Is FOFA the next step in the evolution of financial advice?

Bryan Ashenden tries to find a resemblance between the changes FOFA will bring to the financial advice industry and Charles Darwin’s Theory of Evolution.

Do the Future of Financial Advice (FOFA) changes represent an evolution of financial advice?

The answer to this question may depend on whether or not you subscribe to Charles Darwin’s Theory of Evolution.

While the main FOFA measures have now been introduced into Parliament, there are still a number of issues and concerns arising within the industry about how these new measures apply and in what circumstances.

In this article, rather than doing a deep dive into the current FOFA Bills and all the issues they raise, we will look at a few of the key issues and changes that have arisen since the two tranches of draft legislation were released for comment in August and September 2011.

Slowly (but surely?)

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Darwin’s Theory of Evolution is a slow, gradual process. Darwin wrote that natural selection “acts only by taking advantage of slight successive variations; she can never take a great and sudden leap, but must advance by short and sure, though slow steps.”

While some may be of the view that the proposed FOFA reforms are a great and sudden leap forward, another view is that they are perhaps just the next stage in the development of financial planning in Australia. Financial planning, or the need for advice, has been around for decades,  and change has always accompanied this. 

Whether it be from a straight tax management view with the first Income Tax Assessment Act in 1936 or the introduction of the current superannuation legislation in 1993 and the reforms implemented through the Financial Services Reform Act at the beginning of this century, financial planning and the environment in which it has been delivered has been constantly evolving.

Certainly, there is no argument that the current process feels slow. The reform process commenced back in February 2009 when the Parliamentary Joint Committee (PJC) launched its inquiry into the collapse of Storm Financial and Opes Prime, and the financial services industry generally.

That inquiry delivered its findings and 11 initial recommendations in November 2009. The Government announced its planned reforms five months later in April 2010 and made further announcements a year later.

Draft legislation was released for comment in August and September 2011, and quickly followed with the introduction of the two FOFA Bills into Parliament in October and November.

The Bills have now been referred through to the PJC (perhaps reflecting the “circle of life”) and to a Senate Economics Committee (SEC). The PJC is not due to hand back its report until 29 February 2012.

The House of Representatives only sits for eight days following the release of this report before it breaks over Easter.

The SEC follows with its report due to be delivered on 14 March 2012. If the SEC recommends any further amendments to the FOFA Bills, Parliament only sits for a total of five days before rising for the Easter break.

Parliament then doesn’t resume until Tuesday, 8 May 2012, which is the commencement of the Budget sittings.

As a result, the FOFA Bills are unlikely to be enacted until late March at the earliest.

Interestingly, this timeline aligns with the original dates forecast by Treasury at the beginning of the consultation process in April 2010, when they forecast the Bills would be passed through Parliament around Easter 2012.

The timing of the passage of the Bills raises the often asked question – will there be a deferral of the FOFA measures for 

12 months? Many in the industry are requesting a deferral and many are expecting that it will be forthcoming.

Indeed, the latest news (as reported in the Sydney Morning Herald on 19 December 2011) is that the announcement around deferral may come from Bill Shorten's office some time in January 2012.

However, until any such deferral is announced, it’s important that financial advisers and licensees start preparing for these reforms now, rather than waiting until the legislation is ultimately passed or a deferral is announced.

While not ruling out the possibility of a deferral, here are some reasons why this may not occur (or may not be as significant as many have requested):

• After the FOFA reforms, the next major set of reforms coming to the financial services industry are those from the review of the Australian superannuation system (Stronger Super reforms), including the introduction of MySuper from 1 July 2013. 
  Up to 11 tranches of legislation to give effect to the Stronger Super recommendations are expected, and with many of these changes due to commence from 1 July 2013, it may be difficult for products, platforms, systems and financial advice process to evolve and include these changes on top of changes required for FOFA.
• In the Cabinet reshuffle announced in December 2011, Minister Shorten retained carriage of the financial services and superannuation portfolios. 
  If a new Minister had been appointed, they may have been in a position to announce a deferral while they were personally brought up-to-speed on the history and context of all the FOFA reforms. With Minister Shorten retaining this responsibility, there is no longer a need for this.
• On 13 December 2011, the Australian Securities and Investments Commission (ASIC) issued a media release in which it announced that it would issue regulatory guidance on the best interests duty, scaled financial advice, and conflicted remuneration before 1 July 2012.

