The Commonwealth Treasury


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

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Chapter 10: Other issues

The purpose of this Chapter is to address some of the many issues that may be considered subsidiary or consequential in the design of compensation arrangements. These include the treatment of APRA-regulated bodies, limitations on payments (capping) and the required connection with Australia.

These issues are not only of relevance to any broad statutory scheme.

A: Treatment of APRA-regulated bodies and those with high financial requirements

265. If standard compensation arrangements such as professional indemnity insurance are required, should all financial services licensees be required to have them?

266. Financial services licensees which are regulated by APRA would appear to be in a special position and it may be that the standard requirement for compensation arrangements are inappropriate.68

267. Should such licensees be allowed to `self-insure' (that is, to set aside particular funds for the purpose), or make other arrangements approved by ASIC in place of professional indemnity insurance, if that is required? Should such bodies be exempt from any requirement for professional indemnity insurance or, indeed, any compensation arrangements? Are different approaches appropriate for different types of body regulated by APRA?

268. Should the following be treated the same way:

269. We note that:

Secondary issue 18

Should special provision be made for financial services licensees which are regulated by APRA, have high financial requirements or high market capitalisation, or have the requisite connection with such a body?

B: Measure and nature of compensation

270. The appropriate measure and nature of compensation will depend on the grounds for claiming which the compensation arrangements provide.

271. Looking briefly at the possible grounds for claiming discussed in Chapter 5:

272. In any case, the payment will be subject to any cap set — see paragraphs 279 to 281.

Consequential loss

273. There are several options in relation to paying claimants for consequential loss including:

Accounting for profits

274. It is inappropriate for a compensation scheme to account to the client for profits made by the licensee from misuse of the clients' assets/property.

275. In trust law, seeking compensation with interest is an alternative to requiring the trustee to account for the profits (the first being based on disavowal of the trustee's conduct, while accounting for profits is based on adoption of the trustee's conduct). A claimant cannot seek both.

276. The claim for compensation of a person who has recovered from the wrongdoer on either ground should, to that extent, be reduced.

Interest, costs, contributory negligence

277. Interest should be payable on any cash compensation payable (excluding amounts attributable to the costs of making the claim) calculated from the date of entitlement to make the claim until the date of payment. The cost of pursuing the claim should also be recoverable.

278. Where appropriate, any contributory conduct of the claimant or the claimant's failure to mitigate the loss should be taken into account.

Secondary issue 19

How should the loss be measured and should consequential loss be covered?

C: Should there be capping of payments?

279. This question has two limbs:

280. The CASAC Consultation Paper72 suggested that caps would help keep costs within reasonable bounds and reduce investor expectations. It indicated that a cap, if sufficiently liberal, might ensure that most retail claimants recover all or a significant portion of the funds due to them.

281. Another question in this context is whether there should be a minimum threshold for claims. While this could reduce the number of small claims, CASAC pointed out that it could also discriminate against the retail investors who have very limited funds.

Secondary issue 20

(a) Should there be capping of the amounts paid in response to claims?

D: What form of capping is appropriate?

282. If the view is taken that capping should be imposed, then the following questions arise:73

Secondary issue 20

(b) If capping were accepted, what form of capping would be appropriate?

E: Subrogation75

283. Generally, claimants who accept compensation are required to assign, or are deemed to have assigned, their relevant rights against the licensee to the scheme operator. This is obviously appropriate, at least to the extent of the payment made by the scheme operator to the client.

284. Taking this one step further, a scheme may require subrogation of all rights against the licensee so that the scheme operator can take a class action for all the claims of affected retail persons (with any surplus (over administrative costs) being paid to the successful claimants).

285. Clearly, retail claimants should not be financially disadvantaged by subrogating their rights in return for compensation, nor should the scheme profit from exercise of subrogation rights.

286. Subrogation implies it is a scheme of first resort. An alternative, which may be considered appropriate to a pre-insolvency situation, is to require the claimant to take all reasonable steps before claiming from the fund.

