, the average claim against adviser groups was approximately $81,000 and the average settlement amount was approximately $19,000 per investor.
(b)	ASIC has pursued or is in the process of pursuing other actions against auditors, directors, and a trustee in relation to Westpoint. To date those settlements have recovered an additional $67.45 million for the benefit of investors through the liquidation process.  Overall, investors in Westpoint have recovered an average of around 43 cents for each dollar invested.

3.9	Table 3.2 describes the circumstances of the failure of a number of financial services providers, including whether the provider in question was licensed and/or had registered its scheme, and the nature of any misconduct by a provider that may form the basis of a claim for compensation by consumers.  
3.10	In each case it appears that some consumers may be able to pursue claims for compensation on the basis of inappropriate advice in relation to their investment.  On the other hand, consumers who invested direct in those products would appear to have little chance of compensation even if the disclosures by the provider did not meet the standards of the law.  
3.11	

Table 3.2:  Recent collapses of financial services providers
Circumstances of collapse	Scope for consumer compensation claims (a)	
Westpoint
Consumers acquired financial products such as promissory notes which were used to fund the group’s property development schemes.  Investors were effectively lending money to property developers (or to finance companies who on-lent it to developers).
Westpoint was unlicensed and operating unregistered managed investment schemes.  Some businesses which provided financial advice in relation to Westpoint products were also unlicensed.  
In early 2006, the Federal Court ordered the winding up of Westpoint following an application by ASIC on the grounds of insolvency. Investors had invested $388 million in Westpoint.
The liquidator said the investment schemes failed because of high levels of gearing, delays, inappropriate and costly financial structuring, and ineffective management and risk mitigation. 
	Inappropriate advice
Through ASIC’s class action almost 1,000 clients have claimed against seven financial advisers who had recommended Westpoint products (see Table 3.1). The action against those advisors was based on negligent advice, misleading and deceptive conduct and/or acting in breach of their licence conditions. Specific breaches were said to include:
•	failing to investigate and understand the nature and risks of financial products recommended; 
•	failing to undertake a full analysis of the client’s financial circumstances, and making recommendations to invest in the products that were not suited to the client’s risk profile;
•	failing properly to warn the client of the risks of investing in the products, and the risks of investing against equity in the family home;
•	making misleading or deceptive statements concerning the features and risk of the products; and
•	providing inaccurate or incomplete information to clients.
In addition, FOS says it dealt with complaints from over 400 Westpoint investors, largely against financial advisers, resulting in 37 awards valued in all at $2.4 million.  FOS understands those awards were not paid due to the insolvency of the respondent licensees.  
Consumers who invested in Westpoint products based on recommendations from unlicensed advisers could not progress claims through FOS because those advisers had not joined an EDR scheme.  	
Agribusiness collapses
Consumers invested in managed investment schemes which provided capital for a number of agribusiness schemes relating to tree or olive plantations for example.  
Under these schemes some years would pass before the plantations could be harvested and make returns.  They collapsed when they incurred cash flow problems.  
In some cases, a new scheme operator was found and investors may have received a return lower than that offered in the PDS.  Otherwise the schemes were wound up and assets were distributed between the banks (as secured creditors) and investors (who lost all or part of their investments as unsecured creditors). 	Inappropriate advice
In some cases it seems that consumers who invested through advisers have claimed compensation on the basis of inappropriate advice, which for example failed properly to warn of the risks of investing or of the unsuitability of the investment given a client’s risk profile.
Disclosure (b)
Some concerns were expressed about the accuracy and adequacy of disclosure by certain agribusiness managed investment schemes operating prior to mid 2009, particularly the non‑disclosure of historic yield information and inclusion of favourable opinions about performance by third parties who might not be best qualified to provide such opinions.  ASIC assessed the disclosure documents of 20 agribusiness schemes marketed in that period and took action against 12 including by requiring the issue of supplementary PDSs, issuing stop orders on misleading PDSs, and by having one PDS removed from offer.  	
Babcock & Brown
Consumers invested in high risk and complex structured investments, such as hedge funds and infrastructure funds, which failed due to difficulties in the debt market during the global financial crisis.  	Inappropriate advice
In some cases it seems that consumers who invested through advisers have claimed compensation on the basis of inappropriate advice, which for example failed properly to warn of the risks of investing or of the unsuitability of the investment given a client’s risk profile.	

Storm Financial
Storm Financial was a financial adviser which appears to have provided ‘one size fits all’ advice to clients to invest in ‘Storm-badged’ managed investment schemes which were backed by shares and managed by other fund managers. 
