Australia: Part II - Prohibited Payments
Future of Financial Advice

2.1 Conflicted remuneration and volume-based shelf-space fees

AFS licensees participate in one way or another in arrangements with other licensees and/or their representatives. Invariably, some of these arrangements will provide for payments or receipts which from 1 July 2013 are prohibited under FOFA, either because they represent the payment/receipt of "conflicted remuneration", and/or the receipt of "volume-based shelf-space fees".

Conflicted Remuneration

Conflicted remuneration is any benefit (monetary or soft-dollar), given to a licensee/representative who provides financial product advice to a retail client, that could reasonably be expected to influence the choice of financial product recommended or the advice given to the retail client.²⁵

FOFA imposes a prohibition on both a licensee/representative accepting conflicted remuneration, and an issuer/seller providing conflicted remuneration.²⁶ In addition, FOFA expresses a presumption that a volume-based benefit is conflicted remuneration.²⁷

The prohibition is primarily targeting adviser trail commissions and rebates. Exceptions to the prohibition include the following:²⁸

• benefits given solely in relation to insurance products, except group life policies and life policies for default members (ie these last items are caught by the prohibition).
• benefits given by the retail client.
• soft-dollar benefits less than $300 and which are infrequent.
• soft-dollar benefits for genuine training/education purposes or for IT support, and which are relevant to the provision of financial services.

Note the ban on conflicted remuneration currently applies where "financial product advice" is provided: that is, it applies even when merely general advice is provided. The Coalition proposes, however, to limit the ban on conflicted remuneration to personal advice.

Volume-based shelf-space fees

Where an AFS licensee (referred to as a platform operator for the purposes of the prohibition) provides a custodial arrangement, a benefit is given by a fund manager to the platform operator, and a financial product to which the custodial arrangement relates is a product in which the fund manager deals, then that benefit is prohibited if it is a volume-based shelf-space fee. ²⁹

FOFA prohibits the platform operator from accepting the volume-based shelf-space fee.³⁰

Section 964 is a complicated provision on its face. In simple terms, however, it is attempting to deal with the situation comparable to where food distributors pay more to have their products on preferential shelving in supermarkets (ie they buy "shelf space"). In the financial services context, it is referring to the situation where product manufacturers pay more to have their products listed on platforms or APLs.

Flat fees are not volume-based, and so are not caught by the prohibition.

There are some exceptions to the prohibition, however, as follows:³¹

• reasonable fees for service provided to the fund manager by the platform operator. The scope of this exception appears clear on its face.
• discounts/rebates paid to the fund manager, the value of which do not exceed an amount that may reasonably be attributed to efficiencies gained by the fund manager because of the number or value of financial products in relation to which the fund manager provides services to the platform operator.

Note the prohibition makes reference to a "custodial arrangement", which is defined for these purposes to have "the same meaning as it has in [section] 1012IA [of the Corporations Act]...". ³²

"Custodial arrangement" is defined in section 1012IA to mean:

"an arrangement between a person (the provider) and another person (the client) (whether or not there are also other parties to the arrangement) under which:

1. the client is, or is entitled, to give an instruction that a particular financial product, or a financial product of a particular kind, is to be acquired; and
2. if the client gives such an instruction, a person (the acquirer), being the provider or a person with whom the provider has or will have an arrangement, must (subject to any discretion they have to refuse) acquire the financial product, or a financial product of that kind; and
3. if the acquirer acquires the financial product, or a financial product of that kind, pursuant to an instruction given by the client, either:
4. 1. the product is to be held on trust for the client or another person nominated by the client; or
   2. the client, or another person nominated by the client, is to have rights or benefits in relation to the product or a beneficial interest in the product, or in relation to, or calculated by reference to, dividends or other benefits derived from the product."

In simple terms, a custodial arrangement arises where a client is entitled to give instructions to a provider to acquire a particular financial product, and the provider must acquire that product, subject to any discretion they have to refuse to acquire that product. It typically encompasses "wrap"-style products and Investor Directed Portfolio Services (often referred to as "IDPSs")

Grandfathering

FOFA, however, grandfathers to some extent the provision/receipt of conflicted remuneration and volume-based shelf-space fees which would otherwise be prohibited, if they are given under an "arrangement" entered into before 1 July 2013.³³

What is an "arrangement"?

"Arrangement" is defined in section 761A of the Corporations Act to mean:

"...a contract, agreement, understanding, scheme or other arrangement (as existing from time to time):

1. whether formal or informal, or partly formal and partly informal; and
2. whether written or oral, or partly written and partly oral; and
3. whether or not enforceable, or intended to be enforceable, by legal proceedings and whether or not based on legal or equitable rights."

