The recent Storm Financial case is a rare opportunity for us to see how the Courts interpret the financial services laws. The case contains some important lessons for financial service providers. imac legal summarises the main points.
Australian Securities and Investments Commission v Cassimatis (No 8)  FCA 1023, judgement delivered 26 August 2016, by Edelman J.
This Federal Court case, colloquially called the Storm Financial case (as the directors who were the subject of the legal action were directors of former financial planning firm Storm Financial), represents a rare opportunity to understand how the courts interpret our financial services laws.
imac legal identifies the salient observations and lessons for financial services business below. But of course, a word of caution: it is not known at the time of writing whether the case will be appealed. References to the Act refer to the Corporations Act 2001 (Cth).
Storm Financial (‘Storm’) was a financial planning firm that collapsed in the wake of the GFC. The company had developed and used a particular advice model that included recommending double gearing (borrowing against a home and taking out a margin loan) to clients. Many of these clients suffered large losses when the GFC hit.
This particular case (as there have been others involving Storm) was brought by ASIC against the directors of Storm (Mr and Mrs Cassimatis).
The case was focused on a group of 11 investors who had 5 things in common: they were over 50 y.o; they were retired or nearly so and planning for it; they had limited income; they had few assets; and, they had limited prospect of rebuilding their financial position should they suffer a significant loss.
Each investor went through the ‘Storm model’ which included a ‘primer’ meeting, an education workshop, meetings with an adviser, creation of a cash flow model, presentation of an SOA, borrowing and adoption of a double gearing strategy to invest into index funds, and making additional ‘step’ investments if the market rose or fell by a certain amount or if the client’s circumstances changed significantly.
ASIC alleged that the directors of Storm breached their duties to act with ‘care and diligence’. They did not argue that the ‘Storm model’ was flawed overall, only that it was not right for all investors, of which the 11 investors were a class.
The Cassimatises (i.e. the Storm Directors) argued that the Storm model was viable and that any contraventions of Storm’s regulatory obligations were not reasonably foreseeable. In particular, they relied on the fact that Storm had been reviewed by compliance advisers, ASIC and by its own non-executive directors and that none of these identified ‘any concerns’.
Ultimately, the Court found that “a reasonable director with Mr and Mrs Cassimatis’ responsibilities, and in Storm’s circumstances, would have realised that the application of the [Storm] model to people in the [investors’] circumstances was likely to involve inappropriate advice”, causing Storm to breach s945A(1)(b) and s945A(1)(c) – the ‘reasonable basis’ provisions as they were at the time.
Scoping is King – consideration of the subject matter of the advice
The evidence established that the Storm model was very structured and included collection of a lot of pertinent client information. In this way, the Court was satisfied that Storm had met the 1st limb of the reasonable basis for advice test in s945A(1), principally that they had conducted reasonable investigations into clients’ relevant personal circumstances.
However, where the Storm model fell down, according to the Court, was in the second limb of the reasonable basis for advice test in s945A(1), namely it had not demonstrated reasonable consideration and investigation of the subject matter of the advice.
This is a salient point for a number of reasons. The first reason the Court’s observations about the subject matter of the advice are particularly important is that the Court clearly accepted ASIC’s arguments that the subject matter of advice is to be construed broadly.
It appears that one of the reasons Storm did not meet the required test of “reasonable consideration and investigation of the subject matter of the advice” was that they had misconstrued the actual subject matter of the advice. Storm had relied on a narrow reading of what the subject matter of the advice was.
Storm’s directors argued that the subject matter of the advice was limited to the index funds and cash management trust whereas ASIC argued that the subject matter was the index funds, cash management trust, the home loan, and the margin loan. As a matter of legal construction, the Court was emphatic that the subject matter of the advice is not limited to “a particular financial product”. The subject matter of the advice is much broader.
In fact, the Court said that “the subject matter of the advice contemplates the investigation of all of the matters (and more) upon which the advice will ultimately be based.”
ASIC argued, and the Court accepted, that the subject matter of the advice included:
- what was effectively a ‘scoping’ statement in the SOA, viz: “You have asked our advice on the best ways to continue your wealth building over the next 10 years and beyond. Important financial goals for the future include building a solid financial base that will aid your wealth creation, allowing you to maintain a comfortable lifestyle into your retirement. It is therefore a major aim to produce a portfolio of assets that will result in an income stream independent of your personal exertion work. This will facilitate the transition to relying on income from your capital …”;
- the investment recommendations set out in the SOA. These recommendations included taking out home loans and margin loans, investing in index funds, establishing and investing in a cash management trust, as well as “pay[ing] Storm’s fees … for the advice”.