Storm Financial arranged for approximately 3,000 investors to be double-geared with loans against equity in their homes as well as margin loans that increased their exposure to risk.
When margin calls were made in a falling sharemarket many investors could not pay the call.  This jeopardised their initial investment as well as their home or other assets used as collateral for the margin loan.  	Inappropriate advice
Whether Storm Financial engaged in inappropriate advice is currently the subject of court proceedings.  In some cases it appears that consumers who invested through advisers may be able to claim compensation on the basis of inappropriate advice, which is alleged to include:
•	failing to provide efficient, honest and fair financial services;
•	failing to provide financial advice tailored to each client’s circumstances;
•	providing false and misleading information in Statements of Advice;
•	providing negligent financial advice to clients in breach of duty to exercise reasonable care and skill in providing financial advice to clients.  	
Trio Capital
Trio Capital Limited (formerly Astarra Capital Limited) was the trustee of five superannuation entities.  
It also held a licence as a responsible entity to operate 24 registered managed investment schemes (including Astarra Strategic Fund) and was the operator of three unregistered managed investment schemes.
Investors in Astarra Strategic Fund included four APRA-regulated superannuation funds whose trustee was Trio Capital, as well as self managed superannuation funds and direct investors.
It is alleged that Astarra Strategic Fund invested its assets into hedge funds located in the Caribbean and that there may be little, if any, evidence that the purported investments were actually made, or if they were, they may not have had any realisable value.  Most of the assets invested appear to have been subsequently lost.
Trio Capital products were recommended by some financial advisers and claims for compensation have been made through FOS against those advisers.
In December 2009, APRA suspended Trio as the trustee of registered superannuation entities and appointed ACT Super Management Pty Limited (ACT Super) as the acting trustee.  At the same time, ASIC suspended Trio Capital’s licence as a responsible entity.  This regulatory action was taken because of numerous breaches of licensing conditions and concerns regarding the valuation of superannuation assets and the legitimacy of investments.  A former director of Trio’s investment management company has been convicted of dishonest conduct and making false statements in relation to financial products.  
Trio Capital was placed into administration and Astarra Strategic Fund was ordered to be wound up, but to date the liquidator has been unable to recover the vast majority of investments made by Astarra Strategic Fund.  	Inappropriate advice (c)
In some cases it seems that consumers who invested through advisers have claimed compensation on the basis of inappropriate advice, which is said to include:
•	failing to investigate and understand the nature and risks of financial products recommended; 
•	failing to undertake a full analysis of the client’s financial circumstances, and making recommendations to invest in products that were not suited to the client’s risk profile or did not achieve adequate diversification of client assets;
•	failing properly to warn the client of the risks of the gearing strategies recommended;
•	failing to disclose matters that may be reasonably expected to have influenced their advice to recommend Astarra products and gearing strategies – including the receipt of commissions and a marketing allowance paid by Trio Capital. 
	
Opes Prime
Opes Prime on-lent to secured creditors shares that were transferred to Opus Prime by clients in exchange for margin loans. Clients were unaware that the ownership of their shares had been transferred to the secured creditors. 
It was alleged that Opus Prime operated unregistered schemes.	Inappropriate advice
In some cases consumers who invested on the basis of financial advice have claimed compensation on the basis of inappropriate advice, which for example failed properly to warn of the risks of investing and the unsuitability of the investment based on a client’s risk profile.	
Source: ASIC information provided to the review and on public record.
(a)	In many of these cases ASIC has/is taking action for corporate misconduct by directors and officers, breaches by auditors and breaches by lenders or credit providers.
(b)	PJC Inquiry into aspects of agribusiness managed investment schemes, September 2009, paras 4.72 – 4.74, and ASIC Submission to that Inquiry, August 2009, p 32-33 and 60.
(c)	FOS submission to the PJC Inquiry into the collapse of Trio Capital, pp 5- 6.

Trio Capital
3.12	The Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) has been conducting an inquiry into issues associated with the collapse of Trio Capital Limited. It is expected to report in May 2012.
3.13	As noted in Table 3.2, Trio Capital was the trustee of five superannuation entities and also held a licence as a responsible entity to operate 24 registered managed investment schemes.  In its interim report, PJCCFS says there was a ‘large level of cross investment between superannuation funds and the schemes where Trio was the common trustee’ and that the collapse of Trio centred on fraudulent behaviour mainly in relation to funds in two registered managed investment schemes, Astarra Strategic Fund and ARP Growth Fund. PJCCFS says it is considering a number of issues including the extent to which APRA and ASIC are able to conclude that ARP Growth Fund was the victim of ‘market failure rather than fraud’.