This definition is very broad, with the consequence that it can be satisfied in a broad range of circumstances. The words "(as existing from time to time)" suggest that changes can be made to an existing arrangement with the effect that a new arrangement is formed. This leads to the question as to what type of changes are required in order for a new arrangement to be formed.

With this in mind, one can already see that it is crucial that an analysis of all existing payment arrangements in which an AFS licensee participates with other licensees and/or representatives is undertaken to determine which of those falls within the meaning of an "arrangement" under the Corporations Act. Once those arrangements are determined, it is necessary to assess which payments/receipts under those arrangements are at risk of losing grandfathering in the event that changes are made on and from 1 July 2013 such that it could be said that a new arrangement then arises. Where this occurs, all prohibited payments/receipts must cease in relation to that new arrangement.

What is the scope of the grandfathering concession for pre-1 July 2013 arrangements?

The proposed legislation governing the grandfathering of existing arrangements has taken many forms, and has been extremely confusing in a number of respects. Accordingly, it is helpful to survey how the grandfathering provisions have evolved to where they sit today.

Prior to March 2013, the legislation operated to widen the scope of the grandfathering concession considerably. For example:

? Industry was advised in late 2012 that draft regulations released in July 2012, which had the effect of removing grandfathering protection for conflicted remuneration paid in relation to new financial products acquired post-1 July 2013, would not be proceeded with. On this basis, all payments made pursuant to pre-1 July 2013 arrangements - even where they relate to a new financial interest acquired post-1 July 2013 - could continue to be grandfathered. ? draft regulations, which were issued in September 2012, would allow "platform operators" to grandfather existing arrangements under which conflicted remuneration is paid. Prior to these draft regulations, the legislation as it then stood prevented a platform operator from being able to grandfather existing arrangements, meaning that all payments of conflicted remuneration to a platform operator and receipts from a platform operator would need to cease on and from 1 July 2013.

On the basis of the above, all prohibited payments/receipts of conflicted remuneration and volume based shelf-space fees pursuant to existing arrangements could continue post-1 July 2013, for so long as those existing arrangements continued on foot.

So what's changed?

In March 2013, further draft regulations were released for consultation, which operated to narrow the scope of the grandfathering concession in relation to conflicted remuneration.

The draft regulations proposed the following:

• where benefits are given by a "platform operator", grandfathering will only apply to the extent that the payment is made under a pre-1 July 2013 arrangement, and which relate to a "custodial arrangement" provided by the platform operator on the instruction of a person, whhad given the instruction prior to 1 July 2014.
• where benefits are given by someone other than a platform operator, grandfathering will only apply to the extent that the payment is made under an existing (ie pre-1 July 2013) arrangement, and in relation to the acquisition of a financial product by a retail client who did not have an interest in the product immediately before 1 July 2014.

In simple terms, the draft regulations aimed to apply the ban on conflicted remuneration to new financial products acquired by retail clients post-1 July 2014. To the extent that conflicted remuneration is to be paid in relation to a pre-1 July 2013 arrangement, those payments can only continue to be made to the extent that they relate to financial products held by retail clients as at 30 June 2014.

The regulations were formally enacted on 28 June 2013, but with some technical changes.

The regulations as they now stand provide the following:₃₄

• where a "platform operator" acts in that capacity and gives a benefit which relates to an acquisition of a financial product on the instructions of a client, the benefit will be grandfathered only if the client has given the platform operator an instruction to open an account on the platform before 1 July 2014. In other words, grandfathering will apply only in relation to existing clients or clients who apply to open an account on the platform before 1 July 2014.
• where a benefit is given by someone not acting in the capacity of a platform operator, and it is given in relation to the acquisition of a financial product for the benefit of a retail client, the benefit will be grandfathered only where the product is acquired before 1 July 2014.

In very general terms, the regulations appear to provide that grandfathering:

• will apply in relation to pre-1 July 2014 financial products acquired by pre-1 July 2014 clients;
• will not apply in relation to post-1 July 2014 financial products acquired by post-1 July 2014 clients;
• will apply in respect of post-1 July 2014 financial products acquired by pre-1 July 2014 clients, but only where the benefit in question is provided by a platform operator.

In all cases, for any form of grandfathering to apply, the arrangement in question (ie under which the benefits are provided) must be a pre-1 July 2013 arrangement.

The regulations also clarify that the following will not be treated as an acquisition of a financial product post-1 July 2014:

• a retail client has an interest in a managed investment scheme pre-1 July 2014 and acquires a further interest in it post-1 July 2014;
• a "multi-product offering" offers interests in more than one financial product under one offer document, and a retail client opened an account on the multi-product offering pre-1 July 2014 and acquires an interest or a further interest under the facility post-1 July 2014.

