On 4 February 2019, Commissioner Kenneth Hayne delivered his final report (Report) on the financial sector following the most in-depth review of corporate Australia ever undertaken, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Commission).
While the focus of the Commission and the Report was specifically on the financial sector, many of the issues highlighted in the Report are common across other industries.
In this article, we highlight those issues which are likely to resonate with corporate Australia.
If one were to try to identify the overarching theme of Commissioner Haynes' report, it might be said to be corporate culture. The Commissioner places culture as a "root cause" of misconduct in the financial services industry, describing culture as something which can both drive misconduct and discourage it. Commissioner Hayne points out that until very recently, there has been scant overt attention given in Australia to the importance of culture, whether by entities or regulators, but that there are signs of change looking ahead.
Commissioner Hayne emphasises that the primary responsibility for culture rests with each entity, but he notes that APRA also has a role to play (not least because entities with the most problematic cultures are the least likely to change them from within). He suggests that an effective entry point for an entity to assess its culture is through its remuneration and governance structures, as these structures show what an entity values and are an expression of its culture.
As for the role of APRA, Commissioner Hayne emphasises that assessment of culture is an essential part of mainstream prudential supervision, and that it must not be viewed as merely an additional supervisory "add-on". He disapproves of APRA's foreshadowed "retreat" from its previous approach of conducting independent assessments of organisational culture. Noting that APRA's supervisory resources are limited, Commissioner Hayne emphasises that APRA "must have" the resources to supervise culture with increased intensity moving forward.
Commissioner Hayne also notes that recent efforts in the sector to change culture have met with some success, though the process can take many years. The importance of measuring and tracking efforts to change culture over time is emphasised. He cautions against simple "box-ticking", finding that the process of changing culture "demands intellectual drive, honesty and rigour".
Finally, Commissioner Hayne says that culture must be viewed as interconnected with every recommendation in his report. He calls on all financial services entities to take those recommendations and "apply, re-apply, and keep re-applying what is said to their culture and their governance".
Key implications: This emphasis on culture will resonate with boards of most publicly listed companies who are already dealing with the often competing demands of shareholders and customers and managing reputational risk as a result of cultural failings.
Commissioner Hayne has made a number of comments and observations in the Report which are likely to reverberate within Australian corporations.
Commissioner Hayne has been upfront in declaring that the responsibility for corporate conduct (and misconduct) lies with the board, and this has consequences for the board's role, priorities and accountability measures. He has a clear expectation that the board will interrogate management and ensure accountability. To do that efficiently, boards will need to be provided with information of sufficient quality (and the Commissioner has emphasised quality over quantity) to ensure they are able to do so.
If the board does not get this information, then it is incumbent on the board to seek it out. The Commissioner's comments foreshadow a likely move to a greater focus around board documentation: not only do board papers need to be fit for purpose, but the papers around board sub-committees and the like need to also be sufficient for those bodies to perform the tasks allocated to them, whilst minutes of meeting will most likely need to be more detailed given the heightened focus on board discussions.
With regards to directors, the Commissioner's comments are a warning that delivering short-term profits and outcomes to shareholders alone does not equate to acting in the best interest of the company.
Key implications: While Commissioner Hayne has likely only restated the content of a board's legal obligations, his commentary, which at times is quite scathing, should be seen as a shot across the bows of certain board cultures. In the post-Commission environment, boards should ensure they are more across significant matters arising in the business – and ensure that key issues are addressed – while directors will need to adopt a more holistic approach to considering the company's best interest. Such an approach will require balancing both financial and non-financial risks, in particular by:
- ensuring that the sufficient resources and attention are allocated to non-financial risks;
- maintaining clear accountability measures which foster a culture of resolving issues; and
- resolving them effectively.
Commissioner Haynes' recommendations in relation to the financial regulators are directed at driving cultural changes within those organisations, especially their willingness to pursue and prosecute misconduct in the Courts.
He highlights deterrence and public denunciation as key aspects of regulation and says that when misconduct is identified, regulators should ask themselves the question "why not litigate?". He says that the use of negotiation and persuasion as enforcement tools "all too readily leads to the perception that compliance is voluntary" and that financial services entities cannot simply comply with those bits of the law that they find to be commercially acceptable.
He also recommends that the financial regulators should be required to share information and that a new oversight body be established to assess the effectiveness of the regulators in discharging their obligations.
Key implications: This "call to arms" for the regulators may have ramifications for how they engage with industries outside the financial services sector.
Although Commissioner Haynes' recommendations in the Report regarding executive remuneration are confined to entities regulated by APRA, he nevertheless makes a number of comments of wide ranging application.
He is particularly critical of the failure to properly implement remuneration arrangements which involve a variable component measured against management of risk. Presumably to guard against the problem of closing the gate after the horse has proverbially bolted, the Commissioner makes special mention of the clawback of vested remuneration as a way to drive appropriate behaviours and accountability.
