21 February, 2019
Part 1: Seven Key Take-Outs for Trustees | Insight series on the Hayne Royal Commission Final Report
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has shone a spotlight on particular elements of the operation of superannuation funds and what is to be expected from a superannuation trustee (and the directors of a superannuation trustee) who have proper regard to the duties as imposed on them under the Superannuation Industry (Supervision Act) 1993 (Cth) (SIS Act), particularly under the trustee and director covenants in section 52 and 52A, taken together with the 'sole purpose' test in section 62.
While some of the Commissioner's statements on specific trustee behaviours, particularly around the payment of advice fees from member accounts, may have been somewhat surprising; the recommendations in the Final Report of the Banking Royal Commission with respect to the duties of trustees were not unexpected – having regard to the opening and closing submissions made by Counsel Assisting in Round 5 and the Productivity Commission's final report released on 10 January 2019.
With a focus on the statements made in the Final Report by the Commissioner on the duties and governance of trustees, we set out our seven key takeaways for trustee.
A conflicts framework is not enough
The Commissioner focuses considerable attention on the core trustee covenant, the 'best interest' covenant. Put simply this is the trustee's obligation to perform its obligations and exercise its powers in the best interests of the beneficiaries.
This is buttressed by a covenant imposed on a trustee, where there is a conflict of interests and duties, to give priority to the duties to and interests of the beneficiaries, to ensure that the duties to the beneficiaries, to ensure that the interests of the beneficiaries are not adversely affected and to comply with the prudential standards in relation to conflicts. Directors are subject to similar obligations to manage the conflicts of interest and duty that they face.
The Commissioner gave short shrift to statements made by trustees in their submissions that the best interest covenant is complex, limited in scope or is akin to the 'pub test' to determine members' best interests. This duty, he says, is not hard to understand. In saying this, the Commissioner is confirming his conclusion that any action or matter which is within the scope of the trustee's activities or control, even where the matter is not core to the operations of the fund, is subject to the duty.
The Commissioner noted that trustees were satisfied that conflicts could be managed by application of conflicts management frameworks which enable conflicts to be identified, avoided or prudently managed. In addressing conflicts of interests, the Commissioner was critical of a culture which relies on the disclosure of conflicts and maintenance of conflict frameworks instead of actively seeking to avoid conflicts. Avoidance he says is the surest way to prevent a breach of the covenant to give priority to the duties to and interests of beneficiaries.
In this analysis, there was also focus on the Regulator's historical reliance on confirming whether an entity has frameworks and policies in place rather than seeking to "go deeper" to determine whether such principles are applied in practice. The Commissioner's recommendation that a trustee should be prohibited from assuming any obligation other than those arising from its performance of its duties as trustee of a superannuation fund is intended to ensure that there are no unmanageable conflicts faced by trustees which arise from dual roles. This recommendation will, if implemented, at least avoid the obvious conflicts which may arise where a trustee of a superannuation fund invests with itself in other capacities, which could currently occur in a retail fund environment. Care will however need to be taken in implementing this recommendation so as not to prevent a trustee from performing functions which are related to the operation of a fund which are not strictly necessary to the operation of the fund, for example, the provision of certain services to employers.
But the Commissioner stopped short of concluding that 'for profit' funds should be prohibited or inhibited, a proposition that he referred to as a 'radical response'. While noting that there have been failures by trustees to perform their duties in the past, he concludes that an outright prohibition is not to be preferred. Nor does he favour structural separation as a solution to the conflicts which arise within corporate groups in which there are companies that manufacture, administer, or perform investment or insurance functions.
So where does that leave a trustee, especially in the 'for profit' segment. It would be advisable that trustees going forward be vigilant about the process of clearing conflicts and importantly, the considerations which take place at each steps of the process rather than taking comfort that there is a process in place. Potential conflicts of interest will be under great scrutiny going forward by the regulators and coupled with the recommendation of civil penalties for breach of covenants, it is a clear risk area for both retail and industry / profit-for-member funds to proactively manage.
But more than this, the stated expectation to which regulators will have regard, requires fresh thinking by trustees on conflicts. Any attempt to balance the interests of members and shareholders will almost certainly fail. Only clear decision making and behaviours which prefer the interests of members will be acceptable.