There are some further rules, dealing with provision of benefits to employees under enterprise agreements, and separate rules which clarify other technical aspects of the reforms.

The new regulations also appear to suggest that benefits given by a platform operator but which do not relate to the licensee acting as a platform operator for the acquisition of financial products (for example, marketing or sponsorship payments), will not have any grandfathering protection.

What is the scope of an "arrangement"?

Refer to the following by way of a simple example:

The above represents a set of relationships commonly found in the industry, in which the product issuer pays a volume-based rebate to a dealer group, which in turn remunerates its financial advisers. Each of the product issuer and the dealer group is an AFS licensee. The financial advisers would either be authorised representatives of the dealer group, or AFS licensees in their own right.

A number of "arrangement" scenarios can arise above. For example:

• The most common (or likely) scenario is that there are two separate groups of "arrangements" in place here for FOFA purposes: there is one "arrangement" between the product issuer and the dealer group; separately, there are individual "arrangements" between the dealer group and each financial adviser under the dealer group's coverage.
• It could also be the case that the above encapsulates one global "arrangement", involving the product issuer, dealer group and financial adviser. This could be the case even if there were separate agreements between the product issuer and the dealer group, and between the dealer group and a financial adviser: the terms of the agreement themselves do not necessarily limit the scope of an "arrangement", particularly if, for example, the one agreement expressly contemplates the same payment flowing between the product issuer and the financial advisers and provides a regime for the flow of monies between the three groups of entities.
• Also, it could be the case that the product issuer and the dealer group have multiple arrangements between them: for example, if there were separate contractual agreements between them, each of them dealing with a specified product or class of products. Alternatively, there may be one agreement encapsulating every product issued by the product issuer (and all future products).

In considering the potential breadth of an "arrangement", it is useful to consider the entity to which benefits are being provided. This will more often than not assist in determining the participants in an arrangement, and the payments underpinning it. However, we should be mindful of the following:

1. A does not give a benefit to C merely because A gives a benefit to B who, in turn, gives the benefit or a benefit to C. In such a case, it is likely that there are two separate groups of "arrangements" in place here for FOFA purposes: one between A and B; the other between B and C.
2. A's mere awareness that B may or does distribute the benefit it receives to C does not mean that A itself gives a benefit to C.
3. If A positively participates in the broader distribution of the benefit it gives, for example by making payments to C at the direction or request of B, the outcome could well be different. This may well be an example of the global "arrangement" referred to above, involving the product issuer, dealer group and financial adviser. This could be the case even if there were separate agreements between the product issuer and the dealer group, and between the dealer group and a financial adviser: the terms of the agreement themselves do not necessarily limit the scope of an "arrangement".

Following the above, can we develop a simple proposition of law?

Putting the analysis simply, a proposition of law could be adopted to provide that an "arrangement" for FOFA purposes may be scoped by reference to the relevant agreement/document (for example, a contract or client application form), series of agreements/documents, set of circumstances or courses of dealing (particularly where there is no oral or written contract) under which a licensee's or authorised representative's entitlements to conflicted remuneration or volume-based shelf-space fees are derived, and under which those entitlements are expressly or impliedly contemplated.

Ultimately, and as can be seen from the above analysis, it is question of fact as to what arrangements are in place at any given time. These need to be assessed on a case-by-case basis.

What are examples of "arrangements"?

At a high level, "arrangements" would include at least the following:

• Rebate agreements
• Service agreements
• Client application forms
• SoAs
• Employment contracts.

What gives rise to a "new" arrangement?

Any proposed changes to existing arrangements on and from 1 July 2013, such that it could be said that a new arrangement then arises, will cause existing grandfathering to be lost, meaning all prohibited payments/receipts under that arrangement must cease.

The relevant question, then, is the scope to which an existing arrangement can be modified without causing a new arrangement to arise. Of course, and by necessity, this will need to be assessed on a case-by-case basis, which makes it difficult to develop broad guidelines which can be applied against every fact scenario.

In undertaking such an assessment, we would need to consider elements such as:

• contractual obligations;
• contractual rights;
• course of dealing/patterns of conduct;
• performance;
• flows of payments/benefits etc...

In view of the above, query whether, when and how a new arrangement might arise in any of the following circumstances:

Adding a new product or class of products

Does adding a new product to an existing contractual arrangement, without other amendments, and where that arrangement contemplates more than one product, give rise to a new arrangement? Alternatively, is it possible that a new arrangement might arise solely in relation to the new product?

