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The gatekeeper framework in Australia
The roundtable with financial system gatekeepers was convened to examine
expectation gaps in Australia's financial services system and to discuss the
steps that are being taken to deal with those gaps.
Gatekeepers play a crucial role in the functioning of the financial
services system. While the Australian Securities and Investments Commission (ASIC)
sets the regulatory standards for the gatekeepers and expectations of their
performance, the system is 'self-executing'. As ASIC Chairman, Mr Greg
Medcraft, told the committee in September last year:
ASIC is not a prudential regulator, not a conduct and
surveillance regulator. The system we have is based on gatekeepers doing the
right thing and it is self-executing. It is quite important in understanding
what we are currently resourced to do. We are not resourced to be looking at
everybody, and that is a very important message.
Gatekeepers such as the research house, Lonsec Research Property Ltd, acknowledged
that the financial services system has historically been lightly regulated.
Lonsec observed that the regulator has outsourced significant elements of the gatekeeper
function to the private sector, and that ASIC's role is to hold the gatekeepers
The problem of 'expectation gaps' was raised by ASIC at the inquiry held
by the Parliamentary Joint Committee on Corporations and Financial Services
(the committee) into the collapse of Trio Capital Limited (Trio). ASIC's
submission to the inquiry pointed to potential expectation gaps between the
role of gatekeepers in Australia's financial services system and investors'
expectations of that role.
Chapter 7 of the committee's report into Trio canvassed a series of
expectations gaps between what investors and the public expected the gatekeepers
to achieve, what gatekeepers were legally required to do, and what their roles
involved in practice:
- first, and most significantly,
most Trio investors in self-managed superannuation funds (SMSFs) seemed not to
be aware that their investment was not protected to the same extent as
investments made in Australian Prudential Regulation Authority (APRA) regulated
superannuation funds. This has been a clear and recurring theme during this
inquiry and is of particular concern to the committee;
- second and related, there is an
expectation among investors that financial advisers will check the investments
that they recommend to their clients, to ensure not only that there are
prospects for good returns but that they are run legitimately;
- third, there is a lack of
understanding as to how Australian Financial Services Licences (AFSLs) are
issued. The AFSL attaches to the company, not the directors;
- fourth, both the regulators and
investors have expressed frustration at the role of Trio Capital's financial
statement and compliance plan auditors, particularly their inability to verify
information. The auditors cite the limitations on their role and that the
primary responsibility for detecting fraud rests with the responsible entity
(RE). They note that auditors can only obtain reasonable assurance that a
financial report is free from material misstatement, whether caused by fraud or
fifth, there is an expectation in
the public mind that custodians will act to protect and secure the underlying
investment. By contrast, Trio's custodian, the National Australia Trustee
Limited, has noted that the custodian does not have the expertise to question
underlying values of either domestic or offshore funds;
- sixth, there is a lack of
understanding as to the claims made in the reports issued by research houses
and in particular, whether the data provided by the RE upon which these reports
are based has been verified. There is also some confusion as to whether the
ratings are intended as an indicator of future performance, or simply an
assessment of past performance; and
- finally, ASIC has noted that,
compared to the United States and Europe, the level of underlying portfolio
disclosure of managed investment schemes in Australia is very limited. Both
ASIC and Morningstar have suggested there should be disclosure at asset level
for registered managed investment schemes to help investors assess both the
type of financial products they are exposed to, and the extent of that
In March 2013, at its Annual Forum, ASIC convened a session titled 'Bridging
the gap'. The session examined expectation gaps and how gatekeepers try to deal
The committee wanted to examine these issues in more detail by taking a
holistic or system-wide view. At the roundtable, the interest was not only in
how the gatekeepers saw their own roles and responsibilities, but in how they
perceived each other's roles. In other words, in addition to examining gaps
that might exist between investor expectations and gatekeeper roles, the
committee wanted to see whether there were gaps in the system, with confusion
or misunderstanding by one group of gatekeepers about the role of another group.
Following the roundtable, the committee placed a series of written
questions on notice to ASIC based on the discussion with the gatekeepers. These
responses are presented in Appendix 2.
The key gatekeepers in the financial services system—financial planners
and financial advisers, custodians, research houses, auditors, trustees, and
REs—are regulated by ASIC. In the wake of the Trio fraud and other corporate
collapses, ASIC has focused on the roles and standards of these groups. The
roundtable also gave the committee an opportunity to engage with the
gatekeepers and ASIC on the consultations and regulatory changes since Trio.
Some gatekeepers are dual-regulated entities. For example, of the 500-plus
REs operating in Australia in 2012, 33 held both an AFSL from ASIC to operate
as an RE, and a registrable superannuation entity (RSE) licence from the
Australian Prudential Regulation Authority (APRA) to operate as an RSE.
Trio was a dual-regulated entity. It provided RSE trustee services for a
series of APRA-regulated superannuation schemes and RE services for more than
20 managed investment schemes (MISs).
Directors also function as vital gatekeepers in the Australian financial
services system. Although the committee did not specifically invite directors
as a distinct group, the panel did include gatekeeper representatives that
acted as managing directors, as director and chief executive officer, and as
executive directors in their respective businesses.
The following sections provide background information on the different
gatekeepers, noting what they do and their different structures and business
The gatekeepers are discussed in the following order:
- research houses and research report providers;
- financial planners and financial advisers;
REs and fund managers;
- trustees; and
Research houses and research report
Research report providers include research houses. The terms research
house and research report provider have both been used by government agencies
when referring to the research report industry. In November 2008, Treasury and
ASIC released a joint report on credit rating agencies and research houses,
while ASIC's most recent regulatory guidance is targeted at research report
For ease of use, and given that the committee invited two research houses to
participate in the roundtable, this report refers to the providers of
investment research as research houses. However, this designation comes with an
important proviso, and that is that some research is also produced internally
by other entities within the financial services sector such as advisory groups
and fund managers.
Research houses produce investment research on financial products such
as managed funds, structured products, superannuation funds and insurance
A research report typically provides an express or implicit opinion and a
rating (except a credit rating) about an investment product, and a
recommendation to buy, sell or hold the product.