3.14	Trio Capital has since been placed into administration and to date the liquidator has not been able to recover the vast majority of assets held through Astarra Strategic Fund (reported to be $125 million).
3.15	Given the focus of the PJCCFS on Trio, this review has not given the particular circumstances of that case the same level of attention.  Consideration is given however to the scope for recovery by consumers who suffer losses from fraudulent conduct such as has been alleged in the case of Trio, and the extent to which last resort compensation arrangements would assist.  Differences are drawn out between the position of various types of investors in Trio products. 
Uneven recourse to compensation
3.16	The case of Trio Capital, where the facts and legal liabilities are still unfolding, has thrown into sharp contrast differences in the ability of various categories of consumers to obtain relief in circumstances where the value of investments in a managed investment scheme appears to have been destroyed by fraudulent activity.
3.17	Consumers who were exposed to Trio Capital through their membership of an APRA-regulated superannuation fund were able to benefit from compensation pursuant to the last resort arrangements provided under Part 23 of the SIS Act.  For other consumers who were exposed to Trio, whether through SMSFs or as direct investors, the position is less clear.  Whether or not in the facts and circumstances of that case they will have claims and be able to recover compensation against a licensee for loss or damage caused by a breach of its obligations remains to be seen.  
3.18	The uneven outcome, where some investors had recourse to financial assistance following the collapse of Trio Capital, while others may not have is a consequence of the way in which compensation arrangements for consumers of financial services have developed over the years.  The degree of protection afforded in those arrangements reflects the perceived intensity of the financial promises in question.
3.19	Part 23 of the SIS Act was introduced in 1993 as part of a legislative package to strengthen the security of superannuation savings and protect the rights of fund members.  Under Part 23 a trustee of an APRA‑regulated superannuation fund (or approved deposit fund) can apply to the Minister for a grant of financial assistance if the superannuation fund incurs a loss as result of fraudulent conduct or theft. The Minister is required to seek advice from APRA and must be satisfied that the loss has caused a substantial diminution of the fund leading to difficulties in the payment of benefits, and that the public interest requires a grant to be made.  The Minister has discretion over the grant of financial assistance up to the amount of the eligible loss.  
3.20	The financial assistance granted in this way is funded initially from the Consolidated Revenue Fund and may be recouped through an industry levy on APRA‑regulated superannuation funds and approved deposit funds. The effect is that a loss in one superannuation fund is borne by the members of other APRA‑regulated funds that contribute to the levy. 
3.21	ACT Super, the acting trustee of the former Trio Capital superannuation funds, has been granted financial assistance under Part 23 of the SIS Act.  ACT Super is responsible for the equitable distribution of the grant to the superannuation accounts of affected superannuation fund members with investments in the Astarra Strategic Fund.
3.22	In announcing the grant of financial assistance, the Minister said he was satisfied that the fund had suffered an eligible loss under the Act and that the public interest required that a grant of assistance be made to the fund. The assets of APRA-regulated superannuation fund members were found to be substantially diminished as a result of fraudulent conduct or theft, and compensable under Part 23 of the SIS Act on this basis (with such compensation funded by a levy on other APRA‑regulated superannuation funds).  The operation of Part 23 of the SIS Act is described in more detail in Appendix C.
3.23	Other consumers who were exposed to Trio Capital, and suffered losses after its collapse, did not have recourse to the protection available under Part 23 of the SIS Act.  Consumers who invested in Trio products direct, or through their SMSFs, were not eligible for such protection.
3.24	Not surprisingly, there has been marked disquiet on the part of other investors (trustees of SMSFs or individual investors) who invested in Astarra Strategic Fund or other Trio Capital managed investment schemes and whose investments were also diminished as a result of the alleged misconduct of Trio Capital.  
3.25	The policy rationale for the exclusion of SMSF trustees from Part 23 of the SIS Act is that, as trustees of their SMSF, they have direct control over their superannuation savings and unlike investors in other superannuation funds are in a position to protect their own interests.  It would be difficult also to justify levying other funds for fraud perpetrated within a closely held SMSF.  They are subject to a less onerous regulatory regime and are not subject to levies under the financial assistance provisions.  It is understood that the assistance scheme in Part 23 has been affirmed in several reviews over the years. My own disposition is to regard SMSFs for this purpose as more akin to private investors than to the broader based APRA-regulated funds for the protection of whose members Part 23 is designed.