The Court also stated, by way of example of the broad meaning of ‘subject matter of the advice’, that “A recommendation or statement of opinion “in relation to” a financial product such as an index fund must include the recommendation concerning how to borrow to invest in that index fund. The subject matter of that advice is broader still. It is the general subject matter with which the relevant matters relating to the financial product are concerned.”
One of the factors that went to showing unreasonable consideration was the fact that alternative strategies were not considered by Storm. The judge accepted the industry norm that “there had always been an obligation on an adviser to advise on alternative strategies”. And “an SOA should also have contained the ‘pros and cons’ of each alternative.”
Some of the other things it appears Storm did not properly consider were: the capacity of the clients to meet cash flow shortfalls out of their own funds, the possibility (or likelihood) of a market downturn and its effect on the affordability of the recommended strategy, the capacity for the clients to recover from a significant market event and the effect this would have on their retirement plans.
Ultimately, the Court also found that the 3rd limb of s945A(1), being that the advice must be appropriate, was also not met. It followed that these breaches were also enough to prove that Storm had also breached its general obligation in s912A(1)(c) to comply with the financial services laws.
TIP: The Storm case makes it abundantly clear that accurately identifying the subject matter and scoping your advice is critical. Not only must you make reasonable inquiries about the client’s relevant circumstances but, as a professional adviser, you are expected to apply your knowledge and skills to ensure you properly consider all the circumstances that are relevant to the subject matter.
s945A (Reasonable Basis for Advice) vs s961B(2) (Best Interests Safe Harbour)
We do not wish to enter into the realm of speculation but one of the interesting considerations from the Storm case is whether Storm would have fallen foul of the best interests test in s961B had the conduct occurred post-FOFA.
This is pertinent because the best interests test is drafted differently regarding the obligations in relation to the ‘subject matter of the advice’. While s961B does contain numerous obligations in relation to the subject matter, it does not contain the same explicit requirement as s945A to “give reasonable consideration to the subject matter of the advice” (although it is arguable that the explicit requirements as well as the ‘catch all’ obligations in s961B(2)(g) to “take any other step that … would reasonably be regarded as being in the best interests of the client” may amount to a similar, if not more onerous, obligation). This was the main obligation where Storm fell down in relation to s945A, which in turn lead to the advice not being ‘appropriate’.
What is clear, however, as stated above, is that it is imperative for advisers to properly scope their advice and accurately identify the subject matter of the advice. The Storm case also shows that a “one-size-fits-all” advice approach will not necessarily be right for all clients.
In this regard, it is important to note that the best interests safe harbour requirements in s961B(2) contemplate the client’s requirements as being the prime consideration in determining the subject matter of advice. Even though it is possible to discuss, agree and narrow a scope, the primary determinant is identifying the scope that the client has sought, not what scope best suits an adviser, nor what scope best leads to a particular product recommendation. As clients may not always know the scope or be able to clearly articulate it, as an adviser, you are required to apply your mind, skills and knowledge to ensure the scope accurately reflects what the client has sought.
TIP: To nail a scope effectively, you need to ask and answer “what is the client really asking me to do” or, put another way, “what is the problem the client wants me to solve”. See our piece for No More Practice on ‘How to Blitz Your SOAs’. In practice, having established the scope, you should properly consider all the subject matter, inquiries and issues relevant to that subject matter and address them in your advice.
The importance of risk profile
The Court accepted that a client’s risk tolerance and risk profile are essential considerations for an adviser. In this case, the Court found that clients were dealt with as balanced investors, yet their profile was that of a conservative investor.
The Court found that the recommended gearing strategies were too high risk and inappropriate in the clients’ circumstances.
The court accepted the generally used allocations of 60/40 growth/defensive for balanced investors and 20/80 for a conservative investor.
TIP: it is essential to use a structured approach to determining a client’s risk tolerance. Once their tolerance is identified, it is necessary to examine whether strategies that adopt the client’s risk profile will allow them to achieve their objectives. If not, the client will need to re-think their objectives or agree to adopt a (most likely riskier) risk profile. Such risk discussions should be well-documented.
Using gearing for a pre-retiree or retiree is unlikely to be appropriate.
Treating the family home as an asset in an investment portfolio and gearing for pre-retirees and retirees
It was critical to the success of Storm’s financial strategy that the family home be treated as an asset in the client’s investment portfolio. However, the Court rejected this approach.
As well as accepting the general proposition that gearing is a high risk strategy as it increases exposure to volatility via magnified downside risks the Court also found that it was not correct to use the family home as an asset in an investment portfolio. Having said that, the Court also said that Storm’s advice would have been inappropriate even if the family home had been properly included in the investment portfolios.
