“This will not be an open-ended commission, it will not put capitalism on trial, as some people in the parliament prefer…” – Malcolm Turnbull, 30 November 2017
“The root cause for what happened was greed.” – Commissioner Hayne, Interim Report, 28 September 2018
The Australian insurance sector has now had its turn in the spotlight of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the Commission) and, as most had anticipated, the evidence has cast some uncomfortable shadows across the industry. While we must await the Commissioner’s final report to know his thoughts on that evidence given during the insurance round of hearings, the release of the Interim Report on 28 September 2018 and his preliminary verdict on conduct in the banking and wealth management sectors, provides an early insight. The Commissioner says that the cause of misconduct has been inappropriate focus on the short term pursuit of profit at the expense of the longer term interests of the business and compliance with law. In the Commissioner’s words, “[t]he root cause for what happened was greed.”1
It is not my intention to delve into the specific case studies or to consider the appropriateness of the proposed findings. Rather, it is my aim to reflect on the Commissioner’s preliminary views on the cause of misconduct, and to focus on what might be significant implications for the insurance sector. My focus will be on what I see as an inevitable increase in enforcement action, and the increased significance of the general obligations under s912A(1) of the Corporations Act 2001 (Cth) (the general obligations), particularly the obligation to do all things necessary to ensure that financial services are provided “efficiently, honestly and fairly”. As I see it, the general obligations will take a new prominence in the financial services sector, and will become the core consideration for compliance.
In forecasting regulatory developments, I am acutely aware of my recent shortcomings when it comes to making predictions on this topic. In early November 2017, before an audience of insurance clients, I confidently declared that there would be a change of Government before there would be a Royal Commission. Less than three weeks later, the embattled Malcolm Turnbull and then Treasurer, Scott Morrison, were releasing the Terms of the Reference and installing the Honourable Kenneth Hayne as Commissioner. In my defence, as late as 22 November 2017 Turnbull had ruled out the proposal (for the umpteenth time) saying: "A royal commission would simply be an inquiry, take a long time, cost a lot of money and make some recommendations, which would no doubt be to do precisely what we are already doing."2 Mr Turnbull and I had that particularly opinion in common, though it transpires, our conviction in it differed markedly.
I am also conscious that an enormous amount of ground has been covered by the Commission, and the focus of this paper is a very limited sub-set of matters of relevance to the insurance sector. There have now been 6 rounds of hearings across 12 weeks (59 sitting days), with evidence in 75 case studies given by 131 witnesses. There are an array of very significant matters covered by the evidence, and numerous areas of potential reform that will undoubtedly have an impact on the insurance sector. Those issues include remuneration arrangements, the management of conflicts of interest, the role of commissions in the industry, the effectiveness of industry self-regulation, the application of unfair contract terms provisions to contracts of insurance and the extension of the financial services regime to claims handling (to name a few!). They are for the most part beyond the scope of this paper, but will feature heavily in the final report and potentially be the subject of recommendation for reform.
What did the evidence reveal?
During the insurance round of hearings, we heard evidence across 10 case studies of conduct that could, on the submission of Counsel Assisting, constitute misconduct or conduct falling short of community expectations. The distinction between those descriptors has been somewhat lost in press reports, but it is important to recognise that conduct found to have fallen short of community standards may not be conduct that amounts to any breach of law. It is not to suggest that addressing such conduct is not important. At the very least it is a matter of direct relevance to business and market reputation, and are matters that although compliant with law, might assist in identifying areas where the legal framework is not achieving desired outcomes. But significant time has been given to conduct that may not, under existing laws, found any civil remedy or regulatory enforcement action.
In short summary, Counsel Assisting has made submission that the evidence given during the insurance round supports findings that insurers or their representatives misrepresented product benefits in online marketing collateral; relied on outdated medical definitions to deny claims; breached anti-hawking provisions; engaged in aggressive sales tactics, particularly through outbound call centres; employed aggressive retention strategies with the apparent aim of creating a barrier to cancellation; adopted remuneration arrangements which incentivised poor sales conduct; failed to adequately supervise and train third party distributors; failed to address defects in quality assurance programs; failed to identify and/or report significant breaches of financial services law; breached the ban on conflicted remuneration; breached the duty of utmost food faith in respect to claims handling; and failed to properly manage conflicts of interest.3
The submissions of Counsel Assisting point to the likelihood that same general conclusion reached in respect to the banking and financial advice sectors being drawn: that insurers have prioritised the financial success of their business over the compliance with law.