3.26	The uneven treatment of different categories of investors in Trio Capital is further exacerbated by the fact that the fraud, on the basis of which financial assistance was granted to several superannuation funds, apparently did not occur within those funds but within a managed investment scheme - Astarra Strategic Fund - in which those funds had invested.
3.27	Part 23 makes provision for the grant of financial assistance for certain superannuation funds that have ‘suffered loss as a result of fraudulent conduct or theft’.  While the provision is not so limited in terms, it might be expected that fraudulent conduct of the kind contemplated in Part 23 would ordinarily be fraud within the management and operation of the superannuation fund in question.  In the Trio case however the fraudulent conduct appears to have taken place in relation to a managed investment scheme in which the superannuation fund had invested, and the loss suffered was judged to be of an order that met the statutory test of having ‘caused substantial diminution of the fund leading to difficulties in the payment of benefits’.
3.28	A consequence of the grant of financial assistance in that case is that the position of other investors in Trio Capital products, who did not have open to them a comparable avenue for compensation, was highlighted.  From the perspective of those other investors, they were as much the victims of any fraud as were the members of superannuation funds that had invested in the same product.  
3.29	APRA says it suspended Trio Capital as the trustee of its superannuation funds because of numerous breaches of APRA’s licence conditions including a failure to demonstrate due diligence in investing in hedge funds as well as failure to act in the best interests of beneficiaries. 
3.30	The four APRA-regulated superannuation funds which will benefit from the grant of financial assistance had each invested a proportion of their total assets in one managed investment scheme, Astarra Strategic Fund.  The fact that a large part of superannuation funds’ assets appear to have been invested in one scheme itself raises questions about the governance of those funds, their investment policy and risk management.  It may also raise questions about the adequacy of regulation in this area.
3.31	There are some relevant requirements in the SIS Act for trustees of APRA‑regulated superannuation funds to have in place a sound and prudent risk management strategy that deals with the material risks of the trustee, and a risk management plan for each fund. As part of this trustees must address fraud risk, that is, intentional acts to manipulate the fund for personal gain.  Guidance is provided by APRA on fraud risk and the elements of the mitigation strategy required to be put in place. Trustees are also required to subject their risk management framework to assurance processes through their auditors, and to provide an annual signed attestation as to the existence and efficacy of the risk management framework they have in place.
3.32	Notwithstanding these requirements, APRA apparently does not currently have power itself to set prudential standards in relation to superannuation funds.  As part of the Government’s Stronger Super reforms, a Bill has been introduced into Parliament which would impose new duties on superannuation fund trustees, including to develop an investment strategy, and would give APRA powers to make prudential standards in relation to superannuation. APRA says it will use such powers to issue a prudential standard on processes for investment governance and due diligence on investments, as well as on risk management. It expects to finalise the standards during 2012 for commencement during 2013.  
Position of investors affected by fraud
3.33	The position of investors exposed to Trio Capital, whether through SMSFs or as direct investors, is problematic in a case where, as appears to have happened in Trio, the value of their investment in a financial product was destroyed or diminished by fraudulent conduct on the part of the product provider.
3.34	Where fraud can be established the perpetrators may be subject to criminal prosecution and civil action may be open (to the liquidator of the product provider for example) to recover missing assets.  
3.35	Chapter 7 of the Corporations Act does not deal specifically with a licensee’s obligations to compensate clients for loss arising from fraud.  ASIC has stated that:
a consumer will generally be unable to obtain compensation through the licensee or representative where fraud has been perpetrated against the fund as a whole unless the client can show they have a personal action against the licensee or representative.
ASIC appears to be saying that there may be a basis for a compensation claim if the complainant can show it has a personal right of action in relation to some misconduct by the licensee or representative. 
3.36	A consumer who suffers loss from fraud on an investment in a pooled investment, such as a managed investment scheme, will not necessarily be able to establish a claim against a licensee for compensation for breach of a statutory obligation upon the basis of that fraud.
3.37	In a case involving loss from fraud, a consumer might be able to establish that the licensee had engaged in dishonest conduct in breach of section 1041G of the Corporations Act. A consumer who suffers loss or damage by a licensee’s dishonest conduct may claim compensation whether or not the licensee is convicted of the offence.  It is noted also that, under section 50 of the ASIC Act, ASIC can take action on behalf of investors who have suffered loss if it appears to be in the public interest to do so.  Such action can be taken to recover damages from fraud committed in connection with a matter which ASIC is investigating, amongst other things.  
