Commissioner Kenneth Hayne has delivered his interim report on the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. The report details the misconduct in the Australian financial services sector identified during the Commission's hearings; identifies the causes of that misconduct; examines the approach of the Australian regulatory authorities; and discusses the current Australian legislative, regulatory and policy framework.
This Brief Counsel is the first in a series focusing on the interim report. It provides a general overview of the report structure and content. Subsequent Brief Counsels will examine particular parts of the interim report, and the possible implications for New Zealand.
Relevance for NZ's financial service providers
Our financial service providers will be considering the interim report to assess whether they are vulnerable to the types of misconduct identified by the Commission and, if so, how they can address those vulnerabilities. That may involve them focusing on their remuneration structures, systems for detecting misconduct, and their complaints and remediation processes.
Regulators are expecting such a proactive approach. The FMA and Reserve Bank have stated they are watching the Commission, and are seeking assurances that the types of misconduct identified by the Commission have not occurred in New Zealand.
The interim report and the final report (when it is published) are likely to inform the legislative, regulatory and enforcement programmes in Australia for years to come.
Since the Royal Commission began its public hearings in March, it has heard many examples of alleged misconduct in the Australian financial services industry. Much of that misconduct has captured the public's attention. For example:
- a couple losing their home and life savings due to "improper advice" while the adviser received a hefty commission
- banks charging advice fees for customers after they had been informed the customers had died
- an ill and disabled elderly woman being signed-up as the guarantor for her daughter's business loan and losing her house as a result
- a Down's Syndrome man being signed up over the telephone for significant insurance cover, and
- cultural sensitivities being exploited to sell funeral insurance to Aboriginal people.
The report is comprehensive, comprising three volumes, and 1001 pages. It covers the misconduct considered during the first four rounds of public hearings, which focused on consumer lending, financial advice, small and medium enterprises and remote communities.
Due to Commission's time constraints, the report does not cover the recently completed rounds on superannuation and insurance, but these topics will be addressed in the final report.
In the Executive Summary, the Commissioner concludes that the misconduct is indicative of systemic problems in the Australian financial services industry and in the regulatory enforcement. On the question of why the misconduct occurred, the Commissioner stated: "Too often, the answer seems to be greed – the pursuit of short term profit at the expense of basic standards of honesty. How else is charging continuing advice fees to the dead to be explained? But it is necessary then to go behind the particular events and ask how and why they came about.
"Banks, and all financial services entities recognised that they sold services and products. Selling became their focus of attention. Too often it became the sole focus of attention. Products and services multiplied. Banks searched for their 'share of the customer's wallet'. From the executive suite to the front line, staff were measured and rewarded by reference to profit and sales."
The Commissioner was equally critical of the Australian regulatory authorities (ASIC and APRA) in failing to seek public denunciation of, and punishment for, the misconduct. He criticised their failure to undertake court action in order to have penalties imposed.
Instead, ASIC and APRA had relied on infringement notices and enforceable undertakings that did not impose sanctions commensurate with the misconduct's seriousness. In some instances, the misconduct simply went unpunished.
The report does not propose any specific reforms on how to prevent misconduct happening again. Instead the Commissioner identifies various questions he needs to resolve in order to reach his reform recommendations.
The Commissioner left open questions of whether additional laws should be enacted, whether the law should be simplified, or whether the existing law should be administered or enforced differently. This reflects that much of the misconduct appears to be already contrary to law. The Commissioner therefore recognised that there might be little benefit in new laws being enacted. Rather, the better approach might be to simplify the existing laws.
The questions will provide the framework for the final round of public hearings, where the Commission will consider policy matters. After this round is completed, the Commissioner will formulate his final conclusions and substantive recommendations, which will be contained in the final report.
While the Commissioner did not propose any specific reforms, it appears, at the very least from the report, he will recommend changes relating to:
- Remuneration systems – the Commissioner concludes that in all cases of misconduct identified by the Commission, the financial services provider financially benefited from the misconduct. The Commissioner considers that industry members have not been rewarded for doing the "right thing". He also considers that advisers should not earn commissions, as these mean that the adviser's interests will always conflict with the client's interests. The Commissioner questions whether such commissions are commercially necessary, given that some banks had ended them.
- Governance and management structures – the Commissioner concludes that in all the cases of unlawful conduct identified by the Commission, governance and management structures had been inadequate to detect that unlawful conduct. In addition, where that conduct was eventually discovered, there were often few, if any, consequences for the individuals responsible, the remediation was typically unsatisfactory, and regulatory authorities were not notified promptly.
