Australian Govt proposes to establish new compensation scheme for financial services industry

The Australian Government has earlier today opened a consultation regarding its plans to establish a compensation scheme of last resort (CLSR) to ensure that consumers and small businesses receive compensation where a financial service provider is found to have engaged in misconduct and is unable to pay.

The new scheme will also compensate consumers and small businesses that have an unpaid determination from the Australian Financial Complaints Authority (AFCA) after November 1, 2018. The body will be industry-funded, operated by AFCA, and its coverage will extend beyond personal advice failures.

Let’s note that there are several existing compensation schemes in Australia:

• the FCS provides consumers with compensation in the event that a bank or insurer fails;
• the National Guarantee Fund (NGF) provides consumers with compensation for certain losses incurred by investors who trade in shares on the ASX; and
• Part 23 of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) allows for financial assistance to be granted in the event that the fund has suffered an eligible loss as a result of fraud or theft.

The type of compensation covered under these existing schemes differs from that of the new scheme. For instance, if a large insurer fails, policyholders would be compensated under the FCS for the value of their policy, but consumers who had been missold an insurance product would not be eligible for compensation under the FCS for the insurer’s misconduct.

If a determination relates to claims covered by the three existing schemes, the CSLR would not pay any awarded amounts that are covered by the jurisdiction of these schemes. That is, the CSLR would exclude this part of the determination and only pay the residual part of the determination that is solely within AFCA’s jurisdiction.

There are several potential approaches to coverage.

A ‘mid-coverage approach’ to CSLR coverage would include financial services that are not solely provided by prudentially regulated financial firms, such as distribution services (including the provision of financial advice and brokerage services), investment services (including services relating to investment in securities, managed investment schemes and derivatives) or credit provided to consumers and small businesses. This approach would mean that all firms engaged in the provision of these services, regardless of whether the firm itself was prudentially regulated or not, would be captured by the CSLR in respect of eligible services.

The mid-coverage approach acknowledges that there is evidence of unpaid compensation in the provision of covered services and also acknowledges that services provided by prudentially regulated entities are at low risk of leaving a consumer or small business with unpaid determinations. A potential criticism of the mid-coverage approach is that consumers may be unclear as to whether the services they are receiving are covered by the CSLR or not.

A ‘broad-coverage approach’ would be for CSLR coverage to apply to all activities that require a financial firm to hold AFCA membership. This broad based approach is similar to the broad based approach used by the UK Financial Services Compensation Scheme.

A benefit of the broad-coverage approach is that there would be greater protection and clarity for consumers who would be covered under the CSLR in respect of all activities requiring a financial firm to hold AFCA membership, including for prudentially regulated activities. An extra benefit of a broader membership base is enhanced sustainability, as large and unexpected claims costs can be met by a wider range of members.

Such an approach, however, requires prudentially regulated financial firms to contribute to the CSLR when the risk of a determination relating to these services being unpaid is low.

Submissions in response to the discussion paper should be provided by February 7, 2020.