The purpose of this Chapter is to ask whether a broad statutory compensation scheme is warranted and, if so, what should it cover and how should it be structured.
223. Our tentative conclusion from the discussion above is that:
- requiring compensation arrangements through legislation is justified;
- the primary responsibility for making relevant compensation arrangements should be on the financial services licensee.
224. A conservative questioner might ask:
- Does any proved inadequacy in the compensation mechanisms under consideration, particularly in insolvency, justify establishing and operating a broad statutory scheme?
- Should the need for a broad statutory compensation scheme be deferred until a considered evaluation of the effects of the Financial Services Reform regime (including a revised section 912B) can be made?
225. The advantages of a broad statutory scheme are:
- it could provide harmonised compensation arrangements across the financial services sector;
- depending on the scheme adopted, it would provide simplicity and clarity for clients suffering loss;
- a compensation fund manager may well have better resources than the retail client to get to the bottom of an issue, obtain documents and deal with the licensee's insurer and lawyer.
226. The disadvantages of such a scheme are:
- depending on the structure and coverage, it could be a further significant cost to the industry;
- depending on the manner of funding it, there is the likelihood of cross-subsidisation - for example, of the poorly managed or fraudulent by large, well-managed firms, of one activity by another (eg advising by dealing), or one sector of the industry to another;
- if it applies prior to insolvency, it may take some responsibility away from the financial services licensee (except to the extent that the funding mechanism reflects the risk of individual licensees to the scheme, and the exercise of subrogation).
Principal issue 10
Do the financial services industry and consumers consider that a broad statutory scheme is warranted?
227. The options would appear to be to provide for payment in certain specified situations when the financial services licensee:
- was solvent, and on insolvency;
- became unable to pay or was insolvent;
- was insolvent.
228. The argument against covering situations prior to insolvency is that the client has other avenues of redress at this point and there are presumably assets to satisfy successful claims (including the mechanisms required under section 912B).
229. The overseas statutory schemes overwhelmingly address the situation where the financial service provider is unable to pay or insolvent. This was followed by CASAC60 which proposed immediate payment to claimants (within the caps), even where there is some likelihood of an eventual return to those claimants in the insolvency.
230. The second option provides a measure of flexibility over the third in that insolvency is not necessary. However, it may leave the client in some uncertainty as to whether the scheme is available in a given situation and requires some definitive statement that the licensee is unable to pay (which may of itself have consequences on the licensee's financial situation).
Principal issue 11
If a broad statutory scheme is warranted, when should it be available?
(a) Should it be available prior to insolvency? or only on inability to pay/insolvency?
231. In brief, the grounds on which compensation could be available include losses as a result of the licensee's defalcation and fraud, losses of property (including funds) entrusted to the licensee, deficiency on insolvency, failure to enter into and complete transactions as instructed, or some other breach a relevant obligation. These are discussed in Chapter 5 of this paper.
232. It should be noted that the cost of administering compensation arrangements rises in proportion to the complexity of the investigation and decisions to be made by the scheme operator. The issue of administrative complexity is discussed at paragraphs 121 to 123.
Principal issue 11
(b) On what grounds should claims be paid?
233. The Companies and Securities Advisory Committee (CASAC) issued in September 2001 a Consultation Paper that proposed for discussion a scheme to compensate retail clients of insolvent financial services licensees who were intermediaries.61 The scheme would:
- cover the return of client property held by the licensee or losses to retail clients arising from any improper conduct by the licensee;
- be operated by an independent body, with appropriate powers and duties;
- compensate retail clients of financial services licensees who were intermediaries and that were insolvent or unable to pay, even where there was a chance of eventual recovery in an insolvency;
- use the same eligibility criteria as apply in disputes with solvent intermediaries;
- thus the scheme would provide for the return of client property, and compensation for any other amounts that had been or could be awarded by an ASIC-approved dispute resolution body or a court;
- it could cover all investment matters including a fully discretionary securities/derivatives trading account or unauthorised transfers, but not an outright loan;
- the Committee anticipated that this scheme would complement the requirements for external dispute resolution arrangements and the requirement for compensation arrangements in section 912B;
- be subject to compensation caps and to time limits on making claims;
- be funded by levies on financial services licensees dealing (as intermediaries) in investments on behalf of retail clients; and
- include transitional arrangements to deal with funds currently held by the National Guarantee Fund and the Sydney Futures Exchange.