Wholesale users such as financial planners and financial advisers are
the main users of research reports. In other words, the main target group for
research houses are the financial intermediaries in the system. Financial
advice businesses construct an approved product list based on research reports
for use by their authorised representatives. However, some research houses also
offer subscriptions to their reports on superannuation products to retail
Given that research reports are used by both financial planners and
financial advisers (and some retail clients), the quality of investment
research has a direct bearing on the quality of advice that retail investors
receive. ASIC has underscored the importance of improving the quality of research
reports by noting that positive research reports have been given to products
just prior to their failure:
In a number of recent corporate collapses in Australia, the
investment products that failed were either highly rated or the subject of very
recent positive recommendations by research report providers just before the
In addition to poor quality investment research, ASIC also noted other
issues of concern including a lack of due diligence and an over-reliance on
research reports by financial intermediaries, and a lack of awareness about the
potential compromises involved in the reports themselves:
Risks for the investment community are amplified where there
is undue reliance on research reports and a lack of awareness of real and potential
conflicts of interest which may adversely impact on the independence and
therefore the reliability of those reports.
The various conflicts of interest associated with the business models
adopted by Australian research houses are explained in the next section.
Australian research houses: business
models and conflicts of interest
There are five major research houses currently operating in Australia:
Lonsec, Mercer, Morningstar, van Eyk and Zenith. Mercer and Morningstar are the
only two global businesses in the Australian research market.
The research houses use different business models to fund their research
and rely on various combinations of the following:
- subscription fees from end-users such as financial planners and
advisers ('downstream' payments);
- direct payments from fund managers who offer and may have
designed the financial product ('upstream' payments); and
- indirect payments from fund managers ('upstream payments').
Direct payments from fund managers have raised concerns because of the
inherent conflicts of interest that arise when a research house assesses a fund
manager's product and accepts a fee from the fund manager for that assessment.
'Downstream' payments from independent financial planners and advisers
have not raised the same concerns because they avoid these conflicts. However,
less obvious conflicts may still arise when a research house based on a
'downstream' subscription model does accept indirect payments from fund
In 2012, Fairfax journalist Ruth Williams listed some examples of
indirect payments to research houses:
- the licence fees charged by Morningstar when fund managers use
the Morningstar logo and ratings on promotional materials;
- payments from fund managers to advertise in van Eyk's
- payments from fund managers to advertise in Morningstar's Investor
Daily online newsletter;
- sponsorship from fund managers for Morningstar's Investment
- payments from fund managers to attend Mercer forums;
- payments by funds to be listed in Morningstar's industry
- van Eyk's partnership with Advisor Edge, which does accept fees
from product issuers.
Lonsec and Zenith accept payments from fund managers to conduct research
into products. Mercer, Morningstar and van Eyk do not accept these payments and
instead use a subscriber-based business model where financial planning and
advisory firms purchase the research. However, Mercer, Morningstar and van Eyk
do accept some forms of indirect payments from fund managers.
There has been debate in the industry about the number of research houses
in the Australian market. These views have been canvassed in the publication Money
Management, although some contributors preferred to remain anonymous. Even
with the departure of Standard and Poor's in 2012, it has been said that there
are still too many research houses in the Australian market. Some such as Mr Tim
Murphy, co-Head of Fund Research at Morningstar, and Mr Mark Thomas, Chief
Executive Officer at van Eyk Research, have argued that the only reason that so
much research exists in Australia is that Australia still permits a
pay-for-ratings model (direct 'upstream' payments) that underwrites to some
extent the business models of certain research houses.
A corollary of the pay-for-ratings model is that it may have a negative
impact on the perceived value for money of the investment research provided by
those research houses that do not accept fees for rating fund managers and that
rely to a greater extent on charging financial planners for the research.
By contrast, others such as Mr Giles Gunesekera, Head of Third Party
Sales at Principal Global Investors have argued that the diversity of research
houses in the Australian market adds depth and rigour, and that there is no
evidence that conflicts of interest in the pay-for-ratings model have any discernible
impact on the outcomes of investment research.
These arguments are also put forward by Lonsec in chapter 3.
Recent regulatory developments
The global financial crisis gave rise to concerns about the impact of
conflicts of interest within the credit ratings and research report sectors and
the adequacy of existing regulations.
On 22 May 2008, the former Minister for Superannuation and Corporate Law,
Senator the Hon. Nick Sherry MP, announced a review into the regulation of
credit rating agencies and research houses. Following a joint report in October
2008 by the Treasury and ASIC,
the government instituted reforms to the regulation of credit rating agencies
In November 2011, ASIC released a consultation paper on research houses,
followed in December 2012 by its regulatory guide on research report providers.
Avoiding, controlling and
disclosing conflicts of interest
In its regulatory guide on research report providers, RG 79, ASIC notes
that 'indirect conflicts can be as corrosive as direct conflicts to the
integrity of the research'. ASIC provides examples of direct and indirect
- direct conflicts include circumstances where another part of the
business (e.g. investment bank) has provided underwriting or consulting
services to an entity that is the subject of the research;
- direct conflicts include issuer commissioned research ('upstream'
payment). The research report provider's dependence on the income stream
generated by the client relationship has the potential to adversely influence
the independence of the research, ratings process and outcome; and
- indirect conflicts include circumstances where the client
relationships and revenue streams generated by ancillary business units such as
consulting or funds management services may indirectly conflict with the
integrity of the research service. Such conflicts may not directly relate to or
affect a specific piece of research on a specific product or issuer.
Nevertheless, these indirect conflicts share the potential to negatively affect
the independence and integrity of the overall research process. Unlike direct
conflicts, this impact may not be as readily apparent to a user of the
of the Corporations Act 2001 requires licensees to 'have in place
adequate arrangements for the management of conflicts of interest'.
Given that research houses face conflicts of interest in relation to the
funds and products that they assess, RG 79 identified the management, and where
necessary, the avoidance of conflicts of interest, as a core element in
improving the 'credibility and integrity' of research. RG 79 does not prohibit
research houses from accepting payments from product issuers to research an
issuer's products. Rather, ASIC requires the conflict of interest to be
'effectively and robustly managed'.
The committee notes that RG79 will come into effect on 1 September 2013.
ASIC will conduct surveillance to monitor the effective management of conflicts
of interest, and it has given notice that it reserves the right to revisit
conflict avoidance if research standards do not improve.