- Intermediaries engaged by financial services providers – the Commissioner noted that there was confusion as to their roles, their relationships with customers and financial service providers, and their legal responsibilities, especially with respect to assessing the product suitability for each consumer.
The Commission has been embarrassing for ASIC and APRA. These agencies will want to regain the confidence of the public and politicians, so it will be expected that they will take a firmer enforcement approach. ASIC has stated that it will take a "more intrusive, enduring, and with onsite visits, more physical" approach to supervision as a result of the Commission's findings.
The interim report has been embarrassing for the Australian Government as well. Senior government members had resisted earlier attempts for an inquiry into the industry, claiming it to be unnecessary and unproductive. The Labor Party has begun a campaign to have the Commission extended, as the Commissioner had earlier stated that time constraints had meant that not all the witnesses had been heard. It has also promised that, if elected, it will set up a taskforce (located within the Federal Treasury) that will implement the Commission's recommendations.
Chapman Tripp comment
The interim report has been described by Australian commentators and politicians as a "day of shame", a "game-changer" and a "frank and scathing assessment". It has been recognised as comprehensive and tough. However, when the dust settles, the report's allegations of industry-wide greed may be seen as too extreme. It may also be acknowledged that the industry generally provides considerable financial benefit to its customers. For every case of misconduct identified, there will be many thousands of cases where customers have been provided with the financial services they require on reasonable commercial terms.
We hope this is not lost sight of when the Commission makes its recommendations – that any proposed reforms need to be a proportionate responses, and not unduly interfere with the industry's ability to meet market demand for financial products and services.
The report does not extensively analyse the competing policy considerations that any reform in this area must negotiate. This will occur in the final round of public hearings, and it is here that the Commission will need to address some difficult issues. For example:
- The report suggests that the Commission will recommend reforms that place greater emphasis on customers' interests. The Commissioner considers that the misconduct cited shows that financial services providers have failed to adequately manage customers' interests and that they will inherently prefer their own interests in the event of a conflict. While the report briefly acknowledges financial services providers' are profit-motivated businesses, it does not provide much conceptual thinking as to how the interests of the customers and the financial services provider should be more satisfactorily balanced than currently happens. The Commission will need to ensure that desirable customer services do not become uneconomic as a result of any changes. As much as this may seem heretical in the current climate, there may be cases where customers would prefer to determine what is in their own subjective best interests and place value on choice, rather than to losing opportunities out of an abundance of protectionism.
- The report focuses mainly on the financial advice misconduct, which was often pronounced as clearly unethical or unlawful. However, in the rounds that considered small-medium business and agricultural lending, the alleged misconduct was often less clear cut. In these rounds, the Commission heard complaints about banks' lending decisions with respect to customers who were willing to accept that lending. Arguably, the complaints were primarily related to the banks' commercial judgement, and their exercise of legal remedies when the commercial ventures failed or were in jeopardy, as they were about breaches of rules. Any reforms in these areas will need to recognise that commercial ventures will often fail; that lenders need to be able to respond prudently; that to some extent customers should be expected to look after their own interests and exercise discernment about their borrowing; and that banks will withhold lending in such cases where they consider they cannot enforce their legal rights under lending arrangements. The report contains little substantive analysis on these matters.
- The Commission needs to be realistic about what can be achieved through regulatory reform. The Australian industry's size, the complexity of financial service providers' organisations and of their regulatory requirements and, most importantly, human nature and ingenuity, mean that the prevention of all misconduct may be practically unachievable, even with the best governance, culture and regulatory frameworks. In reaching its recommendations, the Commission should recognise that there are limits to what management can reasonably know and influence. Again, the report does not appear to adequately acknowledge these realities. Hopefully, if the Commission recommends greater sanctions for misconduct, these sanctions distinguish between simple mistakes or misconduct due to poor implementation by "bad apples", from misconduct arising from systemic failures that should reasonably have been prevented.
The report identifies the possibility that improper behaviour is best remedied under existing frameworks with greater enforcement, without the need for regulatory overhaul and the adverse economic consequences that may arise if it goes too far. We expect that such a conclusion would ultimately be a good outcome for the Australian financial services industry and for consumers generally. In our view, however, effective remediation of customers should take priority over imposing penalties. While both are punitive and incentivise compliance, consumers benefit directly from remediation. For that reason, requiring engagement with, rather than enforcement by, regulators may still lead to the best overall outcomes.
The Commission has invited submissions on the questions identified in the interim report. Submissions close on 26 October 2018.
Subject to the Commission being extended, the final report is required to be delivered by 1 February 2019.
The information in this article is for informative purposes only and should not be relied on as legal advice. Please contact Chapman Tripp for advice tailored to your situation.