In the same release, however, ASIC also stated that for the first 12 months (ie, through to 30 June 2013) of the FOFA regime it will adopt a facilitative compliance approach – that is, provided industry participants are making reasonable efforts to comply with the FOFA reforms, ASIC will adopt a measured approach where inadvertent breaches result from a misunderstanding of requirements or systems issues.

However, where ASIC finds deliberate and systemic breaches they will take stronger regulatory action.

ASIC’s approach was expected, and is consistent with the approach it took with the introduction of the Australian Credit Licensing regime at the beginning of 2011.

However, it’s important to remember that this announcement by ASIC does not prevent consumers from taking legal action where, for example, they believe financial advice received is not in their best interests.

However, we need to be cognisant of the breadth of proposed relief provided from ASIC as it is restricted to the misunderstanding of requirements or systems issues.

With all of the discussion and engagement that has occurred (and continues to occur) in relation to FOFA, it may be more difficult to argue a misunderstanding of requirements.

A process of natural selection?

Darwin’s other main argument in his Theory of Evolution was the introduction of the concept of natural selection. Natural selection acts to preserve and accumulate minor advantageous changes over time.

In essence, those that are stronger and adapt to the changing environment will survive. The weaker, or those unwilling (or perhaps unable) to adapt, will gradually die out.

Put differently, natural selection is about preserving those advantages that enable you to compete better in the world.

FOFA certainly represents a change to the world in which financial advisers operate.

While some may easily adapt to this new environment, others must be willing to change in order to survive, or face the significant risk of being forced out of the industry – either through the inability to comply with the new requirements or being left with a business model that relies heavily on any potential grandfathering relief.

Such business models run a significant risk of losing value over time to the seller (rather than the purchaser), given that any grandfathering relied upon would presumably be lost on a change in financial adviser or licensee.

The three main areas of the FOFA reforms that financial advisers will need to focus on are the best interest duty, the so-called opt-in regime and the ban on conflicted remuneration.

Best interests duty

The FOFA Bills introduce a very broad ‘best interests’ duty, requiring the provider of the financial advice to act in the best interests of the client in relation to the advice.

However, a significant change in the FOFA Bills before Parliament (compared to the draft legislation released for consultation) is that the current version contains what could be regarded as a defence mechanism for financial advisers.

Increasingly referred to as the “seven steps defence”, the Bill states that if the provider of the financial advice can prove they have fulfilled seven requirements, they will be taken to have satisfied the broad best interest duty.

The seven steps can be summarised as follows:

1. Identify the objectives, financial situation and needs of the client;

2. Identify the subject matter of the financial advice sought by the client (and the above, as relevant to that advice);

3. Make enquiries to obtain complete and accurate information if it’s reasonably apparent that the information is incomplete or inaccurate;

4. Decline to give the financial advice if you don’t have the required expertise;

5. Conduct a reasonable investigation of products that might achieve the client’s objectives;

6. Base all judgements on the objectives, needs and financial situation of the client; 

7. Take any other steps that would reasonably be regarded as being in the best interests of the client.

While some of these steps are relatively straightforward and consistent with financial advice processes and obligations today (such as step 1), other obligations still raise questions as to the breadth and intent of their operation. Such difficulties will hopefully be resolved by the time the duty becomes effective.

For the majority of financial advisers, the concept of acting in the best interests of the client should not be of concern, as this is what they do today. The duty, as drafted, only focuses on the activities undertaken by the adviser at the time the advice was provided – not the end result of the advice, eg, whether it was successful or not.

In order to commence preparing for the introduction of the duty, financial advisers and advice businesses should be reviewing their current advice processes and testing whether they believe the processes would stand up to a best interests scrutiny today.

A comprehensive and consistent financial advice process, supported by relevant documentation of discussions, will be important to provide a defence against future potential claims.

Indeed, maintaining clear records of why certain recommendations or actions were not made to a client will be as important as the recommendations actually made.

Opt-in measures

Much has been made of the proposed opt-in measure intended to apply to new clients (ie, those who haven’t been provided with personal advice prior to 1 July 2012) every two years, and whether it should instead be an opt-out approach.

The debate over opt-in versus opt-out, however, really misses the importance of this measure. The opt-in requirement, at its essence, simply requires the client to sign off every two years that they wish to continue their ongoing advice relationship with a financial adviser.

While there are potential difficulties in getting people to sign and return documents generally or situations where clients are overseas, these can be addressed by introducing the opt-in document earlier than every two years and/or doing it in face-to-face meetings with clients that occur regularly, such as annual reviews.

Ultimately, this is about being closer to your clients, which is a positive outcome.

The more important piece around these measures is not the opt-in itself, but the annual fee disclosure requirement. 