Quality and transparency of the
RG 79 sets out the criteria for quality and transparency in research
methodology and the processes used to compile a research report. ASIC expects a
research report to:
have clear, unambiguous and transparent reasons for
recommendations and opinions;
- be based on 'reasonable grounds': objective, verifiable facts and
- have 'proper purpose': offers or threats of favourable or
unfavourable research must not be used to solicit benefits or other business,
and research must not be used to unfairly or artificially increase trading
volumes or to otherwise generate revenue for the provider's ancillary
- provide a past performance warning where research ratings are
based on past performance;
- have a clear and prominent disclosure statement about who
commissioned and paid for the report;
- publish all research (including adverse research) to reduce the
perception that conflicts of interest may interfere with the research process
- date all research and give users the information to assess
whether the research is current; and
- provide both positive and negative research ratings, with access
to historical research to counter any perception that conflicts of interest may
influence the ratings process.
ASIC proposes further measures in RG 79 that it considers to be
best-practice for research houses. These measures include:
back-testing 'the past performance of researched or rated
products against relevant benchmarks';
mentoring, supervision, and ongoing training and development for
research analysts as a response to continuing innovation in financial products;
- subjecting all research reports to evaluation such as peer
Financial planners and financial
The financial planning and advice industry has been a key focus of this
committee through the 2009 Inquiry into Financial Products and Services,
The Trio inquiry in 2012, various bill inquiries into the Future of Financial
Advice (FOFA) legislation, and the proposed amendments to the Corporations
Act 2001 to restrict the use of the terms 'financial planner' and financial
The next section describes business models (such as vertical
integration) in the financial planning and financial advisory sector. It also
gives a brief outline of the conflicted remuneration models that existed in the
financial planning and financial advisory industry prior to FOFA. This is
followed by a summary of the FOFA reforms.
The committee notes, however, that despite the FOFA reforms, concerns
have been expressed in the media that FOFA does not adequately address the
conflicts of interest arising from vertical integration in the financial planning
and financial advice industry.
These concerns and the responses to them by roundtable participants are
discussed in chapter 3 in the section on the quality of financial advice and
the relationships that financial advisers have with research houses and fund
Business models and remuneration
A significant degree of vertical integration exists in the financial
services sector whereby large banks and financial conglomerates own a fund
management arm that creates financial products and also own large financial
advisory dealer groups that may recommend these products.
In its submission to the committee's financial products and services
inquiry in 2009, ASIC noted that there were '749 adviser groups operating over
8,000 practices and employing around 18,200 people'. However, large dealer
groups and banks dominate with the top 20 dealer groups having approximately 50
per cent market share. In 2009, the top groups included Professional Investment
Services, AMP Financial Planning, Count Wealth Accountants, Commonwealth Financial
Planning, ING-ANZ, AMP Group, Aviva Group, AXA Australia, NAB and Commonwealth
As a consequence of vertical integration, the committee's report noted:
Around 85 per cent of financial advisers are associated with
a product manufacturer, either as financial advisers working within the group
and using the dealer's support services or as directly employed authorised
representatives under that corporate entity's AFSL.
Furthermore, of the remaining financial advisers, many received
commissions from product manufacturers. ASIC therefore concluded that in
addition to providing advice, the vast majority of financial planners and
financial advisers acted as a sales force for product manufacturers.
The various business models in the financial advisory sector were explained
by ASIC in their submission to the financial products and services inquiry:
- Medium to large sized 'dealer
groups' that often operate like a franchise where the licensee offers back
office support. The advisers operate as authorised representatives who retain a
right to take clients with them if they move to another licensee. The licensee
is paid a proportion of the remuneration made by the authorised representative.
Example: AMP Financial Planning.
- Institutional-owned financial
adviser firms with employed advisers. Advisers in bank owned financial adviser
firms are generally employed by the bank. Advisers are paid a proportion of the
commissions earned or salaries or a combination of both. Example: Westpac
- Smaller firms that have their own
licence and might outsource compliance functions to specialist dealer services
providers such as Paragem Partners or to large dealer groups who provide dealer
to dealer compliance services. Example: Securitor.
Prior to FOFA, ASIC advised that in 2008, only 16 per cent of total
advisor revenue came from fee-for-service. The proportion was higher among
truly independent advisers. The vast majority of remuneration came from
commissions paid by product manufacturers and volume-based bonuses:
Because an explicit fee for service would likely be perceived
by retail investors as high in relation to the value of advisory services, most
financial advisers tend to charge low or zero fees for service, in order to
encourage business. They then get remuneration indirectly by receiving commissions
from product manufacturers on the funds invested by retail investors. Product
manufacturers recover the costs of commissions from the overall charges within
the investment products.
Trailing commissions (usually 0.6% of account balances) are
the main remuneration method for financial planners, with seven in ten planners
citing them as a form of remuneration. Other forms of remuneration include
initial commission on new investment/contribution (up to 4-5% of
contributions), volume bonuses (i.e. additional commission of up to 0.25% of
account balances), and fee for service charged to the client (up to 1% of
account balance, or a flat fee, perhaps related to the hours involved). These
amounts would not all be paid at the maximum level.
Trailing commissions are more common among aligned
independent and aligned planners, while bank-based planners favour up-front
After considering the business models in the financial planning and
advisory sector, the committee highlighted the sales-advice conflict: that is,
the sales imperative within the business structure of the vast majority of the
financial advisory sector may conflict with the financial advisers' duty to
provide advice that best suits the needs of the client.
Accordingly, the committee's report on financial products and services recommended
that the Corporations Act 2001 be amended to explicitly include a
fiduciary duty for financial advisers to place their clients' interests ahead
of their own, and that payments from product manufacturers to financial
advisers should be banned. The FOFA provisions arose out of these
recommendations and are covered next.
Future of Financial Advice (FOFA)
The FOFA provisions came into force from 1 July 2013. Between December
2012 and March 2013, ASIC issued five regulatory guides on FOFA. They are:
- RG 246 on the 'conflicted remuneration provisions' in Divisions 4
and 5 of Part 7.7A of the Corporations Act 2001;
- RG 245 on the disclosure provisions in the FOFA reforms;
- RG 183 that, among other matters, clarified exemptions from the
- RG 175 on the 'best interests' duty of financial product advisers;
- RG 244 on scaled advice.