The A-Team
The themes of corporate culture and governance pervaded each round of the Commission's hearings and therefore it was no surprise that the proper governance of a fund was recognised to be of "critical importance". The Commissioner was clear to avoid any recommendations as to "best practice" in terms of board size, composition and how a fund selects its board members and instead, focused on what he considered the central issue – a board which is "skilled and efficient in the proper supervision of the funds in the best interest of members". However, two themes stood out in the deliberations on this topic and that is firstly, that boards should make provision for regular and orderly board renewal and replacement but avoid unexpected or wholesale turnover of trustees and secondly, that proper governance should be for APRA to actively supervise.
In addressing the theme of board turnover, the Commissioner touches on a matter which concerns the behaviour of trustee shareholders, whom owe no duties under applicable legislation. It is not immediately apparent how the Commissioner considers that the trustee boards can take action to address any difficulties caused by the actions of a shareholder. In any case, the Commission hearings tend to indicate that such difficulties are rare.
As for the matter of APRA's supervision of matters of governance, the Commissioner refers to the prospect of legislation being passed which will give APRA power to issue directions to a trustee. The relevant Bill, the Treasury Laws Amendment (Improving Accountability and Member Outcomes in Superannuation Measures No.1) Bill 2017 was introduced and read in the House of Representatives for the first time on 18 February 2019, having languished in the Senate for over a year. At the date of writing, it appears likely that this Bill will likely achieve assent by the Governor General before the election.
Regardless of the passage of legislation, the 'take-out' here is that trustee boards should review their policies around director selection having regard to the Commissioner's comment as to "central issue" and any long director tenures need to be considered carefully. Further, any decisions (or non-actions) taken by boards which raises a query with respect to the level of influence a sponsor, shareholder or third party has on a director/s will be potentially closely examined by the regulators.
Trustee boards should also expect that APRA may change its prudential standards around governance, especially to reflect a requirement for an improved assessment of board skills. This was the subject of a Productivity Commission recommendation (recommendation 19) which is likely to gain traction in light of the Commissioner's comments.
The bigger the better?
The Productivity Commission's report supported steps to facilitate and encourage more mergers between funds. Interestingly, the Commissioner did not make any specific recommendations with respect to mergers but rather, in its comments, identifies that board composition (post-merger) is critical to the success or otherwise of a merger and that accordingly, the likelihood of effective management and 'who will do what' post-merger needs to be carefully considered as part of the overall assessment by a fund looking to merge. It appears that the Commissioner does not accept, prima-facie, that a merger will always be advantageous to a member (on the basis of economies of scale or otherwise).
Accordingly, we consider the 'take out' for any trustee should be that considerations around mergers must ensure that the best interest test is applied when assessing not just the objective 'output' of a merger but also when assessing the post-merger life of the fund including the efficiency of a proposed new board, the time-frame around benefits flowing to members as a result of the merger and appropriately documenting the consideration process as to same.
Further, when the Treasury Laws Amendment (Improving Accountability and Member Outcomes in Superannuation Measures No.1) Bill 2017 commences, APRA will have the power to make directions to a trustee in connection with a stalled merger. A trustee will almost certainly wish to ensure that action is properly considered and taken without the need for a direction from APRA.
Keeping it simple
The Productivity Commissions' report stated that a "clearer articulation of what it means for a trustee to act in members’ best interests under the Superannuation Industry (Supervision) Act 1993 (Cth)" should be pursued. It posed that this could be done by way of legislative change, greater regulatory guidance and/or proactive testing of the law by regulators.
As set out above, in answering this question, the Commissioner made it clear that he considered no such legislative change or extension of the best interest test was required and that it was "not hard to understand". The Commissioner found that by keeping beneficiaries 'front of mind' at all times, trustees can achieve compliance. This concept is echoed throughout the Superannuation section of the report with the Commissioner emphasising that the test must not just be applied to the outcome of actions, but importantly, to the instigation, process and method in which decisions are implemented by trustees.
Hibernation of over for BEAR
Commissioner Hayne has recommended the extension of the BEAR to all APRA regulated institutions. This recommendation has both Government and Labor opposition support – indeed the Government went so far in its response as supporting an extension of a similar regime to all non-prudentially regulated financial firms.