3.38	In the investigations following the collapse of Trio Capital, a former director of the investment management company Astarra Asset Management Pty Limited, which invested funds raised by Trio, has been convicted of dishonest conduct in the course of carrying on a financial business and of making false statements in relation to financial products. Whilst dishonest conduct on the part of a director was established in that case, in practice it may not always be possible to establish that the licensee’s conduct was dishonest.  
3.39	There could be practical problems given the murky facts and circumstances that commonly surround fraud in identifying dishonest conduct and assessing how much of the failure of an investment product can be attributed to that conduct.  
3.40	There is also a specific obligation upon licensees in sections 981B and H to hold certain monies held on behalf of a client in a trust account before for example investing it with a product issuer as directed by the client.  A consumer who suffered loss where a licensee did not hold investment monies in a trust account as required would have a basis to claim compensation for loss resulting from that breach.  In a recent case of licensee fraud the financial adviser in question failed to invest client funds as instructed but misappropriated them upon receipt. Whether or not there were funds available to meet the claim may be another matter.
3.41	A consumer might possibly seek to rely on a breach by a licensee of a general licensing obligation such as to:
•	do all things necessary to provide the financial services efficiently honestly and fairly;
•	manage conflicts of interest that might arise for a licensee or representative;
•	adequately train and ensure the competence of its representatives; and
•	have adequate risk management systems in place. 
3.42	Further, a consumer may be able to recover where the loss can be attributed to fraudulent conduct on the part of a representative (including an authorised representative, employee or director) of the licensee. Under section 917E, a licensee is liable to a client in respect to any loss or damage suffered by the client as a result of a representative’s conduct.  ASIC says in Regulatory Guide 126 that a minimum feature of adequate professional indemnity insurance cover is that it indemnifies the licensee against liability for loss or damage suffered by retail clients because of breaches of Chapter 7 by the licensee or representatives including liability:
for fraud or dishonesty by directors, employees and other representatives of the licensee (although such cover is not required for a sole trader).
3.43	While consumers may be able to make out a claim against the licensee, it does not follow that they will be able to recover compensation.  In some cases the licensee’s business will have collapsed and it will have ceased trading following the fraudulent misappropriation of funds.  In those circumstances there would be little prospect of recovery.  It should be noted that, while any professional indemnity insurance held by the licensee should cover fraudulent conduct on the part of a licensee’s representative, it would not extend to fraudulent conduct by the licensee itself.  Given the inherent moral hazard a licensee would not be able to acquire professional indemnity insurance cover for fraud committed by itself.  
3.44	FOS says it is not dealing with any complaints against Trio Capital itself but only against financial advisers who recommended that their clients invest in Trio Capital. FOS also says it could not accept new complaints against Trio Capital because Trio is no longer a member subject to its scheme. It seems that FOS, in taking this position, has not exercised its discretion to continue to deal with complaints brought against a former member.  ASIC requires of an EDR scheme that:
... its Constitution and/or Terms of Reference allows the scheme to exercise a discretion about whether to cancel a scheme member’s membership and/or handle complaints or disputes in respect of the scheme member where the scheme member ... ceases to carry on business ... ceases to have a licence; and/or becomes insolvent under administration.
3.45	Where a product issuer has failed following fraudulent activity, affected consumers might look to bring a claim against another licensee in the distribution chain with whom they have dealt.  In most cases of this kind it appears action has been taken against a financial adviser who advised a consumer to invest in a pooled investment scheme that becomes the subject of fraud.  FOS says it has received complaints from individuals and trustees of SMSFs who were advised by financial advisers to invest in Trio Capital products:
Twenty-eight of those disputes have been lodged against one Australian financial services licensee.  The remaining four disputes are shared between three other licensees...
Generally the applicants have alleged that the recommended gearing strategies exposed them to unsustainable levels of debt, there was inadequate diversification of assets within their portfolios and the assets used as leveraged security carried significant liquidity risks and the licensee used poor or inadequate know-your-client practices. 
They also are alleging misleading and deceptive conduct in relation to the risks of the Astarra fund. They have also made allegations about possible conflicts where the marketing allowance that was paid to the adviser was ... a significant incentive for the licensee to recommend the product. They also make allegations about failure to disclose the significant risks in the investments. 
FOS is still handling these cases and has not decided any of them yet.
