Regulatory “Rinkles” – Spotlight on differential pricing in financial services

THE ISSUE

The issue of differential pricing of financial products on investment platforms has arisen as a news item over the past several weeks. This edition of FSR Australia Notes sheds some light on this topic, and the legal furphies and controversies surrounding it.

THE STARTING POINT

The starting point is to articulate the concept of differential pricing.

The concept refers to several different but related notions. The first is differential pricing across a set of financial products, typically represented on an approved product list or an investment platform menu. The second is differential pricing across different cohorts of clients (for example, advised and non-advised clients).

Differential pricing is an entrenched feature of our economic system and so, it is no surprise to see it manifest itself in financial services.

From here, we can say that differential pricing and the ability to implement it is part of the world of contractual choice in financial services. It allows financial product providers and investment platforms to customise pricing through individualisation of the contractual bargains they enter into.

Of course, appropriate disclosure is likely to be required under the prescribed product disclosure regime in Chapter 7 of the Corporations Act. Further, a complicating dimension is added in respect of products governed under trust law. In some cases, the applicable trust instrument will provide a specific power to issue financial products on different terms, but in many cases, it will not. However, a trustee has an intrinsic ability to offer products on different terms, subject to its duties and powers under the trust instrument and law.

The discussion and analysis below proceeds on the basis that there is no deliberate inflation of the pricing of external products with the intent to create an artificial differentiation between the pricing of in-house products and the pricing of external products, all with the goal of creating a bias towards in-house products. This scenario could, in some circumstances, run counter to certain legal obligations.

We now turn to the different scenarios and legal principles at play.

SCENARIO 1: DIFFERENTIAL PRICING BETWEEN CURRENT AND PROSPECTIVE INVESTORS

Here, differential pricing can apply as follows:

• differential pricing and terms between existing and prospective investors; and
• differential pricing and terms between cohorts of existing investors.

In the former scenario, there is no legal principle that prohibits such differential pricing. Financial products are typically sold via contractual arrangements, as well as through trust structures. It is open to a financial product provider to set different pricing based on different dates of product acquisition, with such pricing being reflective of different costs and market forces.

The latter scenario is trickier territory and usually involves an additional layer of consideration, as the basis for differentiation may not always be apparent. Particularly in the area of financial products governed by trust law, trustees will typically be subject to statutory and general law duties in relation to differential treatment of members, including on the basis of pricing of financial products.

Specifically, the duty of impartiality at general law and the various statutory counterparts may apply, as may the duties of fair or equal treatment that apply to superannuation trustees and responsible entities. For example, in the case of a superannuation fund trustee, the section 52 SIS Act covenants impose obligations on the trustee to act fairly within and between classes of fund members. Similarly, responsible entities of registered managed investment schemes are required, under Chapter 5C of the Corporations Act, to “treat the members who hold interests of the same class equally and members who hold interests of different classes fairly.”

It is crucial to note, however, that the legal dimensions of these duties of impartiality or fairness have often been misunderstood. The duty is expressed as requiring a trustee to treat all members of the same class equally and members of different classes fairly. The point is, however, that the duty should not be construed as imposing an obligation to treat members identically (see commentary cited below) and does not prevent a trustee from applying differential pricing.

First, by definition, differential pricing can exist as between different classes of clients.

But second, the duty should not be construed as requiring the trustee to treat all investors equally in an institutional sense. Rather, the duty is targeted to not advantaging one group of investors at the expense of another group. In other words, where there are legitimate reasons for the differential pricing, such pricing will be consistent with the impartial or fair treatment obligations. For example, the costs associated with administering products for non-advised clients may be lower than the costs of administering the same product for advised clients. Similarly, in many cases, the legacy version of a product will be more expensive to operate as compared to its modern counterpart. It is legally permissible and legitimate for a trustee to take account of these varying costs when determining pricing, without necessarily relying on the necessity of a legal analysis that each of these scenarios involves different classes of investors.

This position is supported by the legal commentary on this topic. For example, in the context of a responsible entity’s duty of fairness under Chapter 5C of the Corporations Act, it is stated that the obligation “is not, presumably, to be treated literally, but is interpreted to mean that members are treated equally having regard to the size of the interests which they hold.”[1] In other words, the duty is to be applied contextually, rather than literally and as mentioned above, reflects a duty of impartiality between investors.

The issue of differential pricing was specifically considered by the Administrative Appeals Tribunal in Re Equitiloan Pty Ltd v Australian Securities and Investments Commission.[2] In that case, Member McCabe commented as follows:

“ASIC says that differential withdrawal fees are objectionable, but I do not agree. Where the fees vary according to the amount invested or the point in the investment term at which the withdrawal is made, there is a clear economic explanation for imposing differential fees.

