Regulatory "Rinkles" – Spotlight on Transitional Issues for Grandfathered Conflicted Remuneration

This edition of Regulatory Rinkles follows on from our previous edition on Spotlight on Conflicted Remuneration and focuses on the transitional issues facing product issuers and advice licensees who are looking to end or deal with their existing grandfathered arrangements before the grandfathering exemption is removed from 1 January 2021.

LEGISLATIVE BACKGROUND - THE END OF FOFA GRANDFATHERING

The current exemption from the ban on conflicted remuneration enjoyed by many grandfathered arrangements will be removed from 1 January 2021, following the enactment of the Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Act 2019 (Cth) (EGCR Act)[1] and the Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Regulations 2019 (Cth) (EGCR Regulations).[2]

Section 1528 of the Corporations Act 2001 (Cth) (Corporations Act) has been amended to provide that, from this date, the prohibition on conflicted remuneration will apply:

“…to a benefit given on or after 1 January 2021 to a financial services licensee, or a representative of a financial services licensee, if the benefit is given under an arrangement entered into before, on or after the application day” (emphasis added).

The “application day” is 1 July 2013, which is the date from which compliance with the FoFA package of legislation that introduced the prohibition on conflicted remuneration became mandatory.

It should be noted that a new “pass-through” regime will co-exist with the prohibition on the payer continuing to pay the relevant conflicted amounts and the recipient continuing to receive those amounts, provided the amounts are passed through to product holders under the requirements of the pass-through scheme (see below).

It should also be noted that the amending legislation does not remove the separate life insurance (or LIF) grandfathering exemption that is provided under section 963B of the Corporations Act for life products entered into, or applied for, prior to 1 January 2018. This exemption is due to be reviewed by ASIC in 2021, but continues for the time being.

PASS-THROUGH SCHEME FOR PAYMENTS OF CONFLICTED REMUNERATION

Introduction

To help mitigate the effects of the end of the grandfathering regime on persons who are legally obliged to continue to pay monies or other benefits under existing contractual arrangements after 1 January 2021, which will now be banned conflicted remuneration, the Corporations Regulations 2001 (Cth) have been amended to provide for a scheme for these benefits to be paid to the ultimate product holder.

In essence:

• product holder rebates must be provided within a year of the obligation to pay conflicted remuneration arising; and
• the amount to be rebated must be objectively “just and equitable” in the circumstances, and can be paid as an amount of money directly to the product holder or by providing some other benefit, such as reducing a fee the product holder is liable to pay.

It should be noted that the pass through scheme applies only to conflicted remuneration for the purpose of section 963A of the Corporations Act. It does not apply to volume-based shelf-space fees that are prohibited under section 964A of the Corporations Act, and in respect of which the EGCR Act will also end the current grandfathering regime from 1 January 2021.

The “just and equitable” requirement

The term “just and equitable” as used in the EGCR Regulations is not defined, but the concept may usefully be compared to other similar statutory legislative concepts, such as the “fair and reasonable” requirement under the superannuation regulations in relation to a superannuation trustee’s obligations when charging fund expenses to members.[3]

EGCR Regulation 7.7A.15AK(3) provides that certain matters must be taken into account when determining whether amounts to be paid are just and equitable, as follows:

• the amount of conflicted remuneration that would have been payable;
• the amount invested by each product holder in the financial products. The Explanatory Statement to the EGCR Regulations notes, not surprisingly, that the larger the investment, the larger the rebate should be;
• the structure of the fees that the product holders have paid in respect of the financial products. The Explanatory Statement states this is relevant to whether the product holder has incurred the cost of the conflicted remuneration;
• the extent to which the amounts to be paid and the amount of benefits to be provided to product holders equals the amount or present value of the conflicted remuneration paid; and
• any other relevant matters, but noting that the Explanatory Statement states that a lack of information or records is not a relevant matter that can be taken into account.