Two of the key provisions in the FOFA legislation are the ban on
commissions on superannuation and investment products, and the fiduciary duty
for financial planners and financial advisers to act in the best interest of
Prior to FOFA, a financial planner or financial adviser could charge a
client on-going fees regardless of the level of service provided. Under FOFA, however,
'opt-in' and fee disclosure requirements have been introduced that mean
advisers must gain client consent for on-going fees:
Advisers will be required to request their retail clients
opt-in, or renew, their advice agreements every two years if clients are paying
ongoing fees. In addition, an annual statement outlining the fees charged and
services provided in the previous 12 months must be provided to clients paying
ongoing fees. This means advisers will be in regular contact with their clients
and will need to demonstrate the value of the services they are providing their
However, there is a provision for exemption from the 'opt in'
requirements if a financial planner or financial adviser can show ASIC that
they are bound by a code of conduct that achieves a similar outcome to
The Financial Planning Association (FPA) has submitted its code to ASIC.
Should ASIC find the code acceptable, approximately 8500 FPA practitioners
would be exempt from the 'opt-in' requirements. The Association of Financial
Advisers is also drafting its own code of conduct, which if accepted, would
exempt another 2000 practitioners from 'opt-in'.
Chapter 7 of the Corporations Act 2001 states that under an
arrangement between a provider and a client, the custodian holds a financial
product, or a beneficial interest in a financial product, in trust for, or on
behalf of, the client or another person nominated by the client.
In other words, a custodian holds the assets of another party for safekeeping.
The Australian Custodial Services Association (ACSA) defines custody as the:
safekeeping of assets (such as shares, bonds and other
investments). The safekeeping function reduces risk for clients (asset owners),
and provides the definitive book of record for institutional holdings and
The use of a custodian means that the assets are separated from the
investment manager, and it is argued, the assets are therefore better protected
in the case of the insolvency of a RE or trustee.
Although the principal role of a custodian is the safekeeping of assets
and the settlement of securities transactions, additional custodian services may
involve administration of the fund or scheme including unit pricing, tax and
statutory reporting, portfolio/fund valuation, and unit registry services.
Furthermore, where trustees do not satisfy the capital requirements of
either APRA for superannuation trustees or ASIC for registered MISs, a
custodian is appointed as a condition of a licence being granted to the trustee.
under the remit of ASIC, but the operations of custodians are also of interest
to APRA because custodians provide services to RSEs that are regulated by APRA.
Furthermore, where a custodian is an authorised deposit-taking institution, it
falls under APRA's supervision.
Size and structure of the industry
As at 31 December 2011, assets of Australian investors worth
approximately $1.82 trillion were held in custody. ASIC expects this figure to increase
to $6.4 trillion by 2026.
The custodial industry in Australia is highly concentrated among a few
firms, with the six largest custodians having 84 per cent of the market:
||Assets in custody
Market share (%)
National Australia Bank Asset
Treasury and Securities Services
Expectation gap around the role of
The Trio inquiry exposed an expectation gap between what retail
investors understood as the role of a custodian and what custodians are legally
required to do. There was an expectation that a custodian would act to protect
and secure underlying assets. However, in its submission to the Trio inquiry,
ANZ laid out the functions of a custodian. Significantly, it noted that
custodians are not required to confirm the existence of underlying assets:
It has been suggested in submissions made to the Committee
that a custodian is required to confirm the existence of a fund’s underlying
assets. This is incorrect. The custodian’s role and function, as bare trustee,
is to hold assets on behalf and upon instruction of the RE. Its duty, which is
owed exclusively to the RE, is to act on proper instructions from the RE in
relation to those assets. The role of the RE is to manage the assets of the
scheme, including activities such as investment strategies and valuations. A
custodian does not have discretion to choose whether or not to act on a proper
instruction which is lawfully given by the RE. The custodian has no discretion
regarding the investment or management of the custodial assets.
Given the misunderstanding of the role of the custodian, in its report
on Trio, the committee recommended that ASIC should consider changing the name
'custodian' to a term such as 'Manager's Payment Agent' that better reflected
the limited role of the custodian.
Between 2009 and 2011, ASIC reviewed the Australian custodial industry,
including industry liaison and surveillance. In July 2012, ASIC released Report
291, 'Custodial and depositary services in Australia'.
The proposed name change was one element of discussion.
In its submission to Report 291, ACSA argued that changing the name
'custodian' to a term such as depositary would do little to close any
expectation gap around the role of a custodian. In particular, ACSA noted that
custodian businesses operate globally and that under proposed European Union
directives, the terms custodian and depositary will have different meanings and
different responsibilities. ACSA expressed concern about the confusion that
could arise if Australia diverged 'from globally accepted practice'.
This perspective was reiterated at the hearing by Mr Paul Khoury, Deputy
Chairman of ACSA:
We are strongly of the view that the title 'custodian' is
firmly appropriate, for a number of reasons. Most importantly, we operate in a
global environment and, from a consistency perspective that is a broadly
well-accepted term that we operate in. But ultimately what we are trying to do
is avoid confusion.
Instead of a name-change, Mr Khoury observed that a better approach
would be to educate Australian consumers on the functions and responsibilities
of a custodian. He also suggested that specific information about the role of a
custodian could be included in prospectuses and product disclosure statements.
As part of its education campaign, ACSA released a document in 2012,
'The role of a custodian'. The document clearly set out the functions, roles,
and responsibilities of a custodian. In it, ACSA cautions that:
It is important not to over or under
interpret the benefits provided by the custodian:
- The custody function protects the
fund's assets firstly by providing clear separation from each investment
manager, and also by ensuring that payments of money and delivery of securities
only take place as the result of a proper instruction (and in accordance with
the rules and conventions of the relevant market’s clearing and settlement
the custodian provides a consolidated view of holdings and transactions. This
role, as a trusted record-keeper (across all of the client's assets and
portfolios), provides the cornerstone for efficient and consistent reporting
custodian does not (and cannot) second guess investment decisions or over-ride
- The role of the custodian is
analogous in many respects to that of a bank or credit union processing
payments for its customers. Banks or credit unions do not stop payments of
customers because they think that spending money on a particular transaction is
'wrong' or 'unwise'. In fact, confidence in the banking system relies on this
lack of discretion and client confidentiality.