234. The model which the Committee proposed for discussion:
- involves omission of the requirements in Part 7.5 on financial markets (including exchanges) to have compensation arrangements (the National Guarantee Fund would be dismantled);
- relates only to securities, derivatives and interests in managed investment
- the Committee indicated that the proposed scheme could provide a model for compensation schemes for deposits, superannuation and insurance but that separate schemes or eligibility rules would be needed and could be a matter for future review;
- assumes the continuation of the requirement in section 912B for financial
services licensees to have compensation arrangements and that these arrangements
would cover the broad range of claims;
- the Committee indicated that it was up to ASIC to develop its policy on the compensation arrangements required under section 912B.
235. CASAC received nine responses to the consultation paper (of which seven were in writing). A number of submissions supported the proposed scheme, one expressing the view that it would:
- simplify compensation arrangements, providing certainty and uniformity and avoiding overlapping and duplication, with the resulting efficiencies benefiting retail investors;
- be consistent with international developments;
- provide broad insolvency protection for investors and place primary responsibility for compensation directly on financial service providers rather than market operators.
236. Some other submissions raised concerns about possible `moral hazard' and the methods and implications of financing the scheme. Was there evidence of such a lack of consumer confidence as to justify the scheme? Why was the UK model (which differs significantly from the US and Canadian models) being adopted?
237. It was also suggested that CASAC should only develop its compensation scheme in the light of ASIC's financial licensing requirements and that detailed justification was needed to move away from the recommendations on risk management and financial safety of the Financial System Inquiry (the Wallis Committee).
238. There was opposition in two submissions to the possibility of compensation for negligent advice and several asked whether the separate treatment of investments (as distinct from superannuation, insurance and deposit products) was consistent with the Financial Services Reform Act. One submission sought a regulation impact statement, while another suggested a discussion of possible alternatives, such as reforming and improving the current schemes.
239. Review of the overseas schemes (summarised in Attachment D) indicates:
- they generally only apply on inability to pay/insolvency (for example,
the United States Securities Investor Protection Corporation, Canadian Investor
Protection Fund, the Irish Investor Compensation Company Limited, the UK Financial
Services Compensation Fund);
- however, the proposed Hong Kong Investor Compensation arrangements would also apply in wider circumstances62 but is limited to exchange traded products;
- they generally provide for compensation for losses of client securities
or money held by the intermediary (eg Ireland, Hong Kong, Canada, United States);
- the exception in this regard is the UK scheme which covers not only the return of property but also claims relating to improper acts or omissions by investment firms in default;
- they relate to various classes of investments (but not the range of financial
products addressed under new Chapter 7):
- the Hong Kong scheme covers securities and commodity dealers and margin financiers;
- the US scheme relates to securities and cash held in connection with securities transactions;
- the Canadian scheme relates to securities, cash balances and certain other property in connection with securities or futures business;
- the Irish scheme includes shares, units in collective investment schemes, futures, options and life and general insurance policies;
- the UK scheme relates to stocks and shares, unit trusts, futures and options, personal pension plans and long term insurance policies such as endowments. (The UK Financial Services Compensation Scheme provides separately for claims in relation to protected deposits and protected contracts of insurance.)
- they variously apply to retail or all clients, and the compensation is capped;
- they generally cover intermediaries (not issuers);
- they provide a safety net but jurisdictions frequently also require professional indemnity insurance/surety bonds.
240. It should be noted that several of these schemes are market-related, although separately administered. Further details of the schemes in the UK, US and Canada were summarised by CASAC and are available on www.camac.gov.au.
241. Both the model CASAC proposed for discussion and some of the overseas schemes give rise to the question whether a statutory scheme limited to market participants or market transactions is warranted. This is discussed at paragraphs 212 to 215.