New clients

Will a new arrangement between the following entities in any of the following scenarios arise:

• Between a product issuer and a dealer group in relation to the payment of conflicted remuneration when a client is signed up by the dealer group post-1 July 2013, when the arrangement extends to all clients of the dealer group?
• Between a product issuer and a financial adviser / representative, in relation to the payment of conflicted remuneration when a client is signed up by the adviser/representative post-1 July 2013, when the arrangement extends to all clients of the adviser/representative?
• Between a dealer group and an individual adviser/representative in relation to the payment of conflicted remuneration when a client is signed up by the adviser/representative post-1 July 2013, when the arrangement extends to all clients of the adviser/representative?

Amending rebate amounts

Will amending the amount of a fee/rebate payable under an arrangement, without other amendments, give rise to a new arrangement? What if the quantum of the change is from 25 basis points (bps) to 30 bps? What about where the change is from 25 bps to 200 bps? What if the change is a decrease in fees?

Mergers/takeovers by licensees

Does a new arrangement arise in the event that an AFS licensee merges with, or is taken over by, another AFS licensee? What about the case where – following a merger/takeover – the licensee in question either ceases to exist as an entity or ceases to hold a financial services license?

Establishing new platforms or restructuring existing platforms

Does the establishment of a new platform, or the restructure of an existing platform, give rise to a new arrangement?

New licensees/representatives

Will a new arrangement arise when relationships with new licensees/representatives are formed (whether in writing or otherwise)? For example:

• A dealer group enters into an arrangement with a new adviser/representative for the payment of trail commissions.
• A fund manager enters into a rebate contract with a new dealer group.

Greater contractual obligations

Will a new arrangement arise when an existing contract is amended to insert new provisions which have the effect of imposing greater obligations on a party than was previously the case?

New payment regime

Will a new arrangement arise when an existing contract is amended to insert a new payment regime which alters the nature and form of the payment obligations under the existing contract (ie goes beyond merely changing the amount of a payment), and which was not contemplated by the existing contract?

In view of the above, it is important for AFS licensees to have adequate guidelines in place against which changes to existing arrangements, or the entry into new arrangements, can be assessed to determine whether they give rise to adverse FOFA impacts (for example, the loss of grandfathering).

Legal advice should be obtained on the FOFA risks of proposed changes to existing arrangements, or the entry into new arrangements. Existing processes will need to be updated to incorporate a legal review of proposed changes to existing arrangements, or the entry into new arrangements.

2.2 Asset-based fees on borrowed amounts

Section 964D(1) of the Corporations Act provides that an AFS licensee:

Section 964E(1) imposes the same prohibition on representatives of licensees.

The prohibition applies where an AFS licensee (or a representative) provides financial product advice to a retail client.³⁵ Therefore, it applies where general advice and/or personal advice is provided (ie not just personal advice).

An "asset-based fee" is defined as follows:³⁶

The other relevant term is "borrowed", which is defined to mean:³⁷

It also provides that an amount is no longer "borrowed" to the extent that it has been repaid.

What is the prohibition trying to target?

Any fees charged by a licensee/representative (as applicable), which has provided financial product advice to a retail client, on borrowed amounts used by the client to acquire financial products, are banned from 1 July 2013.

In short, the ban is targeting fees such as contribution fees and adviser service fees / member advice fees, to the extent that they are charged on the borrowed/geared portion of funds used to acquire financial products.

The ban applies to both upfront fees (eg contribution fees), and ongoing fees (eg annual member advice fees).

The ban does not apply to such fees charged on ungeared portions of funds used to acquire financial products.

The ban also does not apply:

• to wholesale clients;
• if it is not "reasonably apparent" that the amount has been borrowed.³⁸ Note, however, there is an express provision which states that none of the rules affect the duty of the licensee/representative to make reasonable enquiries to obtain complete and accurate information.³⁹ This suggests some overlap with the "best interests" duty; and
• to the extent that the borrowed amount has been repaid.⁴⁰

Is grandfathering available?

Section 1531(1) of the Corporations Act provides that the prohibition only applies to the extent that the borrowed amounts (on which the asset-based fees are charged) are used to acquire financial products on or after the "commencing day" (which is 1 July 2013 for the AFS licensee). In other words, to the extent that the asset-based fees are charged on borrowed amounts used to acquire financial products prior to 1 July 2013, the ban will not apply. This is so even if the fees are charged post-1 July 2013.

Footnotes

²⁵Section 963A.
²⁶Sections 963E - 963K.
²⁷Section 963L.
²⁸Sections 963B and 963C.
²⁹Section 964.
³⁰Section 964A(1).
³¹Section 964A(3).
³²Section 964(2).
³³Sections 1528 and 1529.
³⁴Part 7.7A of the Corporations Regulations 2001 (Cth).
³⁵Section 964B.
³⁶Section 964F.
³⁷Section 964G.
³⁸Section 964D(3).
³⁹Section 964D(5).
⁴⁰Section 964G(2).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.