The purposes of this Chapter are:
194. It can be seen from the summary of the origins of the National Guarantee Fund in Attachment C that, at least in the case of the Sydney Stock Exchange, the decision to establish a fidelity fund was made as a means of protecting its reputation and discouraging regulation following the collapse of a broking firm.
195. Fidelity funds were subsequently required in several jurisdictions by legislation in 1970 and 1975 and in all jurisdictions by the Securities Industry Act 1980 and its successors. The National Guarantee Fund was created in 1987 from the amalgamation of a proportion of the fidelity funds of the capital city exchanges. The relevant provisions were re-enacted in 1989, amended in 1990-94, re-enacted in 2001, and retained in substance in the Financial Services Reform legislation.
196. The ASX's National Guarantee Fund and other Australian exchanges' fidelity funds fall under this heading.
197. The advantages of these funds are:
- they probably provide the greatest certainty for the consumer in relation to the particular conduct covered (see Attachment B);
- they can be used in combination with surety bonds and professional indemnity
- thus the SEGC, having paid a claim, is subrogated to the claimant's rights against the financial services licensee (backed by its professional indemnity insurance);
- compensation fund managers may well be better placed than retail clients to get to the bottom of an issue through obtaining documents and dealing with the licensee, if solvent, or its lawyer;
- in the case of the National Guarantee Fund, funds in excess of the required
minimum are made available for securities industry/financial services industry
- a total of over $110 million has been paid out of the NGF for this purpose since its establishment.
198. We also note that the International Organisation of Securities Commissions' Objectives and Principles of Securities Regulation contemplate that investors in securities markets will have access to compensation for improper behaviour.51
199. The disadvantages of requiring these arrangements are:
- the current exchange-based funds in Australia relate particularly to the
protection of assets, and do not cover advice;
- there is, of course, an issue (discussed in Chapter 5) as to the appropriateness of requiring a compensation scheme to cover additional risk, such as negligent advice;
- putting aside its clearing guarantee functions, the National Guarantee
Fund coverage in relation to investor protection is significantly different
from that required of other fidelity funds;
- is this justified?
- to make them comparable would involve additional costs on participants in other markets, or reducing the level of protection currently provided by the National Guarantee Fund;
- if individual financial markets are required to have such a scheme, how
do the schemes interact in the cases where a participant is a member of several
- this may create complexity for the client, if there is doubt as to which market his or her instruction was to be executed on, or whether it was to be executed on a market at all;
- requiring financial markets to have compensation arrangements may impose
a cost on them;
- however, the National Guarantee Fund currently costs the ASX and ASX participating organisations nothing to maintain or administer;
- on the contrary, as indicated above, the National Guarantee Fund has provided over $110 million for `securities industry development' purposes since its establishment - for example research, investor education and improvements to the automated trading system;
- it is not clear that the requirement on other financial markets to have compensation arrangements imposes an onerous burden;
- compensation arrangements made by the market operator may remove the element
of personal responsibility from the licensee;
- however, in most cases the scheme operator will, when it pays the claim, be subrogated to the rights of the claimant - that is, the scheme operator acquires the rights of the claimant and will take action against the licensee (and its professional indemnity insurer);
- the scheme operator may also seek to prove in the licensee's insolvency;
- compensation arrangements under Division 3 of Part 7.5 involve some regulatory costs in that they must be approved.
200. In summary, market compensation arrangements, while potentially covering the same events as a professional indemnity insurance policy, offer greater comfort to the client by providing both a decision-making process and a source of funds. This is provided to all clients of stockbrokers in the case of the National Guarantee Fund, and, in the case of markets other than the ASX, to retail clients (once the market transitions into the new Chapter 7 compensation regime).
201. CASAC concluded that the compensation arrangements in new Chapter 7 of the Corporations Act:
'can create inconsistencies and administrative complexities in awarding compensation, given that eligibility under a scheme operated by a particular market operator is based on establishing a connection between the actions of insolvent financial service providers and that market. It can also create possible overlapping sources of client compensation between financial market operator schemes and intermediary schemes. The existence of multiple schemes can result in investor confusion, forum shopping, potential inequality and fragmentation of avenues of redress.'52
202. The difficulties are indicated by the relevant provisions of Part 7.553 which seek to establish the necessary connection with a particular market. In the absence of such a connection, the client is left to rely on the section 912B compensation arrangements. (An alternative would be to require the market compensation scheme to cover eligible claims arising from the whole of a participant's securities business, for example.)
203. CASAC considered54 that the Financial Services Reform compensation arrangements could be confusing for retail clients, particularly if a client had to seek compensation from several different schemes in the event that the insolvent intermediary traded on that client's behalf in various markets. It could also create inequalities, to the detriment of investors if different eligibility and recovery criteria applied in different markets.
204. Further, CASAC pointed to:55
- increased regulatory responsibilities and costs, given the requirement for the regulator to assess the compensation scheme of each financial market operator;
- the inefficiency of having several compensation schemes administered separately.
205. There are further arguments against requiring market licensees to maintain compensation arrangements:
- if the purpose of establishing a fidelity fund is to retain confidence in a market, it should be left as a matter for the business judgment of the market operator whether or not to have compensation arrangements, rather than being mandatory;
- separate compensation arrangements for exchange-traded financial products cannot be justified, given the purpose of the Financial Services Reform Act as providing harmonious regulation;
- the requirement is a relic of a previous era and does not fit the range of financial markets (including markets which do not fit the traditional exchange model) which will be regulated under Part 7.2 of new Chapter 7.
