Broadly speaking, a moral hazard is a situation where businesses take excessive risks because they do not have to bear the full consequences of that risk.

The Principals’ Community, which represents a group of 128 self-licensed Australian Financial Services (AFS) licensees encompassing 1,310 advisers servicing about 141,000 client groups, argued that a range of factors related to the CSLR have led to the creation of this moral hazard.

In its submission to the Senate economics references committee’s inquiry into wealth management companies, it detailed that where a vertically integrated financial services business is “facing a stream of claims from advice clients in respect of a related party product which has failed or underperformed”, as in the case of Dixon Advisory, the CSLR incentivises the firm to put its subsidiary into administration.

“The existence of the moral hazard is contributing meaningfully to the disproportionate and arbitrary liability which is being imposed on the financial advice subsector by way of current and future CSLR levies and needs to be addressed,” the submission said.

It added: “The existence of potential compensation from CSLR to be paid to former client creditors of an advice firm could be expected to influence the administrator of an insolvent entity in connection with any proposal for a deed of company arrangement (DOCA) or liquidation.

“If an administrator and DOCA proponent are aware that claims of former clients will be underwritten by access to CSLR, this has real potential to impact the magnitude of any DOCA contribution sought by an administrator or offered by a deed proponent to contribute towards the settlement of those claims.

According to the Principals’ Community, this could then limit how hard the administrator attempts to seek contributions from other parties, including the parent entity, shareholders and directors.

It added that this could also potentially influence the way the administrator responds to complaints lodged with the Australian Financial Complaints Authority (AFCA).

“The administrator of the business has limited resources and responds to AFCA complaints in a formal rather than meaningful manner acknowledging that this class of creditor will likely be eligible to compensation from CSLR,” the Principals’ Community said.

“It will not be in the administrator’s interests to expend limited resources in defending unsecured claims against the company when those claims are ultimately underwritten by CSLR.

“As a result, the combination of a reduction in contributions from third parties to the administration of the insolvent advice entity together with the lack of engagement by the administrator in the claims made by former clients of the advice entity leads to potentially a greater number of and higher compensation payments made by CSLR.”

Additionally, the submission argued that despite the CSLR being designed as a final stop in a consumer’s attempts to receive compensation, the Principals’ Community does not believe that is how it actually functions.

“When complainants present unsatisfied AFCA determinations to CSLR there is no evidence that CSLR requires them to demonstrate that they have exhausted all other avenues of compensation in particular seeking compensation from concurrent wrongdoers such as product providers,” it said.

Fixing the moral hazard

In order to address the immediate issue of compensating Dixon Advisory clients, the Principals’ Community recommended that the government should fund the amount beyond that which has already been paid in by the 10 largest banking and insurance groups in the pre-CSLR levy.

Looking at the moral hazard aspect, the submission said including product providers in the CSLR and enforcing the “last resort” element of the scheme is key to limiting the issues.

“The CSLR operator, pursuant to section 1064(h) of the Corporations Act 2001 (Cth), requires consumers who are yet to attempt to obtain compensation from other sources to pursue other such avenues of compensation,” it said.

“In the case of potential claims against product providers, consumers will be expected to lodge such claims with AFCA to ensure that CSLR will act as it was originally intended – and that was a compensation scheme of last resort.

“Such a requirement is likely to be a much more effective mechanism for dealing with the moral hazard and potential compensation from other sources than the limited practical value of subrogation recovery rights provided to CSLR.”

It also recommended that AFCA’s approach be modified for matters involving an insolvent respondent that “recognises that such parties are less likely to vigorously contest complaints” given the limited resources and “diminished motivation” that the CSLR creates.

“This is particularly relevant in the circumstances for an insolvent advice company which is part of a vertically integrated financial services group,” the submission added.

The Principals’ Community is not alone in pushing for product providers to be included in the CSLR, with both the SMSF Association and the Financial Advice Association Australia (FAAA) and arguing managed investment schemes (MISs) should be added.

“We believe the exclusion of MISs from the CSLR regime has created a significant consumer protection gap in the current regulatory settings that must be addressed to protect those who choose to invest in such products without seeking professional financial advice – either by choice or because they may not realise, they are directly investing in a financial product,” the SMSF Association submission said.

It added: “Excluding MIS products from the CSLR continues to encouraging the creation of inappropriate high-risk products being marketed directly to Australians, including those near retirement who are not able to sustain any incurred financial losses, as in the case of Sterling Income Trust.

“The SMSF Association recommends that the scope of the CSLR is amended to specifically include MIS products.”

However, the Financial Services Council (FSC) argued this could “potentially increase the cost burden on financial advisers” and that there are “more appropriate mechanisms that could reduce the cost burden”.

Along with design and distribution obligations, which aim to reduce the risk of consumer detriment by enduring products are only distributed to their target market, the FSC said the Australian Securities and Investments Commission’s (ASIC) product intervention powers enable the regulator to step in and potentially limit MIS failures before they occur, “reducing their risk of failure and the need for CSLR coverage”.

“Furthermore, there is a moral hazard risk that including MISs within the scope of the CSLR might discourage ASIC from the proactive use of its product intervention powers to protect consumers,” it added.