Late last year, the Federal Court rejected ASIC’s lawsuit against the CBA group for alleged violations of the Corporations Act. The Court’s sensible approach sets an interesting precedent when it comes to conflicted remuneration risks within corporate groups.
What did ASIC complain about?
According to ASIC’s complaint, Colonial First State Investments Limited (Colonial) and Commonwealth Bank of Australia (CBA) contravened conflicted remuneration prohibitions when they agreed to payments related to the distribution of Essential Super products.
Between 2013 and 2017, CBA retail branches sold Essential Super, issued by Colonial, to individuals and small company employers as a default fund for employees who did not choose a superannuation fund.
It further claimed that Colonial transferred millions of dollars to CBA via cash transfers and general ledger entries that it had earned from Essential Super fees. According to ASIC’s investigation, Colonial allegedly offered, and CBA knowingly accepted conflicted remuneration through these arrangements and the subsequent payments and journal entries, violating the limitations within Division 4 of Part 7.7A of the Corporations Act.
CBA’s defence
CBA argued that its use of Colonial as an “in-house capability” to produce and distribute Essential Super did not result in a “real and genuine conflict of interest” and that any “remuneration” passing between the parties related to the arrangement was “an appropriate allocation of costs and revenues between members of the group, to permit appropriate reporting about the performance of separate entities and business centres within the corporation.”
Furthermore, it highlighted ASIC’s regulatory guidance indicating the conflicted remuneration provisions are concerned with substance over form and, should not be applied to an arrangement within a corporate group such as the distribution arrangement between CBA and Colonial, where the scope for influence on any financial advice given is remote.
The ruling: Conflicted remuneration is directed at arm’s length businesses, not corporate groups
After hearing the CBA’s arguments, Justice Anderson ruled that ASIC’s case failed scrutiny because the agreement did not result in any ‘benefit’ to which the conflicted remuneration laws should apply. He also pointed out that the benefit must be of a nature or under circumstances that “could reasonably be expected to influence” either the relevant financial product advice or the choice of financial product recommended and that the Court “should take a substance over form approach and ask whether a real commercial advantage exists amidst the formalities” when determining whether a benefit exists in the context of Section 963A.
Justice Anderson determined that ASIC had “misconceived the purpose and application” of the conflicting remuneration laws in the context of a corporate group like the CBA Group.
“The Conflicted Remuneration Provisions were never intended to operate between business units in the same group of companies or entities within a consolidated group of companies. Rather, the Conflicted Remuneration Provisions are directed to benefits between arms-length entities that are not part of a single consolidated group and legal entities with separate and distinct ownership.”
For the conflicted remuneration rules, the Court accepted expert testimony that the cash transfers and journal entries in ASIC’s claims did not result in a transfer of value between legal entities.
Judge Anderson’s concluded that the appropriate inter-company arrangement did not include a ‘benefit’ that could reasonably be expected to influence advice for the conflicted remuneration provisions is significant and could have broader implications for the way these provisions are applied to other arrangements within corporate groups (such as product distribution arrangements which increase shareholder value but do not have direct financial implications for advisers).
Takeaways
- ASIC did not prove that the arrangements could have reasonably been expected to influence the selection of any financial product or advice, even if they did entail the transfer or receipt of ‘benefits. The relevant product’s frontline distributors were unaware of the arrangements between Colonial and CBA and, thus, could not be expected to base their recommendations on such deals.
- The concept of conflicting remuneration has two parts: the benefit must be reasonably expected to impact either the selection of the financial product to be recommended or the financial product advice to be provided. Justice Anderson noted:
“Both limbs operate in the context of a choice between financial products, where a conflict may potentially arise because the advisor is recommending one product over another… The provision cannot be intended to operate where no other financial product is available, as this would eliminate the requirement that a choice could be made between two options. Clearly, the first limb cannot operate in this case because there is no choice to be made. The better view is that the second limb also presupposes a choice between financial products that creates a situation of potential conflict.”
Notably, the Court suggests that licensees who exclusively distribute a single product will never face the type of conflict of interest that could re-energize the conflicted remuneration restriction.
Due to the prohibition being a civil penalty clause, ASIC was responsible for proving all components of the claimed violations beyond a reasonable doubt in any instance where a consumer opened an Essential Super account based on financial product advice that violated the prohibition. ASIC could not show that any CBA branch employee had made any recommendations or given any statements of opinion “to a single retail consumer, let alone to every, or practically every branch customer,” as the Court put it. Given that the alleged violations are associated with every Essential Super account ever formed, the Court determined that this does not satisfy the burden of proof necessary to avoid a penalty. As such, it is clear that ASIC has a heavy burden of evidence in circumstances where widespread violations of the conflicted remuneration laws are alleged.
