Alert | St John statutory compensation report signals the next wave of reform

18 May 2012

The report by Mr Richard St John into compensation arrangements for consumers of financial services, released on 8 May 2012, recommended the consideration of key reforms which could have a significant impact on the financial sector – although it stopped short of recommending the introduction of a last resort statutory compensation scheme.

The report, widely reported in the press, considers the position of retail clients who incur a financial loss as a result of misconduct by a licensee or its representatives. It is not concerned with situations where financial products fail or fail to perform.

The report analyses the current regime and alternatives found overseas in relation to:

  • the adequacy of current compensation arrangements and financial resources obligations including professional indemnity insurance (PI insurance) as the primary mechanism
  • the performance of compensation mechanisms following recent licensee failures, and
  • how a statutory last resort compensation scheme could work.

It makes a number of very broad recommendations to strengthen the current regime, although significant consultation will be required before any could be implemented. The government is accepting submissions until 6 July 2012 and has indicated that it will provide its response by August 2012.

Summary of recommendations

Instead of a statutory compensation scheme, the report recommends that the government take steps to bolster the current regulatory regime to put licensees in a better position to meet their own compensation claims from retail clients:

  • New obligations on licensees to prove the adequacy of their capital adequacy and compensation arrangements, including:

    • annual audited certification to ASIC regarding currency and adequacy of PI insurance
    • notify ASIC if PI insurance is downgraded, cancelled or exhausted
    • demonstration of capital at risk in the business.

  • Greater prescription and tailoring of capital adequacy and PI insurance standards.

  • Rebalancing the consumer protection risk between advisers and product issuers by:

    • imposing additional disclosure requirements and imposing new restrictions relating to product suitability
    • enabling advisers to join product issuers to external complaint handling (e.g. FOS) proceedings
    • considering the role of research houses.

  • Strengthening ASIC's power to enforce these standards and obligations.

  • Increasing third party rights under PI insurance.

The report does not recommend introducing a last resort compensation scheme at this time, acknowledging that it would place an unnecessary burden on responsible and financially secure licensees to underwrite claims against weaker licensees. Instead, a statutory compensation safety net could be revisited in the future once the regulatory platform has been made more 'robust and stable'.


Following several financial sector collapses, the Parliamentary Joint Committee on Corporations and Financial Services conducted an Inquiry into financial products and services in Australia resulting in the 'Ripoll report'. This report recommended, among other things, that the government investigate the costs and benefits of different models of a statutory last resort compensation fund for investors.

The government's response became the Future of Financial Advice (FOFA) reforms first announced in April 2010. In relation to the compensation scheme recommendation, Richard St John was asked by the government to consider the need for, and costs and benefits of, a statutory compensations scheme for financial services.

Current compensation arrangements

Licensing requirements

Under the Corporations Act, licensees that are not regulated by the Australian Prudential Regulation Authority (APRA) are currently subject to a general obligation to have adequate financial and other resources to provide the financial services covered by their licence and to carry out supervisory arrangements (s912A(1)(d)). ASIC Regulatory Guide 166 and associated licence conditions set minimum financial requirements and provide the licensee with several options to meet these minimum standards.

Licensees not regulated by APRA which provide financial services to retail clients are further required to have arrangements in place to compensate those persons for loss or damage suffered because of breaches of their obligations (s912B). Corporations Regulation 7.6.02AA require such licensees to hold PI insurance unless an exemption applies. The regulation requires a licensee to hold appropriate PI insurance having regard to the licensee's business, clients and exposure to claims.

ASIC does not take an active role in assessing the adequacy of each licensee's PI insurance. Rather the onus is on the licensee to comply with its obligations to obtain appropriate and adequate insurance.

General insurers, banks and other authorised deposit-tasking institutions (ADIs) are subject to statutory last resort protection scheme.

Consumer remedies

A client who suffers loss or damage arising from a licensee or their representative's misconduct can seek redress through:

  • private legal action relating to breaches of general law or the Act
  • ASIC's power to take action on behalf of clients who have suffered loss if its appears to be in the public interest to do so
  • external dispute resolution (EDR) schemes.

Compensation arrangements, and more specifically PI insurance, aims to ensure that successful claims made by retail clients are met by licensees. While PI insurance reduces the risk to a client that a licensee will not have the financial resources to meet an award of compensation, it does not guarantee that a retail client will be compensated.