The Explanatory Statement provides the following additional guidance on the assessment of what is just and equitable:

• in recognition of the practical difficulties that can be inherent in the process of calculating the amount of conflicted remuneration paid, the total aggregate amount of the rebate need not exactly match the conflicted remuneration that would otherwise have been paid, but must closely match it;
• in practice, overcompensation will generally be expected as it is expected that the situations where it would be just and equitable to rebate less than the conflicted remuneration paid will be rare;
• where the cost of conflicted remuneration has been spread out across an entire cohort of product holders, but the conflicted remuneration only relates to advice provided to a smaller cohort of product holders, it will be just and equitable to provide a rebate to the entire group of product holders;
• in some situations, it may be appropriate to pay a one-off lump sum to clients to reflect the present value of future conflicted remuneration. However, this is unlikely to be just and equitable if there is uncertainty about the total amount of conflicted remuneration to be paid over the period the product is held;
• the costs of rebating the monetary benefit back to product holders (such as the administrative costs involved) cannot be taken into account in determining whether an amount is just and equitable; and
• there may be situations where a product holder holds a financial product on behalf of another product holder, in which case it is expected that the ultimate owner of the product will receive the benefit of the rebate.

Some additional observations

• As the rebate obligation applies to “covered persons” under the EGCR Act, the obligation can apply not only to product issuers but also to licensees who pay benefits to their representatives.
• While primarily concerned with the rebate of monetary benefits, the regime will extend to cover non-monetary benefits as well (given that it relates to conflicted remuneration). This flows from:
  • the definition of section 963M(1)(a) of the Corporations Act, relating to a person who is legally obliged to give conflicted remuneration on or after 1 January 2021; and
  • section 963N(1) of the Corporations Act, whereby a covered person must pay amounts or monetary benefits based on the conflicted remuneration.
• Determining the amount of a non-monetary benefit to be rebated will presumably require a valuation of that benefit to be made, which can then be converted into an amount which satisfies the “just and equitable” criterion.
• In relation to record keeping, it is beyond the scope of this article to canvas all the stipulated record keeping objections but in general terms, records will need to be maintained in order to show:
  • how the just and equitable assessment has been made, including assessments of the amounts of conflicted remuneration paid; and
  • compliance with the requirement to pay rebates within 12 months of the obligation to pay the conflicted remuneration arising.

OPTIONS AND TRANSITIONAL ISSUES FOR GRANDFATHERED ARRANGEMENTS

Product issuers and licensees have the following options (among others) to deal with their existing grandfathered arrangements:

• rely on provisions in existing contractual agreements that have the effect of permitting the relevant party to cease the payment of grandfathered remuneration from 1 January 2021, such as provisions that provide that payments can cease where change in law will make such payments prohibited, or where payments can be varied and reduced to nil. It is unlikely that a party will be able to assert that the prohibition results in the arrangement being terminated through the doctrine of frustration (however, this will ultimately be a question of construction);
• where the above types of contractual provisions do not exist, then the parties may instead agree a variation that removes the contractual right to pay conflicted remuneration. Both parties will have the same interest in avoiding being exposed to the prohibition from 1 January 2021, given that it applies to both the payment and receipt of conflicted remuneration;
• where there is an ongoing contractual obligation to pay grandfathered remuneration that is not varied and does not automatically cease by these payments becoming prohibited, or there is a commercial desire to continue to pay notwithstanding any contractual rights to the contrary, then a product holder rebate scheme may be used;
• seek to render the payments non-conflicted by relying on applicable exemptions under the Corporations Act, or by relying on no-action positions from ASIC (see below);
• alternatively, seek to render the payments non-conflicted by negating the relevant influence element, thereby taking the payments outside of the definition of conflicted remuneration; and
• product issuers may wish to stop making grandfathered payments ahead of the 1 January 2021 date, by making lump sum accelerated payments to reflect payments that will become due up to 31 December 2020. Although this gives rise to certain legal issues that need to be navigated, they can be addressed with proper planning.

ENDING GRANDFATHERED PAYMENTS EARLY

The risk in attempting to agree the amount of an early lump sum payment, assessed up to 31 December 2020, is that this amount may well be inaccurate and so be either:

• an underpayment of the amount due, in which case the product issuer may be obliged to make a corrective payment before it becomes unlawful to do so from 1 January 2020, which may well be commercially unattractive; or
• an overpayment of the amount due, in which case the licensee will need to reimburse any overpayment.

