Regulatory Rumbles: Materiality in the efficiently obligation

Snapshot

The efficiently, honestly and fairly (EHF) obligation in financial services continues in its place as one of the most elusive obligations under financial services law.

We are of the strong view that some degree of materiality has to apply to the “efficiently” limb. This is particularly given its place as a licensee conduct obligation with potentially serious consequences for breach.

We favour the following interrogatory approach:

1. First, range: Ask how many people were impacted by the incident?
2. Second, duration: Ask how long did the incident continue for?
3. Third, identification: How was the incident discovered; e.g. through external factors such as a complaint or an internal factor such as a compliance audit/check (which of itself might be an indication of an efficient ecosystem)?
4. Fourth, cause: Ask what the cause of the incident was. Were the reasons avoidable or unavoidable? Systemic or isolated human error?
5. Fifth, remediation and aftermath: How was the incident dealt with, both in terms of remediation and preventative measures?
6. Sixth, severity: Ask what was the severity and impact of the incident? Was there an unfairness aspect?

Background

As we have discussed in previous articles on the EHF obligation, neither the EHF obligation nor relevant case law offers any real sense of whether a materiality threshold applies. However, an increasingly topical issue for licensees is whether a materiality threshold applies to the “efficiently” limb of the EHF obligation. This is extremely relevant as, without prejudging the answer, if some materiality threshold does not exist, then reports of any inefficiency would seem to be extremely onerous (and impractical).

In this context, the weight of judicial interpretation does seem at the present time to gravitate towards a compendious obligation. This said, in the opinion of the authors, the trend towards a singular, non-compendious obligation is not over (and noting also the reform proposal from the Australian Law Reform Commission to entrench a non-compendious formulation in the legislation).

It is in the context of these developments that we consider the applicability of materiality to the efficiency obligation.

It does stand to reason that some degree of materiality should apply. For example, if in the context of providing financial advice, the vast bulk of statements of advice were issued correctly but only a handful were not, it seems fairly uncontroversial that this would not constitute a breach of EHF, subject to the application of the principle discussed below – namely in this case, was there a very severe impact on the handful of customers affected?

Towards resolution of the applicability of an efficiency materiality threshold

Neither the EHF obligation nor the relevant case law offers any clear sense of whether a materiality threshold applies. A breach of the EHF obligation in this sense is like piercing an invisible veil and licensees are understandably struggling to grapple with this invisible threshold.

In our view, as flagged, it does stand to reason that some degree of materiality should apply, especially having regard to the fact that the EHF obligation is a foundational conduct obligation in financial services law which attracts potentially considerable civil penalties. Such an obligation can surely not have been intended to capture, for example, isolated errors and delays, but, as mentioned above, rather focused on matters of a more systemic nature that the licensee could and should have prevented. While any assessment under the EHF obligation will look to the processes that a licensee has in place and not be focussed solely on outcomes, regard must also be had to the consequences of conduct. In some cases, it may also be relevant to consider any neutralising impact of remediation or rectification measures that have been implemented by a licensee. This position is supported by recent case law in the Federal Court which accepts that the standard is not a standard of perfection.[1] Given perfection is not required, this seems to automatically import some room for “slippage” and a threshold of materiality.

We attempt to draw out some of these considerations below:

• Does the conduct have a severity or aggravation factor? We described this principle in a previous EHF article in the following terms:

“…Does the conduct have an “aggravation” element, which would be more likely to be interpreted by a court as a breach of the fairness criterion; such as whether either a harsh outcome of a bad motivation/purpose (e.g. bad faith) can be seen to characterise/taint the incident?”

This is relevant as in our view, a court is less likely to concede a materiality threshold to the efficiency obligation if various types of aggravated conduct are present.

Some examples of aggravated conduct might be:

1. 1. systemic failure to perform trustee services efficiently (i.e. a frequency test); and
   2. repeated inefficient conduct which is identified (or should have been identified and is not addressed).

• How many clients were impacted? The efficiency limb of the EHF obligation would have regard to questions like this, which are sometimes more ambiguous than questions centred around the honesty and fairness limbs. For example, what is the reasonable expected standard of performance? Are we more concerned about the total number of clients impacted (e.g. 10 clients) or the total proportion of clients impacted (e.g. 10%)? Potentially it depends on the impact to the relevant cohort, and the extent to which such number or proportion is reflective of a more systemic and enduring error.[2]
• What was the level of harm? For example, a bulk of statements of advice were issued correctly to clients but only a handful were not. While it may seem uncontroversial that this would not be a breach of the EHF obligation due to the total number or proportion of members impacted, it may be if there was a severe impact on the handful of members affected. Alternatively, if there is no member impact or the incident has been remediated such that there is no resulting impact, this may point towards there not being a breach of the EHF obligation (but noting such conclusion cannot be reached focussing solely on outcomes and regard should be had to other factors).
• Was the incident avoidable? The EHF obligation is not one of strict liability.

Non-compliance is dependent on whether all necessary steps were taken to ensure the relevant financial services were provided efficiently, honestly and fairly. In the vast, vast majority of cases, there will of course be steps that could have been taken to avoid the conduct.

So in this sense, the use of this principle to de-identify conduct from being a breach of the EHF obligation is not going to happen very often. It might occur where the necessary controls were in place to avoid a breach of the EHF obligation, but some uncontrollable or unforeseeable event occurred which thwarted those controls. Isolated human error is one example of this principle/factor.

