In the wake of the Royal Commission’s recommendations, Simon Carrodus takes a look at Best Interests Duty and how to manage them.

The Best Interests Duty and related obligations comprise of four components. The first of these components is the overarching obligation to act in the best interests of the client.

The law provides planners with one way of complying with that obligation, which are the Safe Harbour provisions that comprise of seven steps. These are:

1. Identify the client’s needs and objectives;
2. Identify the subject matter of advice;
3. Make reasonable enquires;
4. Assess your own expertise;
5. Conduct your own product research;
6. Base all judgements on the client’s needs and objectives; and
7. Take any other reasonable steps.

Under the law, if you tick all these steps, a planner will get the protection of the Safe Harbour, meaning the planner is deemed to have complied with Section 961B.

However, this is not the only way you can comply with the Best Interests Duty. Just because you haven’t ticked all the boxes of the Safe Harbour provisions, doesn’t automatically mean you have failed to comply with the Best Interests Duty. Instead, it simply means you haven’t got the protection of the Safe Harbour.

In reality, most licensees do set up their systems to ensure they are compliant with the seven steps of the Safe Harbour provisions. That’s because they are good steps to cover off on, as part of ensuring good compliant advice processes. Also, it’s important to remember that the seven steps are ASIC’s interpretation for the delivery of compliant advice.

Recently, many of the investigations and reports ASIC has undertaken – including Report 515 Financial advice: Review of how large institutions oversee their advisers and Report 562 Financial advice: Vertically integrated institutions and conflicts of interest – are essentially desk reviews, where ASIC is checking for compliance with the seven steps.

Therefore, if ASIC doesn’t see evidence of compliance with the seven steps, it marks this as a failure of the Best Interests Duty. And while this failure may not be strictly correct from a legal viewpoint, it is nonetheless the current regulatory interpretation of the Best Interests Duty that the industry is dealing with. 

What can go wrong?

When you consider the seven steps, there are a lot of areas in which things could go wrong for planners. In my experience, there are two specific danger areas that constantly crop up. They are: 

1. The planner failing to conduct product research, or at least to capture that product research somewhere on file and explain it in the SOA, particularly in relation to the client’s existing product; and
2. The planner failing to link their recommendation back to the stated needs and objectives of the client. If the planner fails to do that, then the planner’s client files begin to look generic when being reviewed by ASIC or the FPA.  

Appropriate advice

Under the umbrella of the Best Interests Duty, planners have an obligation to provide appropriate advice, as outlined in Section 961G. This obligation is about explaining how a planner’s advice addresses their client’s needs and objectives, and why the planner’s advice is likely to leave the client in a better position.

There has to be a coherent narrative to explain the reasons for the advice. For example: ‘For these reasons, at the time of the advice process and based on my analysis of your situation, we think this will leave you in a better position.’

These reasons should be captured and documented in the planner’s file notes and summarised in the SOA.

Conflict Priority Rule

The obligation with the Conflict Priority Rule is to prioritise the client’s interests above those of the planner, the licensee or the corporate group.

The recommendations from the Royal Commission make it absolutely clear that any time a planner recommends an in-house or related-party product, including managed accounts, a conflict arises. 

According to Section 961J, in that type of scenario, a planner has to take appropriate steps to ensure they are prioritising the client’s interests above those of themself, the licensee and corporate group.

It’s important to note that it’s not good enough to just disclose your obligation. You actually have to manage that conflict by explaining why the in-house product is better for the client than their existing product, including how it’s more likely to satisfy their needs and objectives.   

In-house product

When discussing in-house products, we need to refer to ASIC’s Report 562 Financial advice: Vertically integrated institutions and conflicts of interest.

While this report only focused on the big five financial services institutions – CBA, Westpac, ANZ, NAB and AMP – it found that 68 per cent of client funds were invested in in-house products.

ASIC took 200 files, or 40 files from each of the institutions, which related to clients switching out of an external product into an in-house product. ASIC found that 75 per cent of these files were non-compliant with the Best Interests Duty and failed the seven Safe Harbour steps.

According to ASIC, it found a lot of unnecessary replacement of financial products. It deemed these products to be unnecessary in the sense that the current product was perfectly capable of meeting the client’s needs and objectives.

It would be naive to think that this non-compliance was something only happening at the big end of town, and is not something that medium to small businesses need to worry about. But the same conflicts do affect many small to medium-sized advice businesses, including those that use managed accounts.

ASIC Chair, James Shipton, did mention in 2018 that the regulator has plans to extend Report 562 to the broader market, but we’re waiting to see what that looks like. However, the conflicts of interest that ASIC identified with the big five institutions, do apply to the rest of the market.

While the 75 per cent figure of non-complaint files that ASIC discovered with the ‘big five’ is concerning, it should be noted that the regulator did not find that 75 per cent of the advice was inappropriate. In fact, the percentage of inappropriate advice was actually around 10 per cent. Instead, 75 per cent of files failed to demonstrate compliance with the Safe Harbour steps.

