PJC report on Trio Capital: call for a review of the regulation of managed funds

On 16 May 2012, the Parliamentary Joint Committee on Corporations and Financial Services (Committee) tabled its report on its inquiry in relation to the collapse of Trio Capital - the largest superannuation fraud in Australia's history. The report outlines the Committee's view on the causes of the collapse and its recommended regulatory responses to the collapse.

Whilst the Committee aimed some stern warnings in the direction of ASIC, APRA and the financial services industry's various 'gatekeepers' and implored ASIC and APRA to exercise particular vigilance in their regulation and oversight of superannuation investments and managed investment schemes which invest overseas, the Committee also made some important recommendations and observations in relation to the regulation of managed investment schemes. If pursued, the Committee's key recommendations are likely to have significant consequences for registered managed investment schemes.

Compensation for fraud - a levy on all managed investment schemes?

The Committee considered in some detail the compensation arrangements for persons who suffered loss as a result of their investment in the Trio funds. The Committee noted that a compensation scheme for fraud and theft was available to persons who invested in Trio funds through APRA regulated superannuation funds; but not those who invested through a self managed superannuation fund (or invested in the Trio funds directly). Whilst falling short of recommending a compulsory compensation regime for self managed superannuation fund members, the Committee noted that there may be merit in an opt-in insurance scheme for these members and recommended that further efforts be made to investigate avenues to protect investors in the case of theft and fraud by a managed investment scheme.¹

Before the Committee's Trio report was released, Mr Richard St. John reported in April 2012 about compensation arrangements for consumers of financial services. Mr St. John recommended against introducing a more comprehensive 'last resort' compensation scheme for users of financial services. One of  Mr St. John's concerns was the moral hazard that such a compensation scheme could create, in the context of the "limited regulatory measures to protect retail clients from the risk of licensee insolvency".²

Commenting on Mr St John's report, the Committee concluded that, if the policy objections raised by Mr St. John could be overcome, the concept of a levy on all managed investment schemes to fund a compensation scheme for fraud and theft has merit.³ The St. Johnreport outlined elements of how such a scheme may operate; including having compensation contributions levied on industry participants on a post-event basis, with the amount payable dependent on, in the case of managed funds, the contributor's funds under management. The Committee has queried exactly how a scheme limited only to managed investment schemes would operate, including whether it would compensate for all loss and whether managed investment schemes would be broken down into sub-categories (such as by asset class) with those funds in the same category responsible for funding theft or fraud by funds in their own category.

The implementation of a compulsory compensation scheme for managed investment schemes would have obvious complications given the breadth of types of managed investment schemes in operation - including illiquid schemes or structured investment schemes which often do not have access to excess liquid funds to fund compensation levies. If the Government were minded to pursue a compensation scheme, the industry must be given adequate time and opportunity to consult with the Government on the benefits, detriments and practicalities of such a scheme.

Changes to compliance plans and compliance committee regimes

The Committee and many of the persons who made submissions to the inquiry sought to place a large amount of the blame for the fraud on Trio Capital's financial statement auditors and compliance plan auditors. Both the Committee and, in its submissions, ASIC, were quite critical of the role of the compliance plan and compliance committee framework set up by the Corporations Act 2001 (Cth) (Act). In relation to the audit of a responsible entity's compliance with a scheme's compliance plan, the Committee was of the view that "an auditor's assessment of a compliance plan and the work of the compliance committee as 'effective' essentially only means that they exist".⁴

The Committee has recommended that the Government investigate options to improve the oversight and operation of compliance plans and compliance committees, including reviewing the need for:⁵

• more detail in compliance plans. ASIC's submissions noted that in their view the content requirements for compliance plans are set at a high level by the Act, rather than requiring detail on specific matters. ASIC concludes that, as a result, the plans are not being as effective as may have been intended;⁶
• qualitative standards by which compliance plan auditors must conduct their audits;
• liability for the responsible entity and its directors for any contravention (currently the case) rather than only for material contraventions. ASIC submitted that the risk of liability for every compliance plan contravention results in generic compliance plans with low standards;⁷
• legislative requirements as to experience, competence or qualifications for compliance committee members;
• regulatory or member oversight of appointment of compliance committee members;
• an approval process for compliance plan auditors so that ASIC can remove auditors or impose conditions on their approval; and
• governance arrangements to be clearly stated in relation to the proceedings of the compliance committee.

Some of these recommendations are not new. In his 2001 review of the Managed Investments Act 1998 (Cth), Malcolm Turnbull recommended to the Government a range of reforms including the introduction of standards relating to the qualifications and experience of compliance committee members, a power for ASIC to remove and permanently ban individuals from being compliance committee members, as well as ASIC and scheme member notification requirements when there was a change in the compliance committee membership.⁸

Product manufacturers - duties to "consumers as a whole" and product labelling

A number of submissions made to the Committee called for product manufacturers to take more responsibility in delivering products that were suitable for their target investors.

The Financial Planning Association of Australia submitted that product manufacturers and AFSL holders should be subject to a "best interests duty". This duty would place the interests of "consumers as a whole" above that of the licensee and so would add to obligations already owed to investors once they have actually invested in the scheme.⁹ This would conceivably result in difficulties - for instance, for open ended funds where the interests of actual investors may conflict with those of potential investors.