What will not be recovered through subrogation

287. There are, however, limitations on how much can be recovered through subrogation:

Actions which prejudice subrogation76

288. It is clearly undesirable to allow the possibility of compensation being required to be paid in relation to a claim where the retail client has already been paid out by another entity and the scheme operator's rights to subrogation have been prejudiced.

289. The solution adopted in relation to the National Guarantee Fund is to provide the SEGC, which administers the Fund, with a discretion to reduce the payment:

290. The CASAC proposal gives a wider discretion to the scheme operator — any action by a claimant that prejudices the subrogation rights of the scheme against the intermediary should permit the scheme operator to reject or reduce the claim.

F: Connection with Australia

291. What is the appropriate connection with Australia? Just how far should an Australian compensation scheme spread? The questions in this connection include the following:

292. CASAC78 proposed that its scheme apply to any retail client, wherever located, who had dealt directly with an Australian intermediary, wherever located, in relation to any investments on any Australian exchange or `over the counter' market. The Committee considered that this would help to promote Australian financial markets to overseas retail investors, who would be protected in their dealings with Australian intermediaries through a compensation scheme that compares favourably with the more limited coverage of overseas schemes.

293. CASAC also considered there was an issue whether the nexus should extend to Australian intermediaries trading on an overseas exchange or `over the counter' market.

294. One submission to CASAC agreed with the Consultation Paper that the scheme, if it could be extended to foreign clients of local intermediaries without imposing an excessive cost on those intermediaries, could enhance Australia's competitive position in global markets.

295. Another submission expressed the view that the necessary connection with the Australian market may depend on what protection key overseas compensation arrangements offer to Australian investors when they deal directly through an overseas intermediary, or via an Australian intermediary who then uses an overseas agent.

Secondary issue 21

What is the appropriate connection with Australia?

G: Relationship with external dispute resolution schemes

Requirement for licensees to be members of external dispute resolution schemes

296. Subsection 912A(2) of the Corporations Act requires financial services licensees who deal with retail clients to have a `dispute resolution system'. A dispute resolution system consists of:

297. The Corporations Regulations set out the bases against which ASIC will approve external dispute resolution schemes.79 ASIC has also released policy statements setting out how it will administer the external dispute resolution provisions.80

298. The existence of a requirement for each licensee to be a member of one or more external dispute resolution schemes is relevant to the context in which any compensation arrangements will operate.

Features of external dispute resolution schemes

299. Some features of the coverage of external dispute resolution schemes, which are relevant in this context, are:

300. External dispute resolution schemes generally have a discretion about whether to deal with a particular complaint under their Rules and broadly expressed powers to consider complaints about member licensees. However, a complaint that involves an allegation of fraud, for example, may be declined by a scheme if it determines that testing of the evidence and/or cross-examination of the parties is necessary to reach a decision, and that the matter should more appropriately be dealt with in a court.

Roles of external dispute resolution schemes and compensation arrangements

301. This leads to consideration of the respective roles of external dispute resolution schemes and compensation arrangements. In our view, the primary purpose of compensation arrangements is to ensure there are assets to meet proved claims (that meet the criteria). The primary purpose of external dispute resolution schemes is to determine disputes between licensees and clients where the scheme criteria are met. Such schemes cannot provide certainty that the licensee will pay an amount awarded in circumstances where the licensee is prepared to surrender its licence or otherwise becomes insolvent. This means that, in their primary roles, there is no capacity for conflict between external dispute resolution schemes and compensation arrangements.

302. It is only in considering access to compensation that you may see the possibility of conflict, duplication or choice. Ways of accessing compensation arrangements will depend on the nature of those arrangements and their coverage. It may be via a court judgment, an external dispute resolution determination or a direct approach to the compensation scheme operator. Following a winding up order, there will not be the same choice of access routes, as explained in paragraph 53.