So, my advice for planners and licensees is to capture and keep proper documentation around the client advice process. Poor documentation is not defensible when it comes to the Best Interests Duty.

The message from ASIC is clear. If it’s not documented on the file, then it didn’t happen. If you look at ASIC reports 562 or 515, the issue was not necessarily that planners had breached the law. Instead, the issue was there was nothing in the files to demonstrate compliance with the law.

What are planners supposed to do?

Planners need to recognise that their in-house product is not going to be suitable for all clients. If the product is not suitable, the planner can either:

• decline to work with the client;
• refer the client to someone who can better help them; or
• research other external products that are more suitable to the client’s needs and objectives.

In many circumstances, a client is likely to have an existing product. It is completely permissible for the planner to conduct research and analysis to consider whether the product is suitable for the client or whether it’s appropriate to switch the client out of that product and into an in-house product.

However, in order to do so, planners first need to do two things:

1. They have to properly research the client’s existing product. That research needs to be captured in the client file and summarised in the SOA. If the existing product is able to satisfy the client’s needs and objectives, it is going to be difficult to switch the client’s product with an in-house product, even though a planner might come to the conclusion that an in-house product can satisfy some of their needs and objectives better.
2. You have to conduct a like-for-like comparative analysis of the existing product with the proposed in-house product. You can even consider adding a third product in this analysis that is also capable of meeting the client’s needs and objectives. This enables the client to get a better idea of the various options available, including a product’s respective pros and cons, benefits and costs.

It will be difficult for a planner to justify a product switch if the benefits of an in-house product are lower than the existing product, or if the costs are higher. However, if there is a specific client benefit that isn’t being addressed in their existing product, which a planner can link to the in-house product, then a switch could be justified. In this case, the product switch needs to address some needs and objectives that aren’t being currently addressed with the existing product. Essentially, what a planner needs to do is to be able to explain why their in-house product is better able to satisfy their client’s needs and objectives versus the existing product.

Remember, every client is different. If you can’t easily justify a product switch into an in-house product, then simply don’t do it.

Learnings

Over the years, I have advised a number of clients who have had their files reviewed by ASIC, the FPA and FOS (now AFCA). These clients have generally got into trouble for producing inadequate or generic ‘cut and paste’ reasons to justify the product switch. These reasons generally focus more on the planner or the product, and they fail to link it back to the specific needs and objectives of the client.

Some examples of inadequate reasons used by planners for switching include:

• “You want to receive ongoing advice from me, but I don’t advise on your existing product.”

This reason is inappropriate, as it’s all about the planner and not the client.

• “This product provides regular reporting, online access, a range of investment options etc…”

However, this reason fails because, despite all the great features of this product, at no stage has the client said these features are important to them? And even if all these features are important for the client, if they are on a similar retail platform, they are probably already receiving these features. If a planner is going to switch a client out of one retail platform to a similar platform, it’s going to be difficult to justify these benefits which the client is probably already receiving.

The above two responses are clearly inadequate reasons for product switching. Instead, better reasons for switching are:

“You want a lower cost product. This recommended product has lower fees and costs than your existing product.”

This response is linked to a client need and it’s comparing to an existing product.

• “You want fixed insurance cover that does not decrease as you age. Your existing fund does not offer fixed cover. This recommended fund does.”

Again, the client need is linked to the current product, showing that the recommended in-house product is better for the client’s needs and objectives. 

The reason why these two latter responses are better is because they put the client at the centre of the reason, rather than the planner or the product itself.

Royal Commission recommendations

As part of the Royal Commission’s recommendations, there were 10 recommendations that relate directly to financial advice, and a handful more that indirectly related to advice.

Some of the major recommendations include the ending of grandfathered trail commissions from January 2021. Commissioner Hayne has recommended that ongoing fee arrangements should be reviewed annually, and Hayne recommended a single, central disciplinary body for planners.

One of the more interesting recommendations was Recommendation 2.3 – Quality of Advice Review. After going through such a long review process, one of Hayne’s recommendations was for ASIC and Treasury to conduct their own review of the advice sector by the end of 2022, in relation to improvements that have been made to the delivery of quality advice in Australia.

As part of the recommendation, Hayne said the Safe Harbour provisions should be repealed unless there is a clear justification for retaining them.

When you read the Royal Commission’s Final Report, it’s clear that Hayne is not a fan of the Safe Harbour provisions. Many of Hayne’s comments about the financial services laws and the regulatory system that planners operate in, is that they are too complex and should be simplified. His views of the Safe Harbour steps are consistent with that sentiment.

Hayne’s view is that the Safe Harbour steps encourage a ‘tick box’ and a ‘form-over-substance’ approach to advice. He believes if you remove these provisions, and just focus on Best Interests Duty and appropriate advice, then planners would focus more on the deliver of quality advice, rather than a compliance checklist that they have to fill out.

So, as we move ahead, on the topic of Best Interests Duty, we need to be mindful that the Safe Harbour provisions might not be with us for much longer.  

Simon Carrodus is a Senior Associate at The Fold Legal.