A trustee is a person or company that holds or administers property or
assets on behalf of a beneficiary. A trustee must act in the best interests of
the beneficiary and is generally not allowed to benefit or profit from its
position unless specified in the trust document. Trustees perform a range of
functions involving estate planning and management such as the preparation of
wills, Enduring Powers of Attorney, investment and executor and financial
In the corporate trustee sector, the three main licensed trustee company
roles are as debenture issuers, RE and custodian. However, the Financial
Services Council noted that the 'scope of the duties and functions of each role
is different ... and is determined by the structure of the scheme and the
documents that govern the scheme.' For example, the role of an RE is similar to
a trustee, but the RE has additional statutory obligations, while a custodian
acts as a 'bare trustee', meaning the scope of its obligations to an RE is very
Trustee companies often operate as a group of companies with subsidiary
companies that hold an RE licence or a custodian licence.
For example, One Investment Group holds several AFSLs and is licenced to act as
a custodian, as a trustee for unregistered schemes, and as RE for registered
The roundtable focussed on the role of company trustees as custodian and
The RE role is covered in the next section.
The committee was also interested in the role of trustee as it related
to superannuation funds. At $1.3 trillion, Australia has the fourth largest
funds management market in the world, with approximately 45 per cent of that due
to the size of Australia's superannuation savings that now exceed $530 billion.
Given that the Trio fraud involved superannuation funds being invested in a
fraudulent MIS, the committee wanted to scrutinise the role that superannuation
trustees play within the APRA-regulated part of the system as trustees for
registrable superannuation entities.
On 26 March 2008, the Council of Australian Governments agreed that the
Australian Government would assume responsibility for regulating traditional
services provided by trustee companies. On 6 November 2009, the Corporations
Act was amended to include the regulation of traditional services provided by
trustee companies under chapters 5D and 7 of the Corporations Act.
Traditional services provided by a trustee are now specified as a financial
service under section 766A(1A) of the Corporations Act.
On 15 March 2010, ASIC issued a consultation paper on the new
obligations facing trustee companies, including the requirement to hold an
Prior to these changes, some trustees already held an AFSL that authorised them
to provide custodial and depository services. Companies wishing to provide
traditional trustee services along with custodial and depositary services now
need to modify their licence to include trustee services.
Some trustee companies (RSEs) are regulated by APRA. For those
traditional trustees not regulated by APRA, the new regulations introduced by
ASIC required the trustee to:
- have risk management systems in place to deal with the risk that
its financial resources may be inadequate to enable it to continue its
- meet specified base level financial requirements; and
- hold at least $5 million in net tangible assets.
Trustee interactions with
In a recent article, APRA has drawn attention to an expectation gap
between what custodians provide to the trustees of an RSE and what trustees
assumed they were receiving, particularly in the area of asset valuation:
Custodians can play key roles in providing investment
accounting and unit pricing services to superannuation trustees, and may also
provide trustees with investment performance reporting or services such as
foreign exchange or currency overlay.
APRA observed that, in a number of cases, trustees rely on
custodian information and practices around valuation sources, tax calculation
approach and unit pricing methodology without sufficient enquiry or assertion
of the trustee's expectations in this area. This is a consistent theme
identified by APRA in respect of asset valuations.
Based on APRA’s experience, trustees often place reliance on
the fact that valuations for unlisted assets are 'sourced' from the custodian
and thus assume the valuations to be both robust and independent. However, APRA
found that custodians operate predominantly on client trustee instructions and
the extent of custodian input in the area of valuation was less than that
expected by trustees.
In 2011, APRA indicated that it would discuss with trustees the extent
to which trustees monitored and assessed the accuracy of the information that trustees
received from custodians:
As part of its supervisory practices going forward, APRA will
discuss with trustees the extent to which they obtain assurance that unlisted
asset valuations used in NAV (net asset valuation) calculations are adequately
robust. It is not sufficient to simply state that the NAV is obtained from the
custodian and hence it is 'independent'. Trustees also need to assess the source
and adequacy of valuation data used by the custodian. In all cases, trustees
should remember that the valuation process affects member interests and is a
trustee responsibility. Similarly, trustees should have an understanding of the
controls in place at the custodian to check the reasonableness of the pricing
(valuation) data received. APRA expects trustees to know the extent to which
stale price valuations are being monitored and to ensure they are receiving
adequate and timely reporting from the custodians on such prices.
Given the importance of this interaction, the committee was keen to build
on APRA's initial work and examine the wider relationship between RSE trustees,
custodians and REs, and also between the auditors of those of entities.
Fund managers and Responsible
In Australia, the term 'managed funds' covers 'two broad types of
The first are managed funds institutions (such as life
insurance companies, superannuation funds and unit trusts), which buy assets on
their own account. The second are investment or fund managers, which act as
investment agents for the managed funds institutions, as well as others with
substantial funds to invest.
The inquiry was concerned with the investment fund managers that manage
a portfolio of assets and act as the RE for a range of MISs.
Size of the Australian managed
The Australian managed funds sector is one of the largest in the world. REs
manage a significant amount of non-superannuation assets:
As at February 2013, over 500 responsible entities operated
about 4,000 registered managed investment schemes (schemes). The largest ten
investment management groups collectively managed $531 billion for numerous
schemes in the September 2012 quarter, amounting to roughly one quarter of the
funds under management in Australia. In contrast, smaller investment managers
in the sector may only operate one scheme with a relatively small asset value.
Some of the larger Australian retail fund managers include Australian
Ethical, Australian Unity Investments, BlackRock Investments, BT Financial
Group, Challenger, Colonial First State, Hunter Hall, Lifeplan Funds Management,
Macquarie Group, Man Investments, MLC, OnePath, Perpetual and Zurich.
The managed funds sector invests in a range of assets including
Australian and international shares, infrastructure, fixed income securities,
mortgages, property, cash, unlisted private companies, and specialist sectors.
