The Commonwealth Treasury


COMPENSATION FOR LOSS IN THE FINANCIAL SERVICES SECTOR ISSUES AND OPTIONS September 2002

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Chapter 4: The purpose and design of compensation arrangements

This Chapter addresses the purpose of compensation arrangements and some issues relating to their design (for example, simplicity).

The purpose of such arrangements needs to be considered from the perspective of those who will have to contribute to the fund required to make the payments, as well as the perspective of the consumer.

A: What is the purpose of a compensation regime?

106. What is the purpose of compensation arrangements required by legislation? One possible answer is that the purpose of such arrangements is to ensure that there are assets to meet appropriate proved claims against financial services licensees who have caused loss in the course of providing financial services so that consumers continue to have confidence in the market and continue to participate in it.

Principal issue 3

What is the purpose of compensation arrangements which are required by legislation?

107. The emphasis here is on compensation arrangements `required by legislation' — that is, it is not a question of what professional indemnity insurance a wise financial service provider would choose, or what a professional association may require of its members.

108. Consideration of the purpose of required compensation arrangements is closely linked to consideration of the circumstances in which compensation would be payable. This in turn will be influenced by the mechanism chosen and the limitations of that mechanism (for example, the terms on which professional indemnity insurance is available).

109. Nevertheless, it is appropriate to consider first the situations in which compensation should be payable and therefore the next chapter focuses on this subject. This is followed by consideration of how the available mechanisms can or should cover the identified area.

B: Designing a compensation regime

110. In consulting on proposed changes to the UK compensation scheme,33 the UK Financial Services Authority indicated that the compensation arrangements should be:

111. There are two points in this list which deserve consideration now — ease of access and simplicity.

Ease of access

112. To put substantial weight on accessibility at this stage of the discussion may deny consideration of compensation mechanisms which do not of themselves involve a neutral process for deciding claims, such as is provided by the SEGC in relation to the National Guarantee Fund. It also leads to difficulty in distinguishing the role of external dispute resolution mechanisms from that of compensation arrangements (at least during solvency).

113. It appears preferable to focus on compensation arrangements providing funds to meet proved claims, while not losing sight of the consumers' interest in gaining access to it.

Simplicity for consumers

114. Simplicity in the terms of a compensation regime will assist consumers to understand its coverage, and its limitations.

Variety of services and variety of products

115. The Financial Services Reform regime provides a harmonised regulatory regime across the range of financial services. However, any compensation arrangements need to be flexible to fit the range of financial services businesses. Thus, if professional indemnity insurance is generally required of financial services licensees who provide financial services to retail clients, the specific requirements (for example, type and level of cover) may differ depending on the type of work undertaken by the licensee.

116. The need to recognise differences raises a series of questions:

117. We return to this issue in the context of any broad statutory fund in paragraphs 245-249.

Solvency/insolvency

118. Simplicity for the consumer was one of the reasons why CASAC favoured compensation for the same events both before and after insolvency.

119. However, going into external administration is a watershed in the life of any company and its creditors. It is not clear that it should necessarily be different for clients claiming against the licensee.

120. If you consider that compensation arrangements should be required both after the licensee has become insolvent (or unable to pay), and before that time, then should the arrangements cover the same conduct?

Administrative simplicity

121. There is another aspect of simplicity — simplicity in administration, which reduces administrative costs and increases certainty.

122. Costs will be increased where the scheme necessitates complex investigations or where judgments on complex factual situations are required. Grounds for claiming which involve establishing that the licensee had a particular mental state (for example, intention or recklessness) will also cause difficulties for the claimant and increased costs for the compensation provider.

123. In contrast, where claims are easily provable the compensation provider will have a valid right of subrogation and its claims are likely to be accepted by a liquidator.

33 Financial Services Authority CP 5 Consumer Compensation, December 1997, page 8.