It is therefore likely that this will trigger a workstream for the compliance and regulatory teams of superannuation trustees. It will also be necessary for superannuation trustees, their boards and their executives to wrap their heads around the concepts of individual accountability which are a key component of the BEAR regime. Importantly trustees will need to consider and document the accountabilities of certain board members and their executives, and be prepared to report to APRA on the steps taken when there is a failure to meet accountability obligations.
It will be critical for funds and their senior executives to be prepared to face these challenges and to consider how best to ensure that the following obligations:
- act with honesty and integrity
- act with due skill, care and diligence
- deal with APRA in an open, constructive and co-operative way;
- take reasonable steps to prevent matters from arising that would adversely affect the ADI's prudential standing or prudential reputation
- are satisfied and further, to implement appropriate training, policies, audits and the cultural framework to support ongoing compliance.
Trick or Treat
In making its recommendation 3.6, the Commission has recommended an amendment to Section 68A of the SIS Act to potentially read as follows (proposed deletions and amendments noted below):
A trustee of a regulated superannuation fund, or an associate of a trustee of a regulated superannuation fund, must not:
(a) supply, or offer to supply, goods or services to a person; or
(b) supply, or offer to supply, goods or services to a person at a particular price; or
(c) give or allow, or offer to give or allow, a discount, allowance, rebate or credit in relation to the supply, or the proposed supply, of goods or services to a person;
where the above acts may reasonably be understood by the person to have a substantial purpose of having the person nominate the fund as a default fund or having one or more of the employees of the person be, or will apply or agree to be, members of the fund.
Whilst the final drafting of any legislation will be of critical import to assessing the expansion of a trustees' duties and types of internal governance which will need to be in place to ensure compliance, it is clear that going forward the test moves to being subjectively-focused rather than maintaining the objective test of "conditionality". It is not hard to envisage potential legal disputes about the phrases "reasonably be understood" and "substantial purpose" and the evidentiary hurdles ahead for both trustees seeking to defend their compliance and regulators seeking to enforce same. Going forward, trustees will need to be careful in balancing the desire to retain existing members and grow to achieve economies of scale (in order to act in the best interests of members) whilst ensuring compliance with a broader section 68A test.
The Regulator always knocks twice
The Commission recommended that the roles of APRA and ASIC with respect to superannuation should be adjusted to accord with the general principles that:
- APRA is responsible for establishing and enforcing Prudential Standards and practices designed to ensure that, under all reasonable circumstances, financial promises made by superannuation entities APRA supervises are met within a stable, efficient and competitive financial system; and
- as the conduct and disclosure regulator, ASIC's role in superannuation primarily concerns the relationship between RSE licensees and individual consumers.
This division of labour is also overlayed with:
- the consistent theme of the Report that both monitoring and enforcement of ASIC and APRA must increase where the case calls for it; and
- the recommendation that a breach of the trustee's and directors' covenants in section 52, 29VN, 52A and section 29VO of the SIS Act should be enforceable by action for civil penalty.
Trustees must therefore now anticipate and expect expanded levels of reporting and more frequent requests for production of information to the Regulators along with more lengthy investigations into potential breach (self-reported or otherwise).
Trustees also face the spectre of enhanced breach reporting resulting in jeopardy for trustees. Commissioner Hayne has recommended the adoption of the ASIC Enforcement Task Force's recommendation on breach reporting, being to extend the period for reporting from the existing 10 days to 30 days, but requiring that not just significant breaches be reported but those which are still under investigation.
The days of having the opportunity to properly consider the legality of conduct or the extent of a breach before reporting it to ASIC may be coming to an end. And it's all stick for superannuation trustees, as there is no regulatory benefit to be gained by reporting to the regulator quickly and transparently. Rather, a failure to do so will have consequences. Commission Hayne expresses a preference for example that ASIC publish breach report data annually by individual licensee.
Superannuation trustees will no doubt wish to conclude their investigations promptly so that they are not distracted with dealing with the regulator potentially seeking to pursue an enforcement outcome while still determining the nature and extent of a breach and so that they manage the prospect of there being a public reporting of suspected significant breaches.
For further information, please contact:
Meredith Gibbs, Baker & McKenzie
meredith.gibbs@bakermckenzie.com
