Should the CSLR be able to exclude ‘but for’ determinations?

Speaking on an ifa webinar in November, Compensation Scheme of Last Resort (CSLR) chief executive David Berry revealed that about 80 per cent of claims that have ended up at the CSLR land in the ‘but for’ category – leaving just 20 per cent as involving an actual capital loss.

“Let me just start by saying we can't challenge the determination. So, whatever the determination amount is, that's the loss,” Berry explained.

“AFCA [the Australian Financial Complaints Authority] have a very defined way of determining what that loss is, and that includes, if they had have got good advice or appropriate advice at the time, what would their return have been?”

He added that for the 80 per cent that include what he termed a “hypothetical loss”, AFCA calculates whether, because of poor advice, the complainant “didn't get the return that they would have had they got good advice”.

The idea that, through the CSLR levy, advisers will be picking up the tab for poor advice that they had nothing to do with has been a concern since the scheme was introduced.

The reality that this also includes losses calculated based on returns the client could have earned even if they still made a profit is, in the words of Financial Advice Association Australia (FAAA) CEO Sarah Abood, “hard to believe”.

Speaking at the FAAA Congress in Brisbane last week, Abood detailed a case that saw former Dixon Advisory clients awarded $272,669.50 plus interest despite turning a profit from their SMSF’s investment.

As the complaint reached the CSLR due to the collapse of Dixon Advisory, the compensation that can be paid to the client is capped at $150,000.

Based on AFCA’s published determination, it is clear that the advice was not appropriate and the investment allocation over a 10-year period were not in line with the clients’ risk profile.

However, AFCA’s analysis of the actual scenario shows a profit of $1,062,204.40.

In order to determine the ‘but for’ position, AFCA modelled what would have happened if the funds had been invested in a Vanguard fund that was in line with the risk profile, which resulted in an estimated profit of $1,334,873.90.

“So in effect, our profession is being required to underwrite a minimum return guarantee for the clients of every failed advice firm,” Abood said.

“So much for the land of the ‘fair go’.”

AFCA’s approach

Also speaking at the FAAA Congress, AFCA lead ombudsman investments and advice Shail Singh defended the complaints authority’s use of the ‘but for’ approach.

“What a ‘but for’ test means is but for the failing of the adviser, where would the consumer have been invested? It's not about theoretical losses, it's not about opportunity costs. It's about direct loss that arose from the failings of the adviser,” Singh explained.

“But that's what it looks like. It looks like opportunity cost, it does.”

Acknowledging that hindsight is 20/20, he added that if AFCA is not satisfied that it knows what a person would have been in if not for the advice, it’s not going to “award theoretical” amounts.

“We're not going to say, ‘well, that's the best returning fund, therefore we're going to put them into that.’ We encourage submissions. It's often one of the trickiest parts of what we do, but it's ultimately been endorsed by the courts,” Singh said.

Indeed, the application of a ‘but for’ standard is far from a new approach and actually predates AFCA’s existence.

As Singh noted, the Supreme Court of Western Australia ruled in favour of the approach back in 2015 when Patersons Securities launched action against the Financial Ombudsman Service.

It is also clearly noted in AFCA’s approach documents, including the one relating to calculating loss in financial advice.

“Where inappropriate financial advice has been provided, the purpose of compensation is to place the consumer in the financial position they would have been in if the financial adviser had provided appropriate financial advice,” the document reads.

Another approach document, released in January, details how AFCA determines compensation in complaints against financial advice firms where the responsible entity of a managed investment scheme has become insolvent.

“The financial advice firm will only be liable for loss that any such breaches have caused. Direct loss is calculated by applying the ‘But for’ test. This test involves looking at the complainant’s actual losses and determining a hypothetical alternative portfolio that the complainant would have been in but for the financial advice firm’s breach,” it explained.

“We then compare those losses to the portfolio the complainant should have been invested in had appropriate advice been provided. We must ultimately be satisfied that the breach/es caused the complainant’s loss.

“So, in circumstances of a financial advice firm breaching its obligations, and where a MIS the complainant invested in has also failed, the failure will ultimately be taken into account as part of the loss calculation.”

Should this still apply for the CSLR?

While the ‘but for’ test is controversial in many corners, it is when the broader advice sector is being billed for the calculated loss rather than firm that provided the “poor advice” that has prompted the most vocal response.

In its submission to the Senate inquiry in the Dixon collapse, the Financial Services Council (FSC) argued that “going beyond compensating consumers for their actual losses and instead compensating them for hypothetical missed gains undermines the purpose of the CSLR to truly be a scheme of last resort”.

In the FSC’s opinion, the way to fix the situation is for AFCA to determine both the loss according to the ‘but for’ principle when it is seeking compensation from the liable party, while reducing this amount to the “actual financial loss” when the liable party fails to comply with its obligations and the bill is passed on to the CSLR.

“Such an arrangement makes the CSLR truly [a] last resort scheme,” the FSC said.

“It would also provide a more consistent, transparent approach to awarding compensation under the CSLR, reduce costs, and ultimately ensure that compensation is directed toward clients who have suffered verifiable financial harm.”

Speaking at a media briefing during the FAAA Congress, Abood said that while AFCA’s methodology is not new, how it interacts with the CSLR is.

“I think, certainly from our perspective, it seems completely unfair, but also obviously unsustainable,” she said.

“That a compensation scheme of last resort should be paying, basically an income guarantee to those clients. So, the floor is not you've lost money. The floor is maybe you could have done a bit better in the Vanguard balanced fund, so here's $150,000, and that's where the anger is.”

Abood added that beyond the inherent unfairness, the advice sector simply cannot afford to cover the cost.

“You can see the argument when it's a case of a firm that is currently in existence and is the adviser of the client, if they miss something, that meant the client couldn't take an opportunity, and they ought to have been able to, you can kind of see the rationale,” she said.

“I do not see the rationale at all when it when it comes to the rest of the profession who had nothing to do with it, paying that kind of money.”

The shadow financial services minister also weighed in on the topic, referring to the way that AFCA makes compensation decisions as a “major problem”.

“We have people claiming compensation who didn't have a capital loss, they just could have been in a better position and being compensated for the gain that they missed out on,” Luke Howarth said at an AIOFP dinner last week.

“This makes up around 80 per cent of claims – 80 per cent of claims aren't even a capital loss. That is outrageous. You shouldn't be footing the bill for that.”