Platforms have become a significant part of the retail investment market
with most new investment occurring in this fashion. ASIC describes them as
A platform is an administration facility that simplifies
acquisition and management of a portfolio of investments. Platforms allow
retail investors to purchase a range of investments through the one facility.
In one sense platforms are like a department store where you can choose from
different brand names and products in the one place, rather than having to
visit a number of specialty stores.
Financial planners generally place their clients into platforms because
it consolidates the investment reporting process. Retail investors can gain
advantage from being placed in a platform because retail funds can be pooled,
thereby allowing access to products that are normally reserved for wholesale
clients by virtue of the minimum investment requirements (typically $500 000).
The two most common types of platforms are:
- master trusts – a master trust
operates as a managed investment scheme. In a master trust the platform
operator (or trustee) owns all the assets and the investors hold units in the
managed investment scheme; and
- wrap accounts – a wrap account
allows the investor to set up a portfolio of investments where the investment
is made in the name of the wrap account operator (or custodian) but the
investor has a specific beneficial interest in the assets reflected in the
records of the wrap account operator (or custodian). This structure is
increasing in popularity. The service 'wraps' or combines investments into a
single account to facilitate the management of an investment portfolio.
Platform providers charge service fees, and fees are also payable on
specific platform investments.
In contrast to a professionally/actively managed fund, index funds are
passive mutual funds with a portfolio constructed to match or track the
components of a market index, such as the Standard & Poor's 500 Index
(S&P 500). An index fund typically provides broad market exposure, low
operating expenses and low portfolio turnover. The Vanguard 500 Index Fund,
launched in the United States in 1976 by Mr Jack Bogle, was the first
industry fund for individual investors.
Research by the American economist, Dr Burton G. Malkiel, indicates that
over the last 30 years, passively-held index funds have substantially
outperformed the average active fund manager. He also observes that the amount
of under-performance is well approximated by the difference in the fees charged
by the two types of funds. Dr Malkiel acknowledges that some active management
is required for market efficiency because it ensures that information is
properly reflected in securities prices. However, he found that 'the number of
active managers and the costs they impose far exceed what is required to make
our stock markets reasonably efficient' (see chapter 5).
Although index funds were not the subject of the roundtable discussion,
the committee did question the Australian fund managers about the issues raised
by Malkiel. The responses by the fund managers are summarised in chapter 5, and
the full responses are available in Appendix 2.
Responsible Entities and managed
Section 601ED of the Corporations Act states that an MIS must be
registered if it has 20 or more members, or if the scheme is promoted by a
person who is in the business of promoting MISs.
An MIS is typically a collective investment such as a property trust,
cash management trust, equity trust, agricultural scheme, timeshare scheme,
mortgage scheme or actively managed strata title scheme.
A registered MIS must appoint an RE,
and the RE must be an Australian registered public company that holds an AFSL
permitting it to operate the scheme.
The scheme must lodge a constitution and compliance plan with ASIC.
In effect, an RE is a single, clearly identifiable entity that is
responsible to investors for the operation of a registered MIS in accordance
with the scheme's constitution and compliance plan.
The RE has a trusteeship or fiduciary duty to the investors in the
The extent of an RE's accountability is laid out by Mr Justin Epstein,
Executive Director of One Investment Group when he explains that:
The role of a Responsible Entity today, distinct from other
gatekeepers, such as Custodians and Auditors, is to bear the ultimate
accountability to investors for a registered scheme. That is, whilst the
Responsible Entity is not prohibited from appointing an agent, the legislation
states that the Responsible Entity is taken to have done (or failed to do)
anything that the appointed agent has done (or failed to do), even where the
agent acted fraudulently or outside the scope of their authority or engagement.
In this regard, we consider the Responsible Entity to be the critical
gatekeeper for registered schemes.
The Corporations Act requires that all property in a MIS 'is clearly
identifiable as scheme property and held separately from the property' of the
RE and any other MIS, and that scheme property is valued regularly.
Since 28 June 2007, however, neither ASIC guidelines nor the
Corporations Act have placed restrictions upon the investment strategy of a
registered MIS. This has allowed a registered MIS to diversify into, for
example, foreign investments.
Responsible Entity business models
There are two forms of RE: internal, where the manager of the scheme and
the RE are related body corporates, and external where the RE is independent of
the manager of the scheme and does not own or control the MIS.
One Investment Group operates as an external RE for registered schemes, as well
as a trustee and custodian. BT Financial Group is a large financial services
conglomerate that operates an internal RE function, as well as being a fund
The majority of REs are multi-function REs that operate more than one scheme.
The Corporations and Markets Advisory Committee noted in a report published
last year that:
- 39 per cent of REs operate one scheme;
- 32 per cent of REs operate more than one, but less than 5,
- 26 per cent of REs operate 5 or more, but fewer than 50, schemes
(e.g. Trio); and
- 3 per cent of REs operate 50 or more schemes.
Of the 500 plus REs operating in Australia, there are 33 dual-regulated
entities that hold both an AFSL from ASIC to operate as a RE, and a RSE licence
from APRA to operate as an RSE.
Trio Capital was a dual-regulated entity.
Section 601HA of the Corporations Act requires each registered MIS to
have a compliance plan that sets out adequate measures for the RE to undertake
to ensure that the MIS complies with its legal obligations under its
constitution and the Corporations Act.
However, ASIC warns of a 'fundamental risk' that the RE of an MIS may
not follow 'the rules set out in the managed investment scheme's constitution
or the laws governing registered managed investment schemes'.
Chapter 5C of the Corporations Act aims to address the risk that an RE
may not comply with its duties by setting out requirements for compliance
plans, compliance audits and compliance committees.
Each registered MIS must have a compliance plan committee 'made up of
independent and other auditors who are charged with the role of monitoring the
RE's adherence with the plan and other scheme governing documents'.
Section 601JA of the Corporations Act requires each registered MIS to
establish a compliance committee if less than half the directors of the RE are
The compliance plan committee is 'made up of independent and other auditors who
are charged with the role of monitoring the RE's adherence with the plan and
other scheme governing documents'.
However, at the time of the Trio inquiry, ASIC noted that there were no
'legislative requirements as to experience, competence or qualifications for
compliance committee members' and that there was no requirement for prospective
compliance committee members to undergo training.