Possible remedial action
3.46	The introduction of a statutory compensation scheme to underpin the existing compensation arrangements would not in itself provide relief for consumers who do not have access to compensation for losses suffered in a case such as Trio Capital.  It would not resolve the question whether fraud as a factor in the diminution of the value of an investment gives rise to a claim against a licensee.  The ability of consumers to claim compensation would still depend on being able to show they had suffered loss as a result of the breach by a licensee of a relevant obligation, such as the bar in section 1041G on dishonest conduct.   
3.47	Apart from any further measures that may be needed for the punishment of fraudulent conduct, it is questionable whether the law could meaningfully go further in imposing obligations on a licensee that would pave the way for a consumer to recover compensation from that licensee for the fraudulent impairment of the value of an investment.  
3.48	It follows that the introduction of a statutory compensation scheme of last resort, of the kind discussed in Chapter 6, would not be a ‘silver bullet’ to resolve the question whether fraud as a factor in the failure of an investment would give rise to a claim for compensation.  Recourse to such a scheme would still be dependent on the consumer being able to establish loss or damage suffered as a result of a licensee’s breach of its legal obligations.  
3.49	In the course of the review the question has been raised whether a scheme of financial assistance along the lines of Part 23 of the SIS Act could be introduced for investors in managed investment schemes.  Any move in that direction would, it is suggested, call first for a substantial upgrading of the regulatory regime for such schemes.  It would be difficult to justify spreading the cost of investment losses through fraud across other scheme operators in circumstances short of some kind of prudential regime for those schemes. 
3.50	There is a significant difference in the regulatory frameworks that apply to APRA‑regulated superannuation funds compared to that applying to licensees who are not prudentially regulated.  The special arrangements in Part 23 for superannuation funds were introduced in 1993 as part of a package to strengthen the security of superannuation savings and protect the rights of fund members.  That regulatory approach no doubt reflects the fiduciary nature of such funds and the importance of maintaining the integrity of and confidence in funds to which consumers are obliged to contribute for their retirement savings.  On the other hand the regulatory treatment of managed investment schemes does not appear to provide a solid enough framework upon which to transfer to other licensees the cost of compensation for consumer loss resulting from licensee fraud.  It would be difficult to justify a requirement for other licensees to pay compensation for a loss to consumers resulting from the deliberate actions of a fraudulent licensee for personal gain in the absence of some significant enhancement of the regulatory regime administered by ASIC.  
3.51	In any move to provide consumers with better protection against fraud a starting point would be through a strengthening of the regulatory regime for managed investment schemes.  There is scope in particular to require better management of the risk of loss to investors through fraud particularly the opportunity for fraud by employees or representatives.  There are no specific obligations upon licensees at present to mitigate the risk of fraud.  There is only a general obligation on licensees to have ‘adequate risk management systems’ and a requirement on the responsible entity of a managed investment scheme in regard to the separation of scheme assets which ASIC expects would ensure that ‘scheme property is held in a way that minimises the risk of loss by misappropriation’.  
3.52	There is a model for a stronger approach to the management of risk of fraud under the SIS Act where trustees of APRA regulated superannuation funds are required to have in place a risk management strategy that deals with the material risks of the trustees and each fund.  Within that strategy the trustees have to address the risk of fraud (that is intentional acts to manipulate a fund for personal gain) and to institute assurance processes through their auditors.
3.53	With the Stronger Super reforms, the requirement for a trustee to have a risk management strategy will remain in the legislation, and will be supplemented by prudential standards issued by APRA that will provide further requirements for risk management.  
3.54	While a responsible entity of a managed investment scheme, unlike the trustees of a superannuation fund, may not owe fiduciary duties to members, there is still a question whether higher standards of risk management should be expected from them given the potential risk of fraudulent misappropriation of pooled investment assets.
3.55	One possibility would be to require responsible entities of managed investment schemes to have a risk management system that reflects the nature, scale and complexity of its business.  The risk management system might also require independent scrutiny, such as an assessment by an auditor that the controls adequately safeguard investment assets held on a pooled basis and mitigate the risk of fraud.  Licensees would be expected to include a process to monitor their risks on an ongoing basis and update their controls as required.
3.56	Requirements along those lines would go some way but might be of limited value in circumstances where fraudulent conduct is endemic in the management and operation of a managed investment scheme.  
Retail client test
3.57	As indicated above, SMSF trustees are specifically precluded from seeking financial assistance under Part 23 of the SIS Act.  They are therefore broadly in the same position as other investors in regard to access to compensation in a case such as Trio Capital.  Whether or not their position is on a par with other retail clients depends on the application of the retail client test in the Corporations Act.  