“Capitalism will not be on trial”
It is hard to look past the headline grabbing statements made by the Commissioner in the Interim Report expressing his view as to the cause of the misconduct. He says: “[w]hy did it happen? Too often, the answer seems to be greed – the pursuit of short term profit at the expense of basic standards of honesty”;4 and “…[n]o matter whether the motive is called ‘greed’, ‘avarice’ or ‘pursuit of profit’, the conduct ignores basic standards of honesty.”5; and even more directly “[t]he root cause for what happened was greed.”6 Unsurprisingly, these statements have been picked up widely by the press.7
The emotive use of the Biblical sins of “greed” and “avarice”, and their alignment with the expression “pursuit of profit” is unhelpful. The Australian economy is a capitalist system; and the “pursuit of profits” is inarguably a central driver of both personal and corporate conduct in commercial dealings. As a nation we have long recognised the important role of law and regulation in setting the boundaries of acceptable conduct within that system. However, within those boundaries, our system aims to facilitate the pursuit of profits. “Greed” (or in less emotive language, self-interest) is not only acceptable in that context, it is an imperative. By using the terms “greed” and “avarice”, and calling that conduct out as the root cause of misconduct, is the Commissioner asking us to reconsider the capitalist foundations on which the system operates? Does that stand in contrast to the Malcolm Turnbull’s declaration on the day the Commission was announced that the Commission “… would not put capitalism on trial”?
The Commissioner has given these statements some important context, making it clear that:
As commercial enterprises, each of the entities whose conduct was considered in the first round of hearings rightly pursues profit. Directors and other officers of the entities owe duties to shareholders to do that. But the duty to pursue profit is one that has a significant temporal dimension. The duty is to pursue the long-term advantage of the enterprise. Pursuit of long-term advantage (as distinct from short-term gain) entails preserving and enhancing the reputation of the enterprise as engaging in the activities it pursues efficiently, honestly and fairly. And, lest there be any doubt, it also entails obeying the law. But to preserve and enhance a reputation for engaging in the enterprise’s activities efficiently, honestly and fairly, the enterprise must do more than not break the law. It must seek to do ‘the right thing’.”8
Quite rightly, and in contrast to the “soundbite” statements referenced earlier, the Commissioner here makes it clear that commercial enterprises are right to pursue of profits, and, in fact, that legal duties are owed by the directors and officers within those enterprises to do precisely that. In this more measured analysis, “greed” is no longer the heart of the issue; rather the misconduct arises from the directors and officers failing to comply with the law and inappropriately favouring short term profit over the longer term interests of the business by disregarding reputation risk in breach of their obligations to the company and shareholders. Despite the Commissioner’s attack on “greed”, it appears his issue is not with the pursuit of profits at all, but failing to pursue profits within the parameters of the law. Capitalism, it seems, can rest easy.
Customer-centricity – a conflict in duties?
The Commissioner’s statement above is aimed at aligning what might be seen as competing interests – that is, the interests of shareholders’ desire to maximise profits on the one hand, and the interests of its customers on the other. What the Commissioner is saying is that within the confines of the law, and particularly within the financial services sector, the existing law means that those interests are generally aligned. Directors and officers acting in the best interests of the organisation will ensure the organisation complies with the law and will seek to protect the reputation of the business. In doing so, they must ensure the organisation acts in a way that is efficient, honest and perhaps most importantly in this context, fair. Accordingly, having a culture that emphasises the need for customers to be treated fairly does not create a conflict with the duties owed by directors and officers to generate profit for shareholders – in fact, the duty may require it.
It is worth noting that for listed entities, the need to take into account the interests of consumers (among other stakeholders) is currently being considered in the context of proposed amendments to the ASX Council’s Corporate Government Principles and Recommendations (CGP&R).9 The ASX Council is proposing to adopt the concept of a corporate “social licence to operate”, which would require a listed entity’s board and management to have “regard to the views and interests of a broader range of stakeholders than just the entity’s security holders”.10 The proposed amendments to the CGP&R have been subject to consultation, and that requirement in particular has been subject to some criticism, on the basis that consideration of the interests of other stakeholders is not consistent with the existing duties of directors to shareholders.11
In the context of financial services licencees, the Commissioner’s alignment of the interests of organisations and their customers places considerable emphasis on the general obligations, and particularly section 912A(1)(a). The general obligation will define the minimum circumstances where the interests of shareholders and customers are aligned because a failure to comply the general obligation can expose the entity to regulatory enforcement action, and therefore reputational harm. In other words, it is necessarily in the best interests of the company to comply with the general obligation, and therefore the interests of shareholders and the interest of consumers are aligned. Importantly, that alignment may only extend so far as acting in compliance with the general obligation, and not to the extent of favouring (or even giving equivalent consideration to) the interests of customers.