In March 2013, ASIC
released a consultation paper that proposed changes to the risk management
systems of those REs that are not regulated by APRA. The proposed regulations
would also apply to dual-regulated entities (entities that are regulated by
both ASIC and APRA). The changes include a focus on fundamental risk management
practices, fostering a risk management culture, and reviewing the effectiveness
of risk management systems.
Auditors undertake a crucial role in the financial services system,
scrutinising both the financial statements and the compliance plans of
Auditing standards in Australia are governed by the Corporations Act. The
Auditing and Assurance Standards Board is established by section 227 of the
It is responsible for developing auditing standards in Australia.
The Australian Auditing Standards are based on the International Auditing and
Assurance Standards Board International Standards on Auditing. 
Audits must be conducted in accordance with legally enforceable auditing
standards that were introduced for financial reporting periods from 1 July 2006,
following the Corporate Law Economic Reform Program (Audit Reform and
Corporate Disclosure) Act 2004.
Australia's financial reporting system is established by Part 12 of the Australian
Securities and Investments Commission Act 2001 (the ASIC Act). One of the
main objects of section 224 of the ASIC Act is to develop auditing and
assurance standards that:
- provide Australian auditors with
relevant and comprehensive guidance in forming an opinion about, and reporting
on, whether financial reports comply with the requirements of the Corporations
require the preparation of
auditors' reports that are reliable and readily understandable by the users of
the financial reports to which they relate.
Key auditor attributes
Auditor independence is a fundamental principle of the external auditing
By virtue of this independence from the other gatekeepers, auditors occupy a
critical role in the financial services system given that the other gatekeeper
roles including research, custody, trustee, RE, fund manager, financial planner
and financial adviser can all function together as part of one large financial
The Auditing and Assurance Standards Board (AUASB) has developed a set
of requirements to which independent auditors are required to adhere. These
include independence, and the application of professional scepticism and
professional judgement. In addition, in order to obtain reasonable assurance,
an auditor is expected to obtain:
sufficient appropriate audit evidence to reduce audit risk to
an acceptably low level and thereby enable the auditor to draw reasonable
conclusions on which to base the auditor's opinion.
Treasury consultation paper
In March 2010, a Treasury consultation paper found that Australia's
'audit regulation framework is robust and stable' and 'in line with
international best practice'.
In particular, Treasury emphasised two crucial and unique attributes
applicable to Australia. Firstly, that as a statutory body under federal
legislation, ASIC regularly reviews the audit process with its audit inspection
program. And, secondly, that accounting and auditing standards and auditor
independence are all legally enforceable under the Corporations Act.
These two factors contributed significantly to the robustness of the audit
ASIC's audit inspection program and
the response from the audit profession
Following the release of its audit inspection program report for
2011–12, ASIC has placed the audit industry on notice regarding the quality of
financial statement audits.
In its recent ASIC Oversight reports, the committee questioned both ASIC and
the audit profession at length about the steps that are being taken to raise
the level of audit quality in Australia.
The committee notes that on 13 June 2013, ASIC welcomed the development
by each of the six largest audit firms in Australia of 'a genuine and
comprehensive action plan to improve audit quality', noting that each firm had
'taken full ownership for the timely implementation of the plan and monitoring
ASIC asked the six firms 'to focus on improving the consistency of the
execution of audits' and to address the three broad areas requiring improvement
that were identified in ASIC's audit inspection report:
- the sufficiency and
appropriateness of audit evidence obtained by the auditor;
- the level of professional
scepticism exercised by auditors; and
- the extent of reliance that can be
placed on the work of other auditors and experts.
In working with the firms, ASIC notes that the action plans will focus
- the culture of the firm, including
messages from firm leadership focusing on audit quality and consultation on
complex audit issues;
- the experience and expertise of
partners and staff, including increased and better use of experts;
- supervision and review, including
greater partner involvement in working with audit teams in the planning and
execution of audits, and new or increased real time quality reviews of
- accountability, including impacts
on remuneration of engagement partners and review partners for poor audit
quality, often extending the impacts to firm leadership.
CPA Australia guide to auditing and
In February 2013, CPA Australia released 'A guide to understanding
auditing and assurance'. Mr Alex Malley, Chief Executive Officer of CPA
Australia notes that the guide:
explains the value and purpose of auditing and assurance in
plain language. This should assist shareholders who are not experts in auditing
and assurance to better understand the messages from their company’s auditor,
and make use of this information in their decision making.
The guide addresses some of the expectation gaps that have been
highlighted in the wake of recent corporate collapses. In particular, it addresses
the meaning and extent of the 'reasonable assurance' that is obtained in an
audit of financial statements:
While the reasonable assurance obtained in an audit is a high
level of assurance, it is not absolute assurance (a certification that the
financial statements are completely correct). Obtaining absolute assurance is
not possible in financial statement audits for a number of reasons, including:
it would be impractical for the
auditor to test and audit every transaction; and
- financial statements involve
judgements and estimates which often cannot be determined exactly, and may be
contingent on future events.
By contrast, the half-yearly review of financial statements by an
auditor only provides limited assurance.
The guide also deals with unmodified and modified opinions and explains
that an emphasis of matter paragraph is not a qualification, limitation, or
An unmodified auditor's report effectively states the auditor
believes the financial statements present a true and fair view, and are in accordance
with accounting standards and relevant legislation. This is sometimes also
called an 'unqualified' or a 'clean' audit opinion.
An unmodified review report effectively states the reviewer did
not become aware of anything that suggested the financial statements do not
present a true and fair view in accordance with accounting standards.
In some circumstances, the auditor will include additional wording
in the auditor’s report directing users to information that in their view is fundamental
to understanding the financial statements. This may be information included in
the financial statements, such as a note (called an 'emphasis of matter'
paragraph), or information that is included elsewhere (called an 'other matter
paragraph'). It is important to note that an emphasis of matter or other matter
paragraph is not a qualification, limitation or adverse conclusion.
Modified auditor's reports are issued when the auditor
believes the financial statements contain a material misstatement, or when the
auditor is unable to obtain enough evidence to form an opinion.