Firstly, it applies to all clients that are in an ongoing fee arrangement, which essentially covers those who have received personal advice – both existing and new clients.

It also covers situations where the payment received is in the form of a commission, even though non-ongoing personal advice is being provided.

While there has been some speculation that the Bill will be amended so that only new clients are covered by this requirement (as was the case in the draft legislation), there have been no positive announcements from the Government to this effect at this point in time.

Secondly, with a proposed start date of 1 July 2012 and current application of the definition of “disclosure day” to existing clients, taken literally, there may be a need for financial advisers to send out annual disclosure notices to clients immediately after the commencement of the legislation.

As a result, financial advisers should consider what information they need to capture now that will be needed to complete these notices, such as the actual services that the client received for the year. 

However the legislation may be amended to clarify that the first notices for existing clients aren’t required to be sent until 1 July 2013 (ie, a year after commencement).

If amended in this way, the potential risks that many will not be in a position to meet the legal requirements of the notices on 1 July 2012 will be avoided.

It also means that the first time existing clients will need to be sent a notice will align with the first time a new client would potentially need to be provided with similar information (ie, assuming the ongoing fee arrangement for the new client commences on 1 July 2012).

Finally, for those financial advisers who operate in the corporate superannuation market, questions have arisen as to whether the fee disclosure notices will be required to be sent to all members of the relevant employer funds.

If a requirement, thousands of notices may be required to be sent. What is important in these situations is to determine whether the member is in an ongoing fee arrangement with the adviser, as these notice requirements only apply where there is an ongoing fee arrangement.

The initial requirement for an ongoing fee arrangement to be in place is that the client has been provided with personal advice. In the corporate superannuation market, this will be the important question.

Many corporate fund members may only be provided with general advice (ie, their personal circumstances have not been taken into account), and as such, the opt-in and fee disclosure notices will not apply. 

Ultimately, it is the development of a strong and trusted relationship between a financial adviser and their clients that is important. Arguably, clients are likely to pay little regard to the content of fee disclosure notices as they already know the value of their relationship with their adviser.

Similarly, the clients will be ready and willing to opt in for continued services, as they are aware of the risks of continuing in an unplanned and unguided environment.

While the opt-in and fee disclosure measures don’t commence until 1 July 2012, the groundwork needs to happen now to ensure that the right value propositions and valued relationships are in place for all clients, whether existing or new.

Conflicted remuneration bans

The final area of importance is the ban on conflicted remuneration. Conflicted remuneration broadly covers the provision of any form of benefit to a licensee or representative that could reasonably be expected to influence the financial advice that is provided.

An important change from the initial draft legislation now reflected in the Bill is that while any form of volume benefit is presumed to be conflicted remuneration, scope has been provided to rebut this presumption.

In order to fall outside the definition of conflicted remuneration, you will need to prove that the payment/receipt of the benefit could not reasonably be expected to influence the advice provided.

While there is no guidance on how this proof may be given or in what circumstances, it does provide some possible relief, particularly for the ban on employers paying conflicted remuneration to employees.

Where the benefit is paid to someone who is a number of steps removed from the actual provision of financial advice to a client and the amount of the benefit is not significant, the Explanatory Memorandum to the FOFA Bill indicates this may be an example of where the presumption can potentially be rebutted. However, this is in the Explanatory Memorandum only – not the Bill itself.

Some grandfathering relief has been catered for in the FOFA Bills, particularly in relation to commission arrangements in place before 1 July 2012, but no grandfathering relief has been provided at this stage for payments from platform operators.

Conclusion

The FOFA reforms certainly represent the next step in the development of the financial services industry in Australia. Arguably, the reforms are more evolutionary than revolutionary.

Indeed, the financial services industry itself had already commenced some of this journey prior to the announcement of the FOFA reforms by the Government back in April 2010.

On this basis, it would not be an unreasonable conclusion to expect that through its own natural evolution, without Government intervention, the upcoming regulatory environment is one that the industry would have gravitated towards in any event, albeit over a longer period of time.

The FOFA reforms shouldn’t be viewed as the big storm on the horizon, but really as the opportunity or impetus to re-engage (where relevant) with clients, cement the value of financial advice with your clients and the community more broadly, and set everyone up on the journey towards their goals, whether personal or business related.

The reality of not accepting this evolutionary process and preparing now, is that the process of natural selection will force the unprepared out unwillingly, as FOFA hits with a big bang.

Bryan Ashenden is a senior manager, technical consulting at BT Financial Group.