ASIC noted that it had previously submitted, as part of the Committee's Inquiry into Financial Products and Services in 2009, that the Government should consider:

• introducing a duty of suitability for product issuers and intermediaries. This would require product manufacturers and/or distributors to take some responsibility for ensuring products are sold to the right investors; and
• amending the regulatory regime to prohibit the sale of certain products to retail investors or place limitations on the design of products sold to retail investors, in order to safeguard investors from high-risk or unsuitable products.¹⁰

These sentiments were echoed in the St. John report where Mr. St. John indicated that the Government ought to look into whether there should be a greater onus on product issuers to provide suitable products for the target audience. Mr St John concluded "it would be timely to review the current relatively light-handed regulatory regime for the issue of certain financial products into the market, in particular managed investment schemes, and the possible need for some tightening of that regime".¹¹

The Financial Planning Association of Australia also submitted that the Government should work with product providers, research houses, and other stakeholders to establish a comprehensive system of ratings for product risk that ensures disclosure of key product risks and includes:

• identifying specific categories or classes of risk to help the consumer gain a better understanding of the risk involved in investing in a product - including stipulating disclosure requirements and specific risk warnings for each category;
• carrying out stress testing of products and disclosure of possible outcomes;
• stipulating the level of professional support needed to utilise products; and
• establishing requirements for different documentation for different classes of products.¹²

The Committee ultimately did not make any recommendations to the Government in relation to duties of product manufacturers or limitations on the development or sale of products. However, the Government is expected to respond to the St. John report in August 2012 and the managed funds industry will not doubt be paying careful attention to the Government's responses and proposals.¹³

Disclosure of fund portfolios

The Committee recommended that the Government investigate the best mechanism for introducing a statutory requirement for responsible entities to disclose the identity of scheme assets.¹⁴ This suggestion appears to respond to ASIC's comments that, compared to the US and Europe, the level of underlying portfolio disclosure by Australian managed investment schemes is very limited and that such disclosure would help investors assess the type of financial products they are exposed to and the extent of the exposure.¹⁵ It is also seems to be a particular concern of ASIC Commissioner Greg Medcraft, evidenced by his many calls for responsible entities to inform their members about the composition of the assets held in their funds. The Committee also considered that such disclosure would assist in the monitoring of managed investment schemes by regulators and gatekeepers and would, in turn, assist in the detection of fraud.

Custodians

According to the Committee's report, "the collapse of Trio Capital has exposed the very limited role of custodians in Australia".¹⁶ This comment was made in response to what the Committee found to be an expectation gap between what retail investors understand as the role of the custodian and what a custodian is legally required to do.

While the Trio collapse may have exposed retail investors' lack of proper understanding of the role of a custodian, the limited role played by custodians is not new and they have not played a more extensive role since the 1998 changes to the Corporations Act regime for managed investment schemes. Submissions to the Turnbull review of the Managed Investment Act in 2001 observed that custodians have never been intended as watch dogs and instead only act when instructed to do so and only act in accordance with instructions.

The Committee requested that ASIC review custodian businesses and indentify issues requiring regulatory reform - including the safeguards that a custodian could put in place to ensure it is able to identify and report suspicious transfers (outside the anti-money laundering context). The Committee also recommended that ASIC consider requiring the role of custodians be renamed - suggesting "Manager's Payment Agent" as one such alternative, to reflect more accurately the precise role played by custodians and avoid retail investor confusion.¹⁷ Caution should be taken that any change in the name of the "custodian" role does not in itself fail to recognise the real role played by custodians. Changing the description of custodians to something such as a "Manager's Payment Agent" may have an adverse consequence of itself further limiting the role played by custodians.

Change in ownership of Australian financial services licensees

A key question to the Committee by investors who lost money in the Trio Collapse was how ASIC could have allowed an unscrupulous operator to be granted an Australian financial services licence. Trio Capital (formerly Tolhurst) was, according to the Committee, a reputable funds manager prior to its acquisition by the personnel who eventually led it into collapse.

The Committee noted the reforms to ASIC's licensing powers contained in the FoFA legislation, including the greater discretion to be given to ASIC in granting and cancelling Australian financial services licences.  The Committee also took into account the administrative process surrounding changes in responsible personnel of a licensee including notification of changes in responsible managers and in some cases, key person licence conditions.¹⁸

Ultimately the Committee concluded that the Trio Capital case reflects a problem with the current licensing system. The Committee recommended that the Government consider whether current processes in relation to a change in ownership or control of a licensee are adequate.¹⁹

Government response to the Committee's report

The collapse of Trio Capital has been a sensitive political topic, particularly given the impact of people's retirement savings, the alleged failures of regulators and the absence of a fraud compensation regime for SMSF members. The Government's public response to date has been to focus on the SMSF compensation issues, the role of financial advisers and the promotion of its incoming FoFA reforms.

The managed funds industry will no doubt be keenly observing the Government's response to the Committee's recommended and attempting to ensure that any changes in the regulation of managed investment schemes are both practical and beneficial.

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