3.58	Submissions by SMSF trustees provide examples of considerable financial loss from investments in Trio. FOS says it has received compensation claims from SMSF trustees and individual investors for losses incurred in Trio investments:
The disputes we have received have a total amount claimed of approximately $5,200,000 ... (but this) would be an underestimate ... the majority were through self-managed super funds (or) ... investors who invested ... directly. The typical features of the applicants ... are that they were at or approaching retirement age, were retail clients, had more than $500,000 to invest ...
3.59	The definition of retail client in Chapter 7 of the Corporations Act is relevant to the standards of conduct required of licensees in their dealings with retail clients, and to the protection thereby offered to consumers. A consumer has to satisfy that test in order to make a claim for compensation through an EDR scheme.
3.60	Section 912B only requires a licensee to make arrangements for compensating consumers for loss or damage suffered because of breaches of its obligations if it provides financial services to retail clients.  Similarly an EDR scheme is only obliged to deal with a claim lodged by a consumer who is a retail client for the purposes of the Corporations Act.  The FOS terms of reference provide that it:
... may not consider a dispute ... where the value of the applicant’s claim in the dispute exceeds $500,000; and
may refuse to consider, or continue to consider, a dispute if ... the applicant is not a retail client as defined in the Corporations Act.
3.61	The Corporations Act approaches the definition of a retail client in several ways. On one test a person who acquires a financial product or service is generally taken to be a retail client unless the product in question or to which the service relates exceeds $500,000, or the investor meets one of four other tests that look respectively at the investor’s wealth or whether the consumer is a business, a professional investor or a sophisticated investor.
3.62	Under another test a person who acquires certain types of financial products, including a superannuation product, is generally treated as a retail client.  The definition goes on to say, at paragraph 761G(6)(c), that a financial service that relates to a superannuation product, when provided to the trustee of a superannuation fund that has net assets of at least $10 million, is not to be regarded as the provision of a financial service to a retail client.
3.63	In ASIC’s view, financial services provided to a trustee of a superannuation fund, including a SMSF, are generally provided to them as a retail client if the net assets of that fund are less than $10 million at the time the service is provided. This view is based on an interpretation that subsection 761G(6) will apply to the exclusion of the wholesale client test in subsection 761G(7). 
3.64	The test is said to be applied to the asset value of the fund at the time the service is provided and not to other assets held by trustees in their individual capacities.  This separate assessment of a consumer’s assets, depending on whether they are held in their individual capacity or through a superannuation fund, gives those clients greater scope to meet the retail client test and the consumer protection that it affords.  However, it has the potential to cause uncertainty for licensees, particularly financial advisers, who may not readily be able to tell whether they are dealing with a retail or wholesale client, and thus the standards of protection required.
3.65	A number of submissions to Treasury’s review of the retail client definition disagree with ASIC’s view and suggest that the law needs to be clearer in its treatment of superannuation fund trustees as retail or wholesale clients. Those submissions suggest that it is possible to interpret the relevant tests in a different way than ASIC does and that this provides uncertainty for SMSFs in particular.  There appears to be some force in these submissions.  It is not clear as a matter of policy why trustees of SMSFs should be treated more favourably in regard to consumer protection than other private investors.
3.66	Treasury is currently considering submissions in response to an options paper published as part of the Future of Financial Advice reforms, and in particular on the possible need for changes to the definition of a retail client in Chapter 7 of the Corporations Law.
3.67	This is an area where certainty is desirable.  The statutory definition is complex and convoluted and should be clarified in the interests of licensees as well as investors.  The circumstances in which trustees of SMSFs are treated as a retail client should be clarified in particular.  It is arguable that the trustees of a SMSF should be treated as more akin in this context to private investors than to a general superannuation fund.

Assessment
General
The above overview of recent cases in which the collapse of a financial services provider has resulted in large scale consumer losses:
(a)	refers to some of the circumstances surrounding the collapse of those providers;
(b)	points out that some consumers may have recourse to other licensees, and in particular financial advisers with whom they have dealt, for compensation in relation to their failed investment (typically on the basis of inappropriate advice or other mis-selling);
(c)	notes the reality that many consumers (those who invested direct with the provider in question and not through an adviser) may have no access to compensation beyond any rights as unsecured creditors in the insolvency of the provider;
(d)	does not throw much more light on the question, discussed in Chapter 2, of the extent to which consumers are unable in practice to recover compensation owing to the insolvency of the licensee in question.