The Court found that, as a general proposition, it is correct to say that the closer a person gets to retirement the less attractive it will be to borrow against the family home.
Family homes were differentiated from ‘investment’ assets on several bases. For example, because they are an asset that provides shelter and accommodates people’s physical, emotional and family needs.
The Court identified that an adviser can essentially ask one of two questions in relation to using a home as an investment asset:
- “What is the risk of all assets considered as a whole (independently of whether the family home might have to be sold)”; or
- “What is the risk that my investment portfolio might lead me to have to sell my home”.
Question one involves including the family home as an asset. But the second question “requires the exclusion of the family home from the assessment of the risk of the investment portfolio because it is an asset about which the investor has a very different risk profile. Again, almost by definition, the home must be excluded from an analysis of the risk of an investment portfolio when one asks ‘what is the risk of an investment portfolio failing to such an extent that the home might have to be sold.”
The Court found that it may be useful to ask the first question if, for example, a client leased out the home and did not live in it as losing it would not have the same effect as if the client were living in the home. But in the clients’ circumstances in this case, the second question was the appropriate one to ask. The Court accepted the following reasons why financial planners typically do not include a client’s residence in an investment portfolio investment allocation:
- the family home is a ‘personal use and lifestyle asset’. A client would need to expressly agree that they are prepared to sell it and employ the funds in an investment portfolio;
- a portfolio needs to be rebalanced over time but the family home is an asset that cannot be sold or rebalanced;
- if using a strategy similar to Storm, this is designed so that eventually investments would be sold to repay the debt, leaving the profit remaining. But since the home cannot be sold, a financial planner should examine the asset allocation of the investment strategy alone. To include the home is to present a misleading view of the risk and the expected return of the strategy.
TIP: if your clients are pre-retirees or retirees, gearing is unlikely to be appropriate. There are only limited exceptions, including if a client has a lot of wealth and, if using the family home, the client is aware they could lose it and are comfortable with that risk. Use extreme caution in including the family home as an investment within the portfolio.
When are clients retail clients?
s761G provides several instances where a client may be a wholesale client, not a retail client. Storm’s directors relied on the provision that, in conjunction with the relevant regulations, treats a client who invests more than $500,000 as a wholesale client, namely s761G(7)(a) which provides that the following will be wholesale clients:
[where] “the price for the provision of the financial product, or the value of the financial product to which the financial service relates, equals or exceeds … [$500,000] … (but see also subsection (10))”
Some clients were advised in relation to investing more than $500,000 but when it came to the actual investment, less than $500,000 was invested.
The question for the Court was: does the wholesale test apply to the amount of investments that the advice applied to? Or, does the test apply to the amount that was actually invested. Storm argued that it was the former and the Court agreed. The Court decided this was a matter of simple legal interpretation. Not to mention the factual impossibility of being able to determine what a future amount may be! As the determination of whether a client is wholesale under s761G(7)(a) is made at the time a relevant financial service is provided, in Storm’s case, this was when the SOA which contained financial product advice was provided.
The first point to note here is the fact that the Court readily held that it was the total value of all the financial products that covered by the advice that was relevant (i.e. investments in cash management trusts and index funds). s761G does not, from the Court’s decision, require each advised investment to be greater than $500,000. So long as all products are covered by the relevant provision in s761G, it is the aggregate of all advised investments that go towards the $500,000 threshold. The Court indicated that regs 7.1.18(3) and 7.1.19(5) make it clear that the threshold can be determined by aggregating various products that are the subject of advice at a single point in time.
N.B. a word of caution: these wholesale provisions do not apply to superannuation, retirement savings accounts or general insurances
In deciding this issue, the Court made it very clear that the correct time for determining whether a Client is a wholesale client is at the time the advice is provided, not at the time the investment is made. So long as the $500,000 investment threshold was reached when the advice was provided a client can be wholesale even if they subsequently invest less than that threshold amount.
TIP: in dealing with individual clients, if the value of investments (excluding super, RSAs and general insurance) that your advice covers exceeds $500,000 the clients will be wholesale.
Can a husband and wife (or other joint investors) be treated as one wholesale client?
Some Storm clients were husband and wife. Combined, the amount advised on for some couples exceeded the threshold amount in s761G but individually the amount attributable to each party would not have met the threshold.
Storm argued that it could treat the aggregate of the joint investors as the relevant amount on which to determine if the $500,000 threshold was met as the couple was given only the one SOA and treated effectively as only one client.
