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Lessons from the IOOF Case
A recent decision of the Federal Court in Australian Prudential Regulation Authority v Kelaher [2019] FCA 1521 provides some guidance to regulators, trustees of superannuation funds and their advisers on issues related to administering superannuation funds and conducting litigation, explains Noel Davis, Barrister and author of The Law of Superannuation in Australia.
In this case APRA sought disqualification orders in several ways against directors of the trustee of a public superannuation fund, and against three responsible officers of the trustee, for having breached the Superannuation Industry (Supervision) Act. The court, therefore, had to determine whether the breaches alleged had occurred. Ultimately the view was that the evidence was not enough to show the respondents were responsible for breaches.
The evidence
APRA sought to prove its case that breaches had occurred by relying solely on documents brought into existence by the respondents to APRA’s claims, as admissions against interest by the respondents. The judge disagreed that those documents constituted admissions by the respondents. She said it was for APRA to prove its case of contraventions of the legislation by such evidence as it saw fit and the documents put into evidence were not enough proof to warrant disqualification [4].
APRA will, therefore, be mindful, in future cases, of the need to lead written and oral evidence which clearly demonstrates that there were breaches of the legislation and that those before the court were responsible for the breaches.
Covenants of trustees
The Superannuation Industry (Supervision) Act imposes in s52 several covenants on trustees of superannuation funds, with which they must comply. Some of them were considered in this case, in the course of considering whether the respondents had breached them.
- S52(8) Duty to have an operational risk reserve
A reserve is an amount in a fund that is not allocated to members’ accounts or, in a defined benefit fund, is not maintained to pay defined benefits.
The conclusions in this case in relation to the use of operational risk reserves are significant for trustees and their advisers because this is the first case in which it has been considered when trustees can take money out of an operational risk reserve to compensate members who have lost money.
The requirement in s52(8) to have an operational risk reserve was imposed by the Superannuation Legislation Amendment Trustee Obligations and Prudential Standards Act, 2012, supported by standards issued by the Australian Prudential Regulation Authority in the form of the Superannuation (Prudential Standard) Determination No. 1 of 2012. It defines operational risk as the risk of loss from inadequate or failed internal processes, people and systems or from external events (paragraph 6).
The trustee is required to have a strategy for determining when and how the operational risk reserve can be applied (para 19(f)).
The APRA Prudential Practice Guide SPG114 requires that the amount of the reserve must be at least 0.25% of the total amount of the fund-paras [7] and [9].
An important issue in the case was whether, if there are losses in a fund because of the actions of the trustee or its investment managers or otherwise, can the reserve be applied to compensate the members who have lost money or will the trustee or anyone else who caused a loss have to compensate the fund, thus leaving the reserve intact? If the reserve is reduced, it will have to be topped up by the existing members.
There were losses to the fund caused by some companies who were providing services to the fund and the trustee applied money from the reserve to compensate those members who lost money. APRA argued in this case that the trustee should have first attempted to obtain payment from the companies that caused the losses before compensating the members out of the reserve, because the money in the reserve was the members’ own money and they were, in effect, compensating themselves rather than being compensated by those who caused the losses.
APRA’s arguments were not accepted by the judge. She said that it was misconceived to describe the reserve as the members’ own money. Rather, she said, it was money held for the express purpose of compensating members for operational risk, including risks arising from the conduct of the trustee or others. Compensating members from it did not, therefore, involve compensating members from their own money. Rather, it is the use of the money for the very purpose for which it was created: [126].
The basis for APRA’s argument was that the money in the reserve was contributed by the members out of the earnings on their money in the fund and any top up to keep the reserve at the minimum level, after compensating the members, would have to be contributed by the members.
APRA’s argument has some validity. When an amount is paid out of the operational risk reserve and that reduces the amount of the reserve below the minimum required level, the trustee will require that the reserve be restored to the minimum level and, generally, that will be achieved by taking the money out of members’ earnings or by deducting from the members’ accounts the amount required to top up the reserve.
The members, therefore, pay for any money paid out of the reserve to compensate members.
If the members who are compensated are the same as the members whose accounts are debited to top up the reserve (which will be the case if all the current members are being compensated), the members will have paid for their own compensation.
This circular movement of money from the members’ accounts to the reserve as a result of a payment out of the reserve to compensate members gives rise to a strong argument that the money in the reserve is the members’ money and that this aspect of the IOOF decision is not correct.
The judge also disagreed with APRA’s submission that the use of the reserve without exhausting other means of being able to compensate the members was not in the best interests of members and was, therefore, in breach of the trustee’s obligation to act in the members’ best interests. The judge added that the trustee does not have a duty to make claims against anyone who may be potentially liable for a loss of the members before the trustee accesses the reserve: [124].
The judge recognized, however, that, on the winding-up of the fund, the reserve would have to be allocated and for the trustee to allocate the reserve to itself rather than to the members would be a clear breach of the trustee’s duties.
- S52(2)(c) To exercise care, skill and diligence
It was said in the judgement that a trustee’s duty under this covenant does not amount to a duty to avoid all loss and that errors of judgement can be committed without being liable under this covenant [39].
- S52(2)(d) To deal with conflicts of interests by giving priority to members’ interests
An obligation is imposed by this covenant, where there is a conflict between the duties of the trustee to the beneficiaries and the duties of the trustee to any other person or entity,
(i) to give priority to the duties to and interests of the beneficiaries over the duties to and interests of other persons; and
(ii) to ensure that the duties to the beneficiaries are met despite the conflict; and
(iii) to ensure that the interests of the beneficiaries are not adversely affected by the conflict; and
(iv) to comply with the prudential standards issued by APRA in relation to conflicts.
The covenant was considered in this case and it was said in the judgement that the no conflict covenant is not about avoiding conflicts of interest. Rather it’s about managing conflicts because they are inevitable. The conflicts which need to be managed are actual conflicts which have the capacity to significantly impact on the duty to act in the best interests of beneficiaries: [79]
- Duty to get in fund assets
This is a duty imposed by principles of trust law and requires trustees to ensure that they and their custodians have title to all the assets of the fund and that all entitlements are received including capital and income entitlements. It is a duty of trustees, as the legal owners of the assets of the fund, to take proceedings against other parties to obtain payment of amounts to which the fund is entitled and to recover losses. It was said in the judgement in this case that a trustee is not obliged to make such a claim if, in the opinion of the trustee, it would not produce any result. That is a discretion that a trustee must consider in evaluating all the relevant considerations, including the amount at stake, the prospects of success, the issues involved and the available alternatives: [154].
Summary
What was decided in this case warrants careful consideration by trustees and their advisers in determining how the trustees’ obligations should be carried out and whether amounts can be paid from the operational risk reserve to compensate members where losses have occurred. It goes without saying that the judgement will be carefully considered by APRA in relation to the conduct of future litigation.
It will be interesting to see whether courts, in future cases, agree with the decision in this case that a payment out of an operational risk reserve is not a payment from the members’ own money and does not, therefore, amount to the members compensating themselves for losses.
Noel Davis, Barrister
Author of The Law of Superannuation in Australia
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