At present, any overpayment would create the risk that each party would, at the time of the making and receipt of the overpayment, be in breach of the conflicted remuneration provisions of the Corporations Act as these amounts would be in excess of the grandfathered payments.

One solution to this problem would be for the parties to enter into a deed of variation which provides for a lump sum advance payment to be made at the nominated date that is assessed at a level that is a slight overpayment of its assumed liability as at 31 December 2020, so long as the parties agree to amend their existing arrangement to provide that:

• the payment does not fall due to be paid until 31 December 2020;
• the advance payment is an agreed estimate of this liability; and
• the parties agree a process by which the final total amount due will be assessed immediately prior to 31 December, with the licensee remitting the relevant balance due prior to that date.

An alternative, if a formal deed of variation is not practical, would be to rely on the broader concept of consent by the licensees to the variation and the arrangements by way of acceptance of them through the conduct of accepting the accelerated payment.

In our view, a variation to an original agreement that is required to give effect to either scenario is unlikely to constitute a new, non-grandfathered agreement.

ALTERNATIVE CHOICES AVAILABLE

Of course, a clear choice open to a payer of grandfathered conflicted remuneration is to transform conflicted payments into non-conflicted payments. As mentioned above, this could be done by either relying on existing exemptions in the Corporations Act (including for present purposes, no-action positions from ASIC, which include its pronouncements made in ASIC RG 246) or by taking the payments outside of the conflicted remuneration regime by negating the influence on the provider of the financial product advice.

In our view, where this is done appropriately and for a proper purpose, it will not amount to a breach of the anti-avoidance provisions in section 965 of the Corporations Act.

Using existing exemptions and no-action positions

For example, consider the following scenarios where money is currently paid by a product provider to a licensee under a grandfathered arrangement:

• The payment is retained by the licensee

Where the licensee passes on all the benefit of the payment to the relevant clients, then this is unlikely to be conflicted as the influencing effect of the payment is removed.[4]

• The payment is paid from the product issuer’s pockets but it is restructured so that it is paid by the client from the client’s monies

In this scenario, it is submitted that this is not anti-avoidance and would be outside of the concept of conflicted remuneration where the so-called client paid exemption is used (as provided for in section 963C(1)(d) of the Corporations Act).

What about a situation where the payment is made by a provider in circumstances where personal advice has been given by the product issuer? Section 963B(1)(c) of the Corporations Act exempts the making of payments given in relation to the issue or sale of a financial product so long as the relevant retail client has not received any financial product advice in the 12 months preceding the payment being made.

Leaving aside the issue of whether reliance on an exemption is outside the reach of an anti-avoidance prohibition, it is submitted that the structuring of payment obligations to take advantage of this exemption is permissible and should not be anti-avoidance. That said, as always, each situation will need to be considered on its own facts.

Rendering the payments non-conflicted

The core of the conflicted remuneration prohibition is the definition of the term contained in section 963A of the Corporations Act which, as we know, refers to benefits, which because of either the nature of the benefit or the circumstances in which the benefit is given, could reasonably be expected to influence the choice of financial products recommended by the licensee or representative to clients ,or could reasonably be expected to so-influence the financial product advice given.

Completely neutralising influence on an adviser is harder than it might appear, particularly since the conflicted remuneration regime does not contain, or allow, any concept of materiality.

In practice, this means that when influence could exist, rigorous controls would need to be put in place to neutralise any potential influence. This could include:

• independent research as to the quality of the products being recommended;
• training of advisers about the primacy of their best interests obligations under the Corporations Act, including prioritising the interests of clients;
• file recording and auditing to ensure compliance; and
• remuneration elements to disincentivise non-compliant behaviour.

[1] A link to the EGCR Act is here.

[2] Treasury Laws Amendment (Ending Grandfathered Conflicted Remuneration) Regulations 2019 (Cth) (link here), which introduce new provisions into the conflicted remuneration regime contained in Division 4 of Part 7.7A of the Corporations Regulations 2001 (Cth).

[3] See regulation 5.02 of the Superannuation Industry (Supervision) Regulations 1994 (Cth). It is also further evidence of the prevalence of a fairness doctrine in financial services law, as we have previously commented on here.

[4] See ASIC RG 246 at 246.95.