ASIC will appeal the Court’s ruling
Whilst ASIC has appealed the decision, several significant principals from the ruling limit the scope of conflicted remuneration.
It applies to arm’s length dealings
According to the Court’s ruling, a benefit can only be considered “conflicted remuneration” if given in “arm’s length dealings” between unrelated parties. Colonial had no workers and was a wholly owned subsidiary of CBA. Every employee who contributed to the creation and release of Essential Super was a worker for CBA or another CBA entity (other than Colonial).
The Court decided that the conflicted remuneration provisions were never meant to apply to business units within the same group of companies or to entities within a consolidated group of companies. Even though Colonial is a separate legal entity, the Court thought that the arrangement between Colonial and CBA could not be an “arm’s length dealing” because Essential Super was a CBA-branded product that was started and supported by two business units within the CBA group of entities.
The Court’s evaluation of the purported advantage took this restriction on the applicability of the conflicted remuneration provisions into account. The Court determined that the cash payments and journal entries did not result in a transfer of value since they cancelled each other out when the books were balanced, a common accounting technique among business groupings.
Wholly owned subsidiaries are immune from the conflicting remuneration provisions due to the Court’s ruling that the provisions cannot and do not apply to a single business group. Prominent industry players (such as product providers) may decide to buy smaller companies (such as consulting firms) to take advantage of this exemption, which could result in the concentration of the industry. On balance, the Full Court will probably be asked by ASIC to reject this interpretation or to severely restrict the situations in which the conflicted remuneration laws do not apply to corporate groups.
There needs to be a “choice”, so there needs to be more than one financial product
To be influenced by a benefit, a licensee’s product recommendation or advice must be based on a choice between products.
Judge Anderson cited the definition of conflicted remuneration, which states that the nature of the benefit or the circumstances under which it is supplied must be reasonably expected to influence the “choice” of a financial product suggested or advice made to retail clients. The inclusion of the term “choice” in this definition required conditions in which one financial product was preferred over another financial product. The Court did not regard the choice between a financial product and no financial product to be a financial product choice. CBA only offered Essential Super as a superannuation option. As a result, there was no such “option” for any other financial product, and the Court determined that the conflicted remuneration requirements did not apply.
This interpretation means that financial services businesses that only offer one product will not subject to the conflicted remuneration rules. This could make it harder for consumers to get a wide range of financial products and advice from a single source.
The person making the recommendation or providing advice needs to have actual knowledge of the benefit
The Court ruled that the parties giving financial product recommendations or advice must be aware of any benefit being provided to establish whether it is or may be expected to affect the financial product advice or choice.
Customer service representatives from CBA recommended that clients transfer their super to Essential Super. According to CBA and Colonial, none of these employees was ever made aware of the journal entries and cash payments made by Colonial to CBA following the Distribution Agreement. The Court concluded that the alleged benefit could not have swayed these employees for this reason.
The necessity of actual knowledge of the benefit establishes a new defence to the conflicting remuneration requirements. Without the licensee being made aware of the benefit, supervisors or superiors may persuade frontline personnel to suggest a financial product. The licensee may be able to argue in this case that their frontline employees were not actually aware of the benefit. The bar of “actual knowledge” may also be lowered by ASIC to the question of whether the individual is aware, should have been aware, or irresponsible about whether a benefit was being offered.
What is a “benefit”? The Court’s definition.
The Court determined that any “benefit” that a licensee or adviser claims to have received following the conflicting remuneration regulations must produce a “real business advantage.”
A transfer of value between entities must be considered a “benefit” for the purposes of the conflicting remuneration requirements. If the recipient would clearly and significantly benefit financially, this transfer of value is more likely to be viewed as a “real commercial advantage” and hence a “benefit.”
Justice Anderson outlined a few reasons Colonial’s journal entries and CBA’s cash payments did not represent a “real commercial advantage.”
- they cancelled out when the books were balanced, which extinguish any value transfer;
- the cash payments and journal entries did not make a dent in the considerable expenses that CBA incurred when creating and marketing Essential Super; and
- the financial position of CBA was not materially impacted by the journal entries and cash payments. The total alleged advantages came to a measly $23 million, whereas CBA’s Retail Banking Services’ net profit after tax exceeded $26 billion.
The Court also made it clear that, for the purposes of conflicted remuneration, the reimbursement of costs incurred by one party for services rendered in the distribution of a product is not regarded as a “benefit.”
What constitutes a “benefit” may be constrained by the Court’s interpretation. If the benefit does not result in the transfer of value to the licensee, licensees may contend that the compensation structure is not conflicted compensation. Even if conflicted remuneration does not constitute a significant transfer of value to the licensee, it is likely that ASIC will nevertheless think that consumers may still be adversely affected.
It will be interesting to see how ASIC overcomes these challenges as the appeal develops.