In response to a request from the committee, CPA Australia clarified the
distinction between an emphasis of matter and a modified audit opinion:
There is a clear distinction between an emphasis of matter
and modified audit opinion:
- a modified audit
opinion is required where the financial statements are materially
misstated or the auditor is unable to form a conclusion due to a limitation
of scope; and
- emphasis of matter paragraphs
highlight matters that are not materially misstated in the financial
statements but which in the auditors' judgement are of such importance so as to
be fundamental to users' understanding of the financial statements.
The use of an emphasis of matter paragraph does not ever
replace the need for a modified audit opinion where the financial statements
are materially misstated - hence rather than representing a threshold, modified
audit opinions and emphasis of matter paragraphs are two different things or
Professional judgement is relevant to both of these aspects
as it would be involved in forming a conclusion in regard to a material
misstatement of the financial statements, and also in determining whether a
matter is of such importance that it is fundamental to users' understanding of
the financial statements. Australian auditing standards contain comprehensive
requirements including general principles and specific rules where appropriate,
together with a range of guidance statements that have been issued by the
AUASB. However, the availability of this material does not replace the need for
experience and professional judgement in performing an audit.
Fraudulent activity can result in the material misstatement of financial
statements. CPA Australia observes that even though an audit is not designed to
uncover all instances of fraud, 'it is reasonable to expect that an audit would
detect instances of fraud that result in material misstatement'.
An auditor also makes a judgement about the ability of a company to
continue as a going concern for the 12 months subsequent to the audit. This
assumption may be inherently difficult to determine. Furthermore, investors
need to be clear about the nature of an emphasis of matter paragraph if the company
has already disclosed uncertainty about its ability to continue as a going
The going concern assumption involves judgements about events
taking place in the future, which are inherently uncertain. Where there is
significant uncertainty in the company's ability to continue as a going concern
and this has been disclosed by management in the financial statements, the
auditor includes wording in the auditor's report to direct users to the
applicable note in the financial statements. This is called an emphasis of
matter paragraph. If the auditor ultimately does not agree with management’s
assumptions in regard to going concern, the result would be a modified opinion.
Finally, and very importantly, an unmodified auditor's report is an
opinion about the state of the company's financial statements that provides
investors 'with a higher degree of confidence that the information is
materially correct and unbiased. The audit does not, however, express an
opinion 'about the state of the company itself or whether it is a safe
investment'. In a similar way, the audit assesses 'the going concern
assumptions used by management in preparing the financial statements'. However,
the audit opinion 'cannot be taken as a conclusion on the solvency or financial
health of the company'.
Structure of the audit industry and
conflicts of interest
The audit industry in Australia and globally is dominated by four large
audit firms: PricewaterhouseCoopers, Deloitte, Ernst & Young and KPMG. This
has raised concerns both internationally and within Australia about the extent
of competition within the audit market and its potential impacts on audit
In February 2013, the United Kingdom (UK) Competition Commission issued the
provisional findings of its market investigation into the supply of statutory
audit services to large companies in the UK. It concluded that competition in
the audit market 'is restricted by factors which inhibit companies from
switching auditors and by the tendency for auditors to focus on satisfying
management rather than shareholder needs'.
Ms Laura Carstensen, Chair of the UK Audit Investigation Group, found
that existing safeguards, such as audit committees, appeared insufficient to
prevent misaligned auditor incentives or to facilitate a dynamic and
independent auditing market:
Shareholders play very little role in appointing auditors
compared to executive management-and despite the presence of audit committees
and other safeguards-audit firms naturally focus more on meeting management
interests. The result is a rather static market in which too often audits don't
fulfil their intended purpose and thus fail to meet the needs of shareholders.
It is clear that there is significant dissatisfaction amongst
some institutional investors with the relevance and extent of reporting in
audited financial reports. This needs to change so that external audit becomes
a more genuinely independent and challenging exercise where auditors are less
like corporate advisors and more like examining inspectors.
In its previous ASIC oversight report, the committee expressed concern
about the potential conflict of interest that arises when an audit firm has to
balance commercial pressures (retaining client contracts) with adherence to
audit quality (highlighting matters of concern in financial statements and/or
Compliance plan audits
Section 601HG of the Corporations Act requires the compliance plan of
the RE to be audited annually. Under section 601HG(2) of the Corporations Act,
the auditor of an entity's compliance plan cannot be the auditor of that
entity's financial statements, although the auditors may work for the same
The compliance plan auditor is required to state in its report whether
the RE complied with the MIS's compliance plan during the financial year and
whether the plan continues to meet the requirements of Part 5C.4 of the
According to ASIC however, Part 5C.4 of the Corporations Act 'does not
impose any qualitative standards by which a compliance plan auditor must
conduct their audit' and 'does not make it an offence to conduct a poor quality
compliance plan audit'. Furthermore, the auditor is only required to check
compliance with the compliance plan, not the compliance of the RE with the Corporations
Act or the constitution of the MIS.
Finally, the assurance standards for a compliance plan audit do not have
the force of law, unlike the assurance standards for an audit of financial
statements. At the time of the Trio inquiry, ASIC observed that there is no
precedent for a successful action against a compliance plan auditor.
Audits of self-managed
From 1 July 2013, the Superannuation Laws Amendment (Capital Gains
Tax Relief and Other Efficiency Measures) Act 2012 introduced a requirement
for auditors of self-managed superannuation funds (SMSF) to register with ASIC
to conduct SMSF audits.
The registration system administers a competency exam designed to test critical
judgement in relation to superannuation requirements and tax compliance.
Key issues involving auditors
In its report into the collapse of Trio, the committee drew attention to
the role of auditors and expressed concern that:
- an auditor's approval of financial statements does not
necessarily mean that the actual assets underlying the financial statements
- an auditor's assessment of a compliance plan and the work of the
compliance committee as 'effective' essentially only means that they exist; and
- in the case of Trio, the requirement for the auditors to demonstrate
'professional scepticism' about the information given to them was insufficient
to prevent the loss of investors' funds.
At the roundtable, the committee was interested in several aspects of
compliance plans including the adequacy of compliance plans, the capabilities
of compliance committees, the degree of independence that compliance committees
have from the management of the RE, the auditing of compliance plans, the
relationships that the audit profession had with the compliance committees of
REs and RSEs, and the degree of cross-referencing between financial statement
and compliance plan audits.
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