Right from the beginning on the Compensation Scheme of Last Resort (CSLR) officially kicking off in April 2024, the way that compensation amounts are determined has been a hot button topic.
Under the Australian Financial Complaints Authority’s (AFCA) longstanding approach to complaints, it is not simply capital loss that is calculated.
Rather, the overall impact of the firm’s conduct that is considered. In the realm of financial advice, this boils down to what the client’s financial position would have been, but for the advice.
AFCA has previously defended the use of the “but for” approach, highlighting that the standard actually predates AFCA’s existence.
Namely, the Supreme Court of Western Australia ruled in favour of the approach back in 2015, when Patersons Securities launched action against the Financial Ombudsman Service.
While there are some within the advice sector that want to see the ‘but for’ test scrapped altogether, the major push over the last two years has been to remove it from the CSLR.
With Financial Services Minister Daniel Mulino’s release of a CSLR consultation paper on Wednesday, it now looks like this could become a reality.
“AFCA generally determines loss in financial advice complaints using a counterfactual (sometimes referred to as ‘but for’) approach, comparing the consumer’s actual position following the breach with the position they would reasonably have been in had the misconduct not occurred,” the paper said.
“To support fairness, consistency and alignment with jurisprudence, AFCA applies a range of approaches to calculate the counterfactual position, selecting the method most appropriate to the consumer’s circumstances. In most cases, the counterfactual approach results in awards of compensation valued greater than the value of the losses.
“The use of a counterfactual methodology can materially affect the amount ultimately payable by the CSLR. Depending on the nature of the investment, the relevant time horizon and the way the counterfactual is constructed, compensation may exceed capital loss alone, including where losses are assessed across individual products rather than by reference to the consumer’s overall portfolio position.”
Capital loss only or pegged to a benchmark?
While the paper stressed that the government is not considering changes to AFCA’s broader approach to non-CSLR complaints, it has put forward two options to replace the ‘but for’ methodology within the context of the CSLR.
The first of these is fairly straightforward: only capital losses can be covered under the CSLR.
“A capital loss-only approach may also improve predictability for levy payers and mitigate concerns around cross-subsidisation, particularly where scheme costs are driven by long-dated advice failures and benchmarked counterfactual returns,” the paper said.
“It means that the CSLR would not compensate for unrealised investment gains, which may better align compensation with the CSLR’s safety-net purpose.”
However, the second option would retain a counterfactual component, but it would be based on a prescribed benchmark.
Potential benchmarks under the proposal are the headline consumer price index movement to reflect changes in purchasing power over time or the 10-year Australian government bond rate as a proxy for the “medium to long-term market risk-free rate, reflecting minimal credit risk”.
“Under this approach, consistent with the approach under option 1, the counterfactual position would be assessed at the portfolio level across all investments that were subject to the advice,” it said.
“The prescribed benchmark would be applied to that portfolio as a whole to estimate the position the consumer would reasonably have been in, absent the misconduct. Compensation would then be calculated as the difference between that benchmark portfolio position and the consumer’s actual financial position following the breach, up to the $150,000 compensation cap.”
In order to estimate the potential reduction in cost to the CSLR, Treasury modelled a sample of 15 determinations that went to the scheme.
While the paper noted that the results of the sample do not provide a broader sense of the estimated whole-of-scheme impact, it does indicate how “each reform option can materially reduce CSLR outlays for the sampled cases”.
Across the 15 determinations, the current AFCA approach resulted in total compensation of $1,769,113.
Factoring in capital loss only, this was lowered 43.4 per cent to $1,000,470, while the CPI method lowered compensation by 25.2 per cent to $1,323,366 and the bond rate approach saw a slightly lower drop of 24.7 per cent to $1,331,587.
Importantly, any change in how compensation is calculated is not a simple as a ministerial decision, it would require amendments to the primary legislation that established the CSLR framework.
“Imposing Ministerial authorisation conditions on the CSLR operator or regulations cannot validly require the operator to pay a lesser amount specified by the primary law,” the paper noted.