303. The relationship between external dispute resolution schemes and compensation arrangements thus raises the following issues:

Secondary issue 22

What is the appropriate relationship between compensation arrangements and external dispute resolution schemes?

H: Excess funds

304. Prior to the commencement of the Financial Services Reform Act, Chapter 7 made provision for excess funds in the National Guarantee Fund to be used for `securities industry development' purposes.81 The new Chapter 7 makes provision for excess funds in the National Guarantee Fund and other fidelity funds to be used for `financial services industry development' purposes.82

305. If a new compensation regime involved compensation funds (whether held by markets or others), then should provisions allowing for excess payments to be made for financial services education and other appropriate development purposes be retained?

306. The CASAC Consultation Paper83 suggested that levies should be reduced or suspended to avoid this situation and that the operator should be entitled to invest excess funds. However, it concluded that `To use the excess funds for any other purpose would only be justifiable if it directly or indirectly promoted the investor protection goals of the Scheme.'

307. One submission to CASAC supported the proposal that the Scheme operator should be entitled to invest excess funds to increase the revenue available to the Scheme (though it also considered that excess funds should be able to be used for educational purposes).

Secondary issue 23

Should excess funds in a compensation scheme be available for financial industry development purposes, or should there be mechanisms to discourage the build up of such excess funds?

I: Should there be time limits for claiming?

308. Should there be a limit on the time within which one could claim? If so, what should it be and when should it commence?

309. The CASAC Consultation Paper84 suggests three months from notification to `all remaining retail clients'; but in the case of formal liquidation, CASAC suggests that claims made to the liquidator and passed on to the scheme operator would be subject to time limits on creditors making claims in a liquidation.

310. This assumes an ability to identify all clients. In the absence of this capacity (for example, through poor records), the time limit would need to provide for publication of notices in newspapers and sufficient time to prepare and lodge claims after this.

Secondary issue 24

Should there be time limits for claiming and, if so, how should they be set?

J: Level of detail in the legislation

311. In designing any mandatory compensation arrangements, regardless of the mechanism chosen, there is a question about the level of detail to be included in the relevant legislation and the extent to which the detail should be left to be resolved by other means. Those means include being prescribed in regulations, set by ASIC or left for the scheme operator to decide in, for example, disallowable instruments or rules requiring approval.

312. The current solution reflected in section 912B is to set the general requirement in the legislation but to require that the arrangements must satisfy any regulations in place or be approved in writing by ASIC. The factors that ASIC must have regard to are also specified. They include the financial services being provided and `run-off' cover.

313. Similarly, the obligation on those market licensees which are not covered by the National Guarantee Fund to have compensation arrangements sets out the issues to be addressed but leaves the detail to be set by market rules (which need to be approved as part of the compensation arrangements).85

Secondary issue 25

What is the appropriate level of detail in the legislation?

68 It should be noted that, if this argument is accepted, in combination with section 14 of the Insurance (Agents and Brokers) Act/section 985B of the new Chapter 7 (which provides that payment to an insurance intermediary of a premium is a discharge of the insured's liability to the insurer) the area of conduct of insurance intermediaries under discussion in the context of compensation requirements will be limited.

69 For example, section 953B.

70 See CASAC Consultation Paper, page 11.

71 Corporations Regulation 7.5.58.

72 See CASAC Consultation Paper, pages 12-13.

73 See CASAC Consultation Paper, pages 13-14.

74 See CASAC Consultation Paper, pages 13-14.

75 See CASAC Consultation Paper, pages 14-15.

76 See CASAC Consultation Paper, page 15.

77 Corporations Regulation 7.5.75(2).

78 See CASAC Consultation Paper, page 10.

79 Corporations Regulations 7.6.02.

80 ASIC Policy Statements 139 and 165.

81 Division 5 of Part 7.10.

82 Section 892G and Corporations Regulations 7.5.86-92.

83 See CASAC Consultation Paper, page 19.

84 See CASAC Consultation Paper, page 14.

85 Section 885B.