Section 912A(1)(a) and treating customers fairly
The general duty to do all things necessary to provide financial services honestly, efficiently and fairly is intentionally a high-level principle-based obligation.12 It comes with no prescriptive requirements, and very little regulatory guidance.13 Case law informs us that the obligation is “compendious” meaning it is recognised as a single concept, rather than three separate obligations;14 but nevertheless “…connotes an element not just of even handedness in dealing with clients but a less readily defined concept of sound ethical values and judgment in matters relevant to a client’s affairs.”15
In light of that case law, there will be debate as to whether the Commissioner’s focus on 912A(1)(a), and particularly the concept of fairness within it, improperly elevates the standard of conduct required by the general obligation. In simple terms, is it correct that financial services licencees are under an obligation to treat customers fairly? Or is the requirement to do all things necessary to ensure financial services are provided honestly, efficiently and fairly something of a different character?
It is telling that in the history of financial services law reform, the concept of fairness has generally arisen in the context of disclosure. The economic theory underpinning the consumer protection recommendations made by the Financial System Inquiry of 1996/7 (the Wallis Inquiry) was that the risk allocation determined by the market should not be interfered with; but that the imbalance in information about financial products put consumers at a disadvantage.16 Market integrity and consumer protection therefore required product issuers to be clear and transparent about the risk and reward of financial products. Those disclosure obligations levelled the playing field, and ensured consumers were able to participate in the market on a fair basis. The more recent Financial System Inquiry of 2014 (the Murray Inquiry) followed similar thinking. The final report stated: “Fundamental to fair treatment is the concept that financial products and services should perform in the way that consumers expect or are led to believe.”17 Fairness in the context of those reviews, was principally about full and transparent disclosure.
Treasury has recommended that along with a range of other provisions of the Corporations Act, section 912A(1) become a civil penalty provision.18 The Federal Government has accepted that recommendation,19 and barring a decision to delay enactment until completion of the Commission, the industry should expect those reforms to be implemented soon. In light of the changing risk associated with non-compliance with the general obligation, it would be timely to consider closely business practices that, although are compliant with law and disclosure requirements, may still amount to unfair treatment of customers. There is undoubted difficulty in shaping corporate conduct around such nebulous concepts as “fairness”, “even-handedness” and the exercise of “sound ethical values and judgment”, but the industry will need to take proactive steps to define and comply with it. One should not readily assume that fairness is confined to matters of disclosure – if the Commission’s approach is correct, the general obligation will have far wider remit.
Some guidance can be taken from the UK, where entities carrying on regulated activities under the Financial Services and Markets Act 2000 (UK) must comply with a number of general principles, relevantly including the obligation to treat customers fairly (commonly known in the UK as “TCF”). A breach of the principle can give rise to civil penalties, and the penalties can be significant. One financial institution was recently fined in excess of GBP20m for breaches relating to the mis-selling of payment protection insurance, while an insurer was recently fined in excess of GBP8m for poor conduct in respect to outbound sales practices. Extensive guidance on TCF compliance has been issued by the UK’s conduct regulator, the Financial Conduct Authority. Given ASIC’s inclination to closely follow UK regulatory developments, we might see an expansion of guidance on the general obligation in line with the TCF regime.
A new age of enforcement
A key concern of the Commissioner throughout the hearings, and one that occupied considerable space in the Interim Report, was the lack of enforcement action taken by regulators. In the Interim Report, he says:
When misconduct was revealed, it either went unpunished or the consequences did not meet the seriousness of what had been done. The conduct regulator, ASIC, rarely went to court to seek public denunciation of and punishment for misconduct. The prudential regulator, APRA, never went to court. Much more often than not, when misconduct was revealed, little happened beyond apology from the entity, a drawn out remediation program and protracted negotiation with ASIC of a media release, an infringement notice, or an enforceable undertaking that acknowledged no more than that ASIC had reasonable ‘concerns’ about the entity’s conduct. Infringement notices imposed penalties that were immaterial for the large banks. Enforceable undertakings might require a ‘community benefit payment’, but the amount was far less than the penalty that ASIC could properly have asked a court to impose.20
The Commissioner had little sympathy for, or regard to, the legal and financial constraints on the regulators, nor their long term approach to achieving better consumer outcomes through longer term regulatory reform, and less aggressive enforcement strategies. One could make a good case for the regulators here: most of the conduct subject to the hearings was known to them, much of it has formed the basis for lobbying for regulatory change (including for the introduction of the Banking Executive Accountability Regime (BEAR), the introduction of product design and distribution obligations and ASIC intervention powers, and the increases in civil and criminal penalties) and their efforts were driving behaviours in the right direction. Nevertheless, in light of the Commissioner’s view that the primary cause of misconduct was the drive for short-term profit and the failure to consider the longer term reputational harm of the business, his criticism over the lack of enforcement action can be better understood. If the organisations expected no enforcement action to be taken then the risk of reputational harm may have been absent, and so the focus on short-term profit at the expense of consumer interests a more likely outcome.