Trio Capital
The following points emerge from the consideration of the case of Trio Capital where the facts and legal consequences are still unfolding:
(a)	Consumers who were exposed to Trio Capital through APRA‑regulated superannuation funds were able to obtain the benefit of financial assistance under Part 23 of the SIS Act.
(b)	The award of financial assistance under Part 23 was on the basis that their fund had incurred loss as a result of fraudulent conduct or theft, that the loss had caused a substantial diminution of the fund’s assets leading to difficulties in the payment of benefits and that the public interest required a grant to be made. 
(c)	The trustees of SMSFs (who are specifically excluded from financial assistance under Part 23) and other private investors do not have the same ready basis for compensation for losses suffered in the collapse of Trio apart from any rights they have through their investments as unsecured creditors.  In order to recover compensation they will have to attribute their loss to a breach of a licensee’s obligations and even then recovery will depend on the licensee’s capacity to pay.
(d)	Consumers who invested in Trio through financial advisers may have a basis to claim compensation if the advice was inappropriate, for example because it did not properly warn of the risks of investing or of the unsuitability of the investment given a client’s objectives, needs and risk profile.
(e)	There appears to be a reasonable basis in policy for the exclusion of SMSFs from the Part 23 scheme.  Any move to include SMSFs would entail a marked change in the regulatory approach to SMSFs.
(f)	Not surprisingly the fact that some consumers but not others have recourse to compensation in a case like Trio is the cause of disquiet for those who miss out.
(g)	The seemingly uneven outcome is a consequence in part of the piecemeal way in which compensation arrangements for consumers of financial services have developed over the years.  The Part 23 arrangements were introduced in 1993 as part of a package to strengthen the security of superannuation savings and protect the rights of fund members.  This special provision no doubt reflects the fiduciary nature of such superannuation funds and the importance of maintaining the integrity of and confidence in funds to which consumers are obliged to contribute for their retirement savings.
(h)	The fact that the alleged fraudulent conduct in Trio Capital appears to have occurred in relation to a managed investment scheme in which assets of prudentially‑regulated superannuation funds were invested, rather than in those funds themselves, accentuates the difference in the position of the members of those funds who were able to be compensated, and SMSFs and other consumers who invested in the same managed investment scheme.  
(i)	The circumstances in which APRA‑regulated superannuation funds apparently invested a large part of their assets in one managed investment scheme itself raises questions about the governance of those funds, their investment policy and risk management.  It may also raise questions about the adequacy of regulation in this area.  It is noted that proposed new powers for APRA to make prudential standards under the Stronger Super reform process are aimed at providing more effective governance of investments.
(j)	Aside from the members of APRA‑regulated superannuation funds, the position of consumers is problematic in a case where their investment in a financial product is destroyed or impaired by fraudulent conduct on the part of the product provider.  They may have a basis for claiming compensation where they can attribute losses to dishonest conduct on the part of the licensee, where the fraud was perpetrated by an employee or representative of the licensee or funds provided to a licensee for investment purposes were misappropriated before being so invested.  However, where the product issuer has failed their prospects of recovering compensation may be another matter unless there is insurance cover in place that will respond to their claim.  
(k)	The introduction of a statutory compensation scheme of last resort would not be a ‘silver bullet’ that would resolve the question whether fraud as a factor in the failure of an investment would give rise to a claim for compensation.  It would still be necessary for a consumer to attribute loss to the breach of a licensee’s obligation. 
(l)	Apart from any further criminal sanctions, it is questionable whether the law could meaningfully go much further in imposing obligations on a licensee that would pave the way for a consumer to recover compensation from a licensee for fraudulent impairment of the value of an investment.
(m)	It is noted in any event that by reason of the inherent moral hazard a licensee would not be able to acquire professional indemnity insurance cover for fraud committed by itself.
(n)	Any move to introduce a scheme of financial assistance along the lines of Part 23 of the SIS Act for investors in managed investment schemes would call first for a substantial upgrading of the regulatory regime for such schemes.  A starting point in any such move might involve requirements for better management by such schemes of the risk to investors of loss through fraud.  How far such measures would be effective where fraudulent conduct is endemic in the operation of a particular managed investment scheme is another matter.
(o)	Consideration of the position of SMSFs in relation to Trio has drawn attention to complexity and lack of clarity in the definition of retail client.  Clearer tests that can be applied in a practical way are desirable in the interests of licensees as well as consumers.  In the application of the definition to trustees of a SMSF there is an argument for treating those trustees, for the purposes of the definition, as more akin to private investors than to a general superannuation fund.