…

That view proceeds on the assumption there must be an equality of outcomes in every case in order to satisfy the statutory obligation to act equally. That is not necessarily so. If the criteria guiding the discretion are widely known and applied equally to all who seek the benefit of the discretion, and if ASIC can be satisfied:

• • the criteria are directed towards legitimate objectives such as the relief of hardship or inequality; and
  • the criteria will be administered fairly as between members and with integrity,

there is no basis for objection.”[3]

It follows from the above that there is no inherent wrongdoing or breach of obligation or law when it comes to differential pricing, where such pricing is objectively fair, having regard to the relevant circumstances, such as underlying administrative costs.

SCENARIO 2: DIFFERENTIAL PRICING BETWEEN FINANCIAL PRODUCTS

Platform pricing

Differential pricing in this scenario, as mentioned previously, usually occurs in the context of pricing of financial products on platforms or on approved product lists.

We deal with platform pricing first.

Platforms exist in different forms in the superannuation and investment spaces, and non-superannuation platforms are commonly known as IDPSs or wraps.

Where a platform offers a selection of underlying investment options structured as financial products, there is no reason, prima facie, why the trustee cannot set the price of the underlying option. Typically, on the investment menu, some options will be “in-house” and some will be external options.

In the superannuation space, for example, a trustee may have an equitable or statutory duty to obtain the best pricing it can for both investment options issued by its related parties in a corporate group (ie in-house products) as well as those issued by external issuers. This obligation may arise because of an equitable duty to exercise its powers in the best interests of beneficiaries or perhaps equally relevantly, because of the duty to exercise due skill and diligence.

However, there is no legal reason why a trustee would need to price the in-house products on the investment platform otherwise than as its duties dictate. In particular, if it can obtain preferential pricing for “in-house” products over the best price it can negotiate for external products, there is nothing untoward in this outcome (provided disclosure and trust deed requirements are met). In fact, it is an outcome dictated by the fulfilment of its duties. This outcome appears consistent with the concept of fairness and community expectations (to the extent this latter concept is embodied in the former concept).

It is often the case that a platform operator can obtain better pricing for an in-house product because of administration efficiencies inherent in the operation of an in-house product, whereas additional expenditure is often associated with distributing an external product. To assert that this outcome produces product bias is an unscientific and certainly non-legal assertion, and, it is submitted, one which does not flow from the findings of the Royal Commission. In fact, to the extent “value for money” is a theme emerging from the Royal Commission, one would have thought that this outcome is consistent with that theme. For example, a trustee may be able to negotiate more favourable insurance terms and pricing in respect of an “in-house” product, as compared to an external third party product. Here, the lower pricing for the in-house product is passed on to the end investor (ie the retail client).

Legally, it is also important to bear in mind that with pure IDPS offerings, the platform operator has limited equitable duties and therefore, as a matter of law, there is no obvious duty on the operator to negotiate prices to obtain a more favourable financial pricing for customers (ie there is no best interests duty or duty of priority that apply to the platform operator). But even assuming this position, clearly as a commercial imperative, IDPS operators would seek to obtain the best pricing in respect of both in-house and external products – this is inherent in the operation of a competitive marketplace where price acts as a key determinant in investment decisions. It does not follow however that such pricing must be the same across all products.

Approved product list pricing

Similar issues arise in respect of products listed on a provider’s approved product list. Typically, the approved product list of a vertically integrated advice group will also, like a vertically integrated group’s investment platform, contain both in-house and external products. As in the case of a platform, it is often the case that better rates can be negotiated for listed “in-house” products and there is a lower cost base for administering such in-house products.

Where the in-house suite may be cheaper than other external products, the question then arises as to whether the model is flawed due to institutional bias. Much public commentary on this issue focuses on this asserted bias.

This argument seems to confuse, or conflate, the duties of an institution in formulating the approved product list (or the investment menu, as applicable) with the duties and obligations of the entity or person that provides the relevant financial product advice.

The institution may, arguably, have a duty to formulate a list which provides an appropriate selection of product choice for the relevant market. But it is the financial adviser who bears the obligation to advise on the most appropriate product, having regard to the particular client’s personal circumstances. This obligation goes well beyond the pricing of products and extends into product performance, features, risk profile and general suitability to the client’s needs. In the context of differential pricing, it is incumbent on the financial adviser to give due consideration the product pricing (along with other features) to determine the appropriate investment for a client. In other words, while differential pricing is generally permissible, such pricing must be considered when providing financial advice.

While conflicts of interests and institutional bias were important themes in the Royal Commission (along with value for money), it is always necessary to match the theme to the applicable legal obligations. To create a new paradigm on differential pricing based on, for want of better terminology, the “vibe” of the relevant circumstances is ultimately unproductive. The conflation and misconstruction of legal duties that apply to different financial services entities is the source of most of the misunderstanding in this area.

[1] LexisNexis, Australian Corporation Law Principles & Practice, online, at [7.12.0095].

[2] (2003) 45 ACSR 278.

[3] (2003) 45 ACSR 278 at [35].