If one prediction as to the consequences of the Commission can be made with any certainty, it is that the approach of the regulators is set to change dramatically. The Commissioner has raised the question whether the enforcement action should be required unless there is a public policy reason not to.21 Already ASIC has commenced enforcement action in respect to the ‘fees for no services’ issues. It should be expected that culturally the regulators will change, and strategic enforcement action will be preferred ahead of negotiated infringement notices and enforceable undertakings. It should also be expected that ASIC will seek to prosecute in areas where case law has not yet provided sufficient guidance on the scope of regulation – the general obligations in s912A, and the requirement to notify significant breaches udner s912D will almost certainly be a focus. Criminal prosecutions are likely.
The industry should expect the corporate “watch-dog” to turn attack dog.
What else will come of this?
There are a range of significant regulatory reforms either imminent or subject to recent consultation. Of the most relevant to insurers are the imminent enactment of product design and distribution obligations and intervention power legislation,22 the change to penalties resulting from the ASIC Enforcement Review and the application of unfair contract terms provisions to contracts of insurance.23 Each of these warrants a paper of its own, and so cannot be canvassed here. A large number of further reforms will be considered by the Commissioner as a consequence of the evidence heard during the insurance round, including the possible ending of grandfathering exceptions to the ban on conflicted remuneration, the extension of the ban on conflicted remuneration to general insurance, the extension of financial services law to claims handling and the introduction of civil penalties for breaches of the life and general insurance codes of conduct. The extension of the BEAR to the insurance sector also seems a real possibility.
Given the current state of Federal politics and the impending election in early 2019, it would be wise to assume that the reforms are currently in the pipeline and those that will be recommended by the Commissioner in his final report tabled in February 2019, will be acted on. The major political parties are now wholly aligned on the need for the Commission, and neither is likely take the political risk of standing by industry and resisting any consumer protection reforms that the Commissioner recommends. The ASIC Enforcement Review and the product design and distribution obligations legislation have already received Government approval, and should be enacted well before the election.
This represents a considerable wave of new regulation that insurers must be prepared for.
Some final comments
The industry must await the final report to see what recommendations the Commissioner makes that are of direct relevance to insurance. Interestingly, the Commissioner was keen to point out that more regulation is probably not required where a complex regulatory regime already exists. It may be that his recommendations are aimed at more principle-based and less prescriptive regulations being applied.
Nevertheless, in the interim, and in light of impending wave of regulatory reform, it would be in the interests of insurers and intermediaries to be proactive. The following would be a useful checklist to start that process:
- Consider the need to update governance arrangements in light of the recommendations set out in the APRA Prudential Inquiry Final Report on CBA. The approach taken by APRA in that report is reflective of current regulatory thinking and expectations and applies equally to Australian authorised insurers.
- Work on the assumption that treating customers fairly is both a legal requirement and in the best long term interests of the company, and review products and business practices through that lens.
- Review remuneration practices to ensure that they reward behaviours that benefit the long term interest of the company and that reward behaviours that deliver fair consumer outcomes.
- Review and put in place an holistic product governance framework, recognising that with the imminent laws on product design and distribution obligations, the existing boundaries between the obligations of product manufacturers and distributors may become blurred, and that greater control and oversight of third parties (including separately licenced entities) may be required. Ensure that the framework takes into account product data, including complaints, claims, declinature rates and other metrics, and that those metrics regularly inform product development.
- Ensure breach reporting obligations are being met, and that all employees regardless of seniority are properly trained in the identification of potential breaches, and the importance of reporting them. Expect regulatory enforcement action for any material failure to comply with section 912D of the Corporations Act.
- Ensure the compliance function is well resourced, properly embedded in the organisation’s risk management framework and that quality assurance procedures are routinely tested.
- Have strategies in place to deal with a marked increase in the risk of regulatory enforcement action (and consumer and shareholder class actions).
- Routinely review the assumptions and processes by which data is collected and used to avoid potentially far reaching systemic issues caused by inadvertent human error.
The Commission has invited public submissions on a range of issues relevant to the insurance sector, with submissions due on 25 October 2018. The final report is due to be tabled in Parliament on or before 1 February 2019. Finally, readers should also be aware that there are increasing calls for the Commission’s term to be extended. Given my past record, I will avoid making any prediction as to whether that will eventuate, save to say that this time around, a change in Government is unlikely to have any bearing on the decision.
This article was first published in the Australian Insurance Law Bulletin.