The Court unequivocally rejected this. Its approach was based on the legal construction and statutory purpose of the relevant provisions as well as case law. In particular, the Court stated that:
“the purpose of a distinction between ‘retail clients’ and ‘wholesale clients’ is that wholesale clients … are treated as not requiring the same protection as retail clients because ‘it is recognised that wholesale clients do not require the same level of protection, as they are better informed and better able to assess the risks involved in financial transactions. ………….. If a couple, each of whom would be a retail investor, invested jointly then there is twice the vulnerability or exposure to the lack of these protections.”
The result being, each individual client must meet the monetary threshold in order to be a wholesale client.
TIP: assess each individual client on their merits when determining if they are a wholesale client. Don’t treat a couple as ‘one person’ for these purposes, even if you have provided a combined SOA.
Does a breach of s945A automatically mean a criminal offence has been committed?
The ‘reasonable basis for advice’ provisions in s945A were ‘offence provisions’, meaning that breaching them is both a civil contravention and criminal offence (unlike their replacements in the best interests provisions in s961B which are only civil provisions).
One question in this case was whether Storm’s directors could face either civil or criminal liability for breaches of s945A.
ASIC argued that Storm had failed to meet the second and third limbs of the s945A tests (i.e. give reasonable consideration to the subject matter and ensure advice is appropriate).
The Court held that a civil contravention can be found even if only one limb of the requirements in s945A was not met.
However, a criminal offence can only be found where there was intention or at least recklessness as to breaching the requirements. This was because of the inter-operability between the Corporations Act 2001 and the Criminal Code 1995.
s180: Director’s duty to act with care and diligence
Central to the case was ASICs contention that the directors of Storm breached their directors’ duties. In particular, s180(1), which requires a director to “execute their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise”.
ASIC argued that the directors had acted unreasonably within the meaning of s180(1) and placed Storm in a position where it had actually breached the Corporations Act. Justice Edelman postulated that it may not be necessary to prove there has been an actual breach of the Act in order to prove a director did not meet their duties under s180(1). But as ASIC had argued that there was in fact a breach and the case proceeded on this basis, this point was not pursued.
One of the more interesting legal arguments that the Cassimatises made was that as they were directors and were also the only shareholders it was not possible, as directors, to breach their obligations in s180 to act with care and diligence by a course of conduct that was highly likely or even intended to breach provisions of the Act because, as the directors and shareholders were the same people “ratification was implicit.” The Court, however, did not accept this.
ASIC, on the other hand, set a high bar for itself by arguing that the Cassimatises were in breach because they had acted unreasonably with the meaning of s180(1) and placed Storm in a situation in which it had actually breached the Act. In other words, ASIC had to prove that Storm had actually breached the Act in order to be liable under s180. The Court had “serious doubt whether an actual breach by a corporation is a necessary requirement for breach of s180(1) by an officer”.
The corollary of this argument, namely that an actual breach of the Act by a company is sufficient to establish liability under s180(1), was not accepted by the Court. ASIC argued that if a director “failed to ensure” that the company did not breach its duties under the Act, they could be liable under s180(1). But the Court held that what ASIC was arguing was tantamount to a strict liability whereas s180 is not drafted as a strict liability.
Mr and Mrs Cassimatis argued that the nature of directors’ duties is ostensibly a private duty in that s180 is a duty owed to the company. They also argued that a solvent company’s only interest is the interest of its shareholders (with the ultimate conclusion from this argument being that if the shareholders are not wronged then there will be no breach of s180).
The Court concluded that Mr and Mrs Cassimatis each contravened s180(1) by:
“exercising their powers in a way which caused or ‘permitted’ (by omission to prevent) inappropriate advice to be given to the relevant investors. … A reasonable director with the responsibilities of Mr or Mrs Cassimatis would have known that the Storm model was being applied to clients who fell within [a class of investors who were retired or close to retirement, had few assets, little income, and little or no prospect of rebuilding their financial position in the event of suffering a significant loss] and that its application was likely to lead to inappropriate advice. … It would have been simple to take precautionary measures to attempt to avoid the application of the Storm model to this class of persons.”
This is an important finding as many financial services businesses operate with the directors being the only shareholders. In allowing inappropriate advice, it is possible directors will also have breached their directors’ duty in s180(1).
While there were some contributing factors in this Storm case, such as the great level of involvement in decisions and the level of control over all aspects of the business by Mr and Mrs Cassimatis, the principle that a breach of the financial services laws can also amount to a breach of directors’ duties will nonetheless have wide import and application.
In closing, it is important to also state that no criminal breaches by Mr and Mrs Cassimatis were found. It was also accepted that they operated Storm Financial ‘in good faith’. Nonetheless, Storm itself breached the Act, as did Mr and Mrs Cassimatis.
TIP: This serves as a good reminder to directors of financial services companies that they must meet all the general duties of a director as well as ensuring the company meets the specific financial services laws.