Further, were there ways to prevent the breach, such as controls or systems? Were there Board deliberations/intervention which could have been put in place?

In ASIC’s Report 740 Insights from the reportable situations regime: October 2021 to June 2022 (REP 740), ASIC has expressed concern that licensees are inappropriately categorising the root cause of an incident as ‘human error’. Where the root cause of an incident is human error, the implication is that such an incident could not have been avoided by the licensee. It is important to assess instances of human error and whether they are reasonably foreseeable/ preventable versus unavoidable, as this will contribute, in our view, to whether the incident could have and should have been prevented by the licensee (e.g. through a system or other control). In turn, this will also impact upon any analysis under the EHF obligation.

• Has any loss been remediated? The recent case of ASIC v NAB[3] handed down on 7 November 2022 supports the position that the existence or otherwise of a reasonably suitable remediation program can be relevant to whether a financial service has been provided in accordance with the EHF obligation, notwithstanding that remediation activity is not, itself, a financial service:

It would be an unduly restrictive reading of the section if the “service” referred to excluded the steps to be taken if a service has been defectively performed. A “service” is not merely the performance of an act, but includes the terms of the arrangement under which the act is performed, for example that it should not be done with gross negligence. There is merit in the view that unless and until the service has been provided in full and properly according to the arrangement, it has not been provided.[4]

Consequently, consideration can be given to the potentially neutralising impacts of a remediation program, including preventative measures, where such remediation program has been or is being developed to compensate clients who have suffered loss, or otherwise remedy an issue.

• How serious was the conduct? More egregious breaches may attract the honesty and fairness limbs, for example, a bad motivation/purpose (e.g. bad faith). Examples include breach of good faith, acting for an improper purpose, and acting unconscionably. Alternatively, breaches that are more trivial or smaller in nature, for example, a one-off mistake, may not meet the materiality threshold:

[the EHF obligation] does not require commercial perfection whereby any possibility of error or mistake is eliminated. It is most unlikely that the legislature intended that the imposition of penalties could be incurred merely because, from time to time, employees mistakenly enter data into the bank’s computers.[5]

• If several incidents occur that could each, in their own right, be considered a breach of the efficiently obligation, can they be aggregated so that they can be seen to be one breach?

In our view, yes, where such breaches arise from the same pattern of conduct. ASIC in Regulatory Guide 78: Breach reporting by AFS licensees and credit licensees (RG 78) outlines that when there are several incidents arising from a single, specific root cause, these incidents can be aggregated and notified to ASIC in the one report.[6] However, as noted above, ASIC in REP 740 has expressed concerns around how adequately licensees are identifying and addressing underlying root causes of aggregated breaches.

Community (client) expectations

Finally, could a court’s interpretation be influenced by community expectations? That is, would a reasonable client expect a certain degree of “slippage” in the conduct of the licensee’s business.

A parallel occurred in ASIC v Commonwealth Bank of Australia[7] where the Court said:

ASIC submits that the ordinary or reasonable customer would know from the notation on the customer account statement that CBA had charged a fee… However, this ignores another alternative, being that a reasonable understanding of the ordinary and reasonable customer is that the fee has been or, at least, might have been charged in error.

The members of those classes of customers who entered a contract with CBA in relation to the relevant accounts are likely to be taking reasonable care of their own interests. They are also likely to have had their own personal experiences of, or otherwise be aware that there is at least some prospect of, computer systems malfunction, software design errors, and human error in relation to data input. They would be aware that CBA’s systems are computerised and that CBA’s processes involve human interaction with those systems.

Further, the ordinary and reasonable customer would not view a customer account statement as an invoice, but as a record of transactions that have occurred on the account.[8]

This concept of the EHF obligation evolving with community expectations has also received previous support, with Allsop CJ (as he then was) commenting:

With respect, I prefer to view s 912A(1)(a) as enshrining a statutory norm to be read conformably with s 760A and the other provisions of the Corporations Act and the ASIC Act, of course to be applied to an infinite variety of corporate delinquency and self-interested commerciality. But to say this is not to deny that it may implicitly pick up some aspects of what some might identify as social and commercial norms, although reasonable minds might differ as to where to ground such an otherwise free-floating concept.[9]

Note to our readership

This article synthesises (but adds significantly to) our previous articles on the EHF obligation where we addressed materiality in a more generic context around the EHF obligation.

You will find these articles on our HSF FSR Australia Notes. The following are the relevant links:

https://hsfnotes.com/fsraustralia/2020/08/17/fsr-gps-efficiently-honestly-and-fairly-in-practice/

https://hsfnotes.com/fsraustralia/2020/08/31/fsr-gps-efficiently-honestly-and-fairly-in-practice-part-ii/

https://hsfnotes.com/fsraustralia/2022/11/08/efficiently-honestly-and-still-fairly-uncertain-the-quest-for-certainty/

 

[1] ASIC v NAB [2022] FCA 1324.

[2] [2022] FCA 1324, [360].

[3] [2022] FCA 1324.

[4] [2022] FCA 1324, [372].

[5] [2022] FCA 1324, [357].

[6] RG 78.112.

[7] ASIC v Commonwealth Bank of Australia [2022] FCA 1422.

[8] [2022] FCA 1422, [85] and [87]-[89].

[9] ASIC v Westpac Securities Administration Ltd (2019) 272 FCR 170, [173].