He goes so far as to say that he can "see no reason why every financial services entity should not have such arrangements". It should be noted that in reference to the boards of the big 4 banks, he states that they have implemented remuneration policies to encourage appropriate management of non-financial risks and in a way to reduce the risk of misconduct.
Finally and without making any specific recommendation, the Commissioner queries whether listed companies should disclose to their staff information about whether risk-related adjustments have been made to the remuneration of senior executives in an effort to drive accountability.
Key implications: Commissioner Hayne has shone the spotlight on executive remuneration and how and why it can fail to drive appropriate corporate behaviours. Public companies should review his commentary to identify alignment issues within their own remuneration systems.
The Commissioner's recommendations with respect to the financial advice industry have broad implications for the management of conflicts of interest and the standards applicable to all professionals owing a duty to act with skill and diligence.
Commissioner Hayne attributes the issues endemic in the financial advice industry to the "incomplete transformation" of financial advisors from salespeople to professional advisors.
Accordingly, the Report is particularly concerned with increasing the quality and competence of financial advisors through the management of conflicts of interest. The Commissioner's recommendations can be broadly divided into recommendations concerned with the elimination of historical conflicts (such as exceptions to the general ban on conflicted remuneration), and recommendations concerned with increasing the standards applicable to conflict management. In particular, the Commissioner recommends that advisors be required to positively disclose and explain why they are not independent, impartial or unbiased.
Although Commissioner Hayne did not make any recommendations with respect to standards for the education and training of financial advisors, he did suggest that AFSL holders take proactive steps to identify and remediate misconduct by individual financial advisors, and recommended that the law should be amended to establish a new disciplinary system, including registration of all financial advisors.
Of particular interest are the Commissioner's comments on the vertical integration of services relating to product manufacture, sale and financial advice. Although he stopped short of recommending the separation of product and advice, Commissioner Hayne observed that the increased costs of complying with increased regulation may well force the de-integration of these services without the need to mandate structural separation.
Key implications: Any industry which involves the provision of services to consumers will want to carefully consider the commentary and recommendations regarding the avoidance and management of conflicts.
In the Report, Commissioner Hayne takes aim at the phenomenon of "rolling bad apples", where employees who have engaged in misconduct are dismissed, but details of their misconduct are not reported to regulators or industry bodies.
The process of dismissing an employee for misconduct can be a challenging and costly one, and organisations may be left with little appetite for sharing details of the employee's misconduct with others. They may even be concerned about being sued by the former employee for sharing their (often contested) findings of misconduct with third parties.
Notwithstanding this, the Commissioner's findings suggest that industries should bear responsibility for protecting their customers from repeat offenders. Organisations also need to be aware of:
- legislation, codes of practice and rules of industry associations which mandate reporting of misconduct;
- where relevant, laws concerning the concealing of crimes; and
- the protection available for some reports to third parties under State and Territory defamation laws.
The Commissioner also favours the introduction of a new "best interests" duty for mortgage brokers. While stopping short of recommending any immediate change, he suggests that removal of the "safe harbour" provisions for financial advisers would not be without merit.
Key implications: The Report's recommendations in relation to employee misconduct were underpinned in part by a concern that persons who hold themselves out as, or are perceived to be, professional advisers, should be bound to act in their clients' best interests. While the Commissioner's focus is exclusively on the providers of financial services, it is a timely reminder to other industries in which businesses are remunerated partly or wholly by commissions or referral fees, while also offering to find the "best" deal or course of action for their customers.
Consider the following scenario: a customer complains to an organisation about an employee's misconduct, which has caused the customer harm. The organisation investigates the complaint and finds it substantiated. The customer is compensated for the harm caused. Is the organisation's work done? The Commissioner's findings in relation to a number of case studies suggest it is not. Where harm to a customer as a result of employee misconduct is identified, organisations should be asking themselves the following questions:
- Has the employee engaged in other, similar misconduct?
- If so, are there other customers who need to be contacted and offered remediation?
- Is the employee's misconduct the result of a culture or set of practices which needs to be examined further?
Commissioner Haynes' Report is a scathing review of the provision of insurance in Australia and the industry's inability to address issues such as asymmetric information and low value to customers. It highlights the need for all corporates who are predominately sales based to revisit their sales techniques (such as the use of unsolicited calls and requirement of employees to overcome objections).
While the Report proposes the introduction of the deferred sales model to address the capture of ill-informed purchasers of insurance products, this approach has broader appeal. The ability to demonstrate that sales are a function of informed consent in respect of a specified need will go a long way to demonstrating to any Regulator that the sales culture within an organisation is in good health.