Recommendations for strengthening current regulatory regime

The report makes numerous recommendations primarily aimed at enhancing capital adequacy and compensation arrangements standards, secondly increasing the obligations of licensees to prove they have adequate arrangements and finally enhancing the powers and role of ASIC. The recommendations, if acted on by the government, would represent a shift from what Mr St John describes as an 'honour' system regulated through a 'light handed approach' to a system where greater onus is placed on the licensee and where ASIC takes a more pro-active or interventionist approach to ensure compliance.

Adequate financial resources and PI insurance

The report recommends reviewing financial resources requirements for licences and financial advisers with a view to complementing and supporting the reliance on PI insurance as the compensation arrangement.

The report calls for attention to be given to what amounts to adequate financial resources by considering the relative riskiness of the financial services or product offered by the licensee. As part of this, the report recommends greater legislative prescription of the level and type of financial resources and PI insurance required or giving legislative weight to published ASIC guidance. No details of any such potential requirements are provided.

Licensee obligations

The report considers in detail the limitations of the current heavy reliance on PI insurance as a mechanism for ensuring compensation for retail clients. Recommendations therefore include requiring licensees to:

  • submit an annual certificate to ASIC (as part of a licensees obligation to provide audited financial statements) providing certain factual information relating to their PI insurance and certifying that their policy is current
  • provide an annual declaration, signed by senior management, stating that in the process of renewing their PI insurance cover, they have satisfied themselves that the cover meets the established standards
  • include in their annual report to ASIC a declaration by their auditor that it has reviewed and signed off on the currency and adequacy of the PI insurance cover
  • notify ASIC if there are any products or services offered by the licensee that are not covered by their PI insurance policy
  • advise ASIC if their PI insurance policy is downgraded, cancelled, or exhausted during the course of its term
  • demonstrate that they have capital at risk in their business
  • make arrangements to cover claims for compensation after they cease to trade.

Consideration could also be given to increased capital adequacy requirements for issuers of riskier products.

Implications for product issuers

Mr St John is also concerned about the imbalance of responsibility for compensation between financial advisers and product issuers. He concludes that a disproportionate burden is borne by financial advisers under the current arrangements and consideration needs to be given to requiring product issuers to take more responsibility for consumer protection. It is suggested that it may be time to review the adequacy of the conduct and disclosure approach to regulation of product issuers. Preventative measures should be considered to reduce the risk that consumers acquire products not suited to their needs.

Measures that could be considered include:

  • consumer and industry warnings for certain products
  • limiting the sale of certain products to certain classes of consumers
  • preventing the distribution of certain products in the absence of financial advice
  • inclusion of suitability information relating to particular classes of consumers in product disclosure statements
  • stress testing product risks to assess performance in a range of market conditions
  • standardised product labels and terms
  • enabling advisers to 'join' product issuers to external complaint proceedings
  • focussing on the role of research houses when relied on by advisers and consumers
  • mandating or banning certain product features
  • a 'stop order' power to enable ASIC to intervene to halt the issue, and distribution of 'toxic' products (in addition to its current stop order power for product disclosure statements).

Mr St John does not, however, suggest that new investment products should be pre-vetted.

Role of ASIC

Many of the report's recommendations relate to increasing ASIC's role in ensuring adequate financial resources and compensation arrangements. It recommends that ASIC be given the necessary power to take a more pro-active role in monitoring and enforcing licensee compliance with the requirement to hold adequate PI insurance and any new requirements in regard to adequate financial resources.

Specifically, the report recommends the strengthening of ASIC's power relating to:

  • enforcement of financial adequacy and PI insurance standards, by including standards in legislation or giving ASIC guidance legislative force
  • combat phoenix activity by giving ASIC the power to refuse or cancel a licence if a director or manager was formerly a director or manger of a licensee which ceased to trade without meeting awards of compensation
  • prevent a person involved in phoenix activity from becoming an authorised representative, director or manager of another licensee
  • dealing with unlicensed providers, by encouraging consumers and licensees to provide information to ASIC, and
  • introducing an infringement notice regime for minor breaches by licensees.

The report further recommends that external dispute resolution schemes processes be reviewed to better protect consumers who to seek compensation through this means.

Third party rights under PI insurance

The report recommends that the Insurance Contracts Act 1984 (Cth) be amended to ensure consumers can make a claim on the PI insurer when they cannot recover compensation awarded against the licensee as recommended by the 2004 review of the Insurance Contracts Act 1984. The report also recommends that ASIC should be empowered to provide information it has about a licensee's PI insurance to the consumer.

Read Richard St. John's report.

Author(s) Richard Batten