206. While there are difficulties with the current market compensation requirements, there are also reasons to consider retention of market-based compensation arrangements including:
- Government policy is that a market operator must supervise the relevant
conduct of its participants. This is reflected in the provisions of the new
Chapter 7 relating to the obligations on market licensees.56
- Requiring the market operator to have compensation arrangements which would apply in relation to its participants' conduct as intermediaries in relation to retail clients would appear consistent with this supervisory role.
- The special position the ASX has in the Australian financial marketplace and the increasing participation of the Australian population, particularly retail persons, as direct investors.
207. Retail investors on the ASX may wish to consider whether alternative proposed compensation arrangements will provide comparable protection. We note that while there has been only one stockbroker insolvency since 1993, there has been an increased number of claims against the National Guarantee Fund for unauthorised transfer.
208. If market operators were no longer required to make compensation arrangements, and the element of the National Guarantee Fund attributable to clearing house support were paid out,57 there would be no further function for the National Guarantee Fund and it would presumably no longer provide funds for the financial services development account. This leads to the question what would be done with the remaining funds - see secondary issue 15. It is likely that the exchanges would oppose them being used as the basis of any statutory fund of broad application - see paragraphs 250 to 254.
Principal issue 8
Should market licensees continue to be required to make compensation arrangements (as they have in the past and are in Part 7.5)?
209. If the obligation to make compensation arrangements were to continue to be imposed on market licensees, what changes from the current Part 7.5 would be appropriate? for example:
- On what grounds should claims be paid?
- should they be the same across all financial markets? If so, should they be based on the National Guarantee Fund criteria, the current fidelity fund criteria or some other basis?
- if they relate only to property entrusted to the financial services licensee, should this protection extend to authority a financial services licensee has over property of an investor (for example, broker sponsored uncertificated holdings and authority over client bank accounts)? Is this consistent with the treatment of unauthorised transfers of other holdings (including issuer sponsored holdings)?
- Should the arrangements only relate to on-market transactions (rather than all transactions by market participants, whether on- or off-market, that must be `reported' to a market operator, for example)?
- Should the arrangements cover wholesale clients (as the National Guarantee Fund does)?
- How should responsibility be divided where a licensee is a participant on several markets? Is this, in practice, a real problem?
210. A number of other issues of relevance here are discussed in Chapter 10. They include subrogation and capping.
Principal issue 8(a)
If market licensees are to continue to be required to have compensation arrangements, what changes to the current Part 7.5 should be made?
211. A cross-section of international schemes are summarised in Attachment D and some conclusions reached from consideration of these schemes included at paragraphs 239 to 240.
212. Consideration of the various international schemes leads to the question whether a consolidated market scheme would be justified. This would involve amalgamating the existing market arrangements into a single statutory scheme.
213. On the one hand, this would address the issue of responsibility where the licensee participates on several markets and may assist in resolving what to do with the existing National Guarantee Fund and SFE fidelity fund. In addition, if sufficiently similar to the current arrangements, it would provide an assurance of continuity for clients of market participants and it would provide a scheme comprehensible to overseas investors.
214. On the other, such a scheme treats clients of market participants or transactions undertaken on formal markets as requiring a higher level of protection. While they have been treated this way for some time, without further argument it would appear to be inconsistent with the theme in the Financial Services Reform Act of harmonised regulatory treatment across the financial services sector. Further, depending on the governance and structure of such a scheme, it may be seen as involving Government assumption of responsibility more properly borne by market licensees.
215. It also involves many of the issues of any broad statutory scheme see Chapters 8 and 9.
Principal issue 8(b)
Is there justification for a consolidated scheme for financial services licensees who are market participants?
216. In the context of secondary sales, financial services licensees hold (or have authority over) financial products and the money of clients largely for the purpose of settlement. With developments in this area, some licensees will offer services in relation to clearing or settlement and may not be participants on a licensed market.
217. Unauthorised transfer is relevant to certificated and uncertificated securities. It is particularly relevant in relation to uncertificated securities transferred through a prescribed CS (clearing and settlement) facility under Division 4 of Part 7.11. In this case, the mechanism is solely within the control of the CS (clearing and settlement) facility licensee, not the market operator. Indeed, the relevant transaction may have been entered into off-market.
218. Currently, there is only one clearing house with this capacity the ASX Settlement and Transfer Corporation Pty Limited, which was the `Securities Clearing House' of Chapter 7 of the Corporations Act prior to the commencement of the Financial Services Reform Act.
219. Compensation for losses arising from contravention of the Securities Clearing House rules regarding cancellation of certificates, and unauthorised transfer of securities was provided by the National Guarantee Fund,58 and continues to be available under new Chapter 7.59 (This protection does not require conscious wrongdoing on the part of the Exchange participant the fraud may be perpetrated by another.)
220. However, the new Chapter 7 includes the capacity for other clearing and settlement facilities to be prescribed for this purpose and hence also to facilitate the electronic transfer of legal title.
221. As indicated above, there have been an increasing number of claims against the National Guarantee Fund on the ground of unauthorised transfer since 1997. In addition, there is clearly a need to maintain confidence in uncertificated systems.
222. On the other hand, traditionally clearing houses have not supervised the conduct of participants except to the extent that it relates to risk to the facility.
Principal issue 9
Should prescribed CS (clearing and settlement) facility licensees be required to have compensation arrangements in relation to unauthorised transfers/certificate cancellation? or some wider conduct?