As part of a central theme in the Report regarding commissions as a driver of poor behaviour, Commissioner Hayne calls out the Motor Vehicle Industry, noting that commissions paid to dealers have in the past exceeded the value of benefits ultimately paid out to policy holders. The Commissioner recommends a cap on commissions by way of remedy – driving it to zero where there is no evidence of short to medium term underinsurance. It is clear that the Report will force those traditional commission-based industries to now rethink their remuneration structures and come up with new ways to promote sales while balancing non-financial risks.
Of note more generally is Commissioner Haynes' attack on what he describes as "laws heavily influenced by industry lobbyists". He points to a number of anomalies in the legislation that he suggests have been created by government enabling industry interests to be advanced at the expense of consumers. Examples such as the following demonstrate how capture by industry lobby groups can overcomplicate and obscure legislative intent:
- exclusion of life insurance and general insurance from the conflicted remuneration reforms;
- the exemption of insurers selling funeral expenses policies to hold a AFSL;
- the inclusion of the sale of insurance as a financial service (but not the handling and settling of insurance claims); and
- the carve out of insurance from the Unfair Contract Terms legislation.
Commissioner Hayne has described ASIC's ability to influence behaviour through the insurer's licence to operate as "a very blunt instrument of enforcement".
Key implications: The Commissioner appears to be strongly of the view that Regulators should use litigation and enforcement as the primary tool for re-setting the moral compass of corporate Australia. Companies dealing with Regulators should expect a sharper focus on compliance for many years to come.
Commissioner Hayne highlights the fact that particular conventions entrenched within the industry (for example particular fee structures) are no excuse for poor customer outcomes. There needs to be a credible rationale for the entrenched convention, and in relation to consumer facing industries, the rationale is to be based on what is in the consumer interest, and the convention is not to be actually working against the consumer interest.
The Commissioner also exposes instances where market participants observed that important changes should be made to their conduct in the market, yet they did not introduce or implement those changes in their own organisation due to a belief or perception of first mover disadvantage. The Commissioner sees these as being areas for regulatory intervention applicable across the industry so as to remove the problem of a first mover disadvantage.
In the Report, Commissioner Hayne makes it clear that his consideration and findings on industry codes are not to interfere with the broader development or operation of industry codes generally. However, he also comments that in approving an industry code of conduct, ASIC may take into account whether particular provisions are designated as "enforceable code provisions" or not, and states that non-enforceable provisions of industry codes will continue to play an important role in setting standards of behaviour in an industry.
Key implications: The Commissioner develops the fundamental principle that a party is to perform a contract in accordance with its terms in his finding that if you offer another party a stipulated fee, discount or rate, you must have the administration and IT systems in place to deliver that promise before you make the offer. To do otherwise may be misleading or deceptive conduct. If you do not deliver what you have offered, you must rectify the consequences of default as soon as possible.
The Commissioner also identified that senior executives within an organisation may be held accountable for ensuring the organisation's administration and IT systems were in place, and it is not acceptable that there is a disaggregation or delegation of responsibility to different internal teams.
Superannuation and the BEAR
Commissioner Hayne makes a number of sweeping superannuation recommendations that will have broader implications for the financial services industry.
Given the conflicts that can and do arise in the sector, the Report recommends that the trustee of a superannuation fund should be prohibited from acting in any other capacity and should be solely focused on the performance of its duties as a superannuation fund trustee. This is directly targeting the trustee entities in the sector that are dual regulated – both as trustees of a superannuation fund and as responsible entities of a managed investment scheme. The Government has indicated its support for this recommendation and, if legislated, this change will require a number of dual regulated entities to reorganise their affairs.
In a welcome move for proponents of lifting the governance standards in the superannuation sector, Commissioner Hayne has also recommended that the existing Banking Executive Accountability Regime (BEAR) – which clarifies standards of accountability and governance in the banking sector – be extended to apply to all APRA-regulated institutions. He indicates that, given its significance to the Australian economy, the extension should start with the superannuation sector and after a sufficient period for the regulator and regulated to prepare for such an extension of the BEAR.
Commissioner Hayne has also recommended that the BEAR be jointly administered by APRA and ASIC, with the latter assuming responsibility for the consumer protection and market conduct aspects of it. The Government has not only supported this recommendation but has taken it a step further by suggesting that the new BEAR (administered by ASIC) will apply to all Australian financial services licensees, Australian Credit licensees, market operators, and clearing settlement facilities. In other words, if legislated, the new BEAR will also apply to non-prudentially regulated entities.
Key implications: Given the relative infancy of the BEAR and its impact in the banking sector, it remains to be seen whether these recommendations relating to the BEAR will bring about a positive change in the broader financial services industry. Previous regulatory attempts to streamline the regulation of financial products and services have not always generated better outcomes for consumers, nor the industry at large.
As Commissioner Hayne himself concedes, culture plays a significant part: "[c]ulture, governance and remuneration march together. Improvements in one area will reinforce improvements in others; inaction in one area will undermine progress in others".
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