Weighing The Importance Of ‘Financial’ In Best Financial Interest Duty
First published in Investment Magazine, 4 August 2021
The best interests duty is in many ways the cornerstone to the regulation of the superannuation system and has been the most important guiding principle for Australia’s superannuation industry.
The principle of the best interests of members has transcended its legal meaning, to become a normative ideal for member orientated purpose, decision making, and culture. As with any ideal, it hasn’t always been lived up to in practice. This has contributed at least in part to the passage of the Treasury Laws Amendment (Your Future, Your Super) Bill 2021, which adds the word “financial” right in the middle of this cornerstone statutory best interests covenant.
What should be made of the change to the law underpinning this guiding principle from 1 July 2021? What does the change mean legally and practically?
Best interests
The established best interests duty for superannuation funds was accepted to represent a codification of the synonymous duty in the law of equity and trusts. Ensuring that such an important duty wasn’t eroded by the narrow drafting of a superannuation fund’s trust deed, the Superannuation Industry (Supervision) Act 1993 operated to insert into the governing rules an irreducible core covenants which included the duty ‘to perform the trustee’s duties and exercise the trustee’s powers in the best interests of the beneficiaries.’
Ask any lawyer with experience in superannuation about the legal meaning of the best interests duty, and most will promptly cite the 1985 English case of Cowen v Scargill. This foundational case concerned the scope of discretion of trustees to make investments for the benefit of their members, and the extent to which trustee powers were required to be exercised consistently with the purpose for which the powers were granted. It is also important in that it states the law flexibly to enable trustees to make decisions in various circumstances and exercise powers in complex situations which require flexibility of the rule.
Vice Chancellor Robert Megarry’s judgement was important in that it held that trustees of a pension (or superannuation) fund cannot ignore the financial interests of the beneficiaries, adjudicating that:
The starting point is the duty of trustees to exercise their powers in the best interests of the present and future beneficiaries of the trust, holding the scales impartially between different classes of beneficiaries. This duty of the trustees towards their beneficiaries is paramount. They must, of course, obey the law; but subject to that, they must put the interests of their beneficiaries first. When the purpose of the trust is to provide financial benefits for the beneficiaries, as is usually the case, the best interests of the beneficiaries are normally their best financial interests.
It’s important to note that VC Megarry was cautious not to go so far as to suggest that the best interests of beneficiaries were always financial interests even in circumstances where the purpose of the trust was to provide financial benefits. The best interests duty in trust law is well established as a general duty that ‘marshals’ the more specific obligations to act with loyalty, prudence, honesty, and to exercise care, diligence and skill when exercising powers and performing duties.
The best interests duty in general law can certainly be flexible to accommodate a broad range of circumstances and decision horizons, however the redrafted best financial interest statutory covenant could challenge this – and could even create some uncertainty if read literally to limit the application of the statutory duty.
A remedy to what mischief?
Usually changes to the law arise in response to a deficiency which is brought to light by some mischief or a change in circumstances which make the law ineffective or obsolete. The policy intent which has accompanied the push to insert “financial” in the middle of the best interests duty has been associated to the Hayne Royal Commission and Productivity Commission’s Review into Competition and Efficiency in the Superannuation System.
The Hayne Royal Commission found that the existing best interest duty was adequate and should not be changed. Commissioner Hayne found that:
The existing rules, especially the best interests covenant and the sole purpose test, set the necessary standards.
Hayne, no slouch in his understanding of the operation of the law – did however suggest that there may be some benefit in the development of further guidance on the operation of the existing law. This could have taken the form of greater judicial scrutiny if the regulator were to take a more active approach in litigating potential breaches, or more simply by way of regulatory guidance from the prudential regulator.
The Productivity Commission’s Report on Competition and Efficiency in the superannuation system recommended that “the definition of a superannuation trustee to act in a member’s best interest should be amended to be clearer.” It was apparent that the government used this as justification for the change.
If neither of these sources pointed to the mischief that the change sought to address, it is curious to consider what motivated the Parliament to legislate to change the law. The explanatory memorandum to the Your Future, Your Super Bill is probably the best source of insight, and the most reliable extrinsic source to interpret the new duty in the absence of any case law.
The explanatory memorandum states that “by requiring trustees and directors of corporate trustees to act in the financial interests of the beneficiaries, it eliminates the possibility that trustees, and directors of corporate trustees can act in a manner that they judge improves the non-financial interests of the beneficiaries but at the expense of their financial interests.”
The mischief the legislation appears to be attempting to remedy is one anticipating that there is potentially some conflict between the financial interests of beneficiaries and perceived non-financial interests of beneficiaries, where the non-financial interests are prioritised by the trustee.
There also seems to be some conflation with the sole purpose test, as the explanatory memorandum to the Your Future, Your Super Bill goes on to state that the intention of the Bill is to ensure Australians have confidence that “the fund is being maintained solely for their financial interests and not some subsidiary or ancillary purpose.”
Changing the law without changing the law?
Government had indicated that the policy intent was not to change the existing law but rather to provide greater clarity or guidance as to the operation of the best interests duty. It appears that there may have been an assumption that the settled interpretation in case law – that the best interests of beneficiaries of a pension or superannuation fund were usually their best financial interests – could simply be codified by adding the word “financial” to the duty.
The principles of statutory interpretation require that change is interpreted in the context of the extrinsic materials, primarily the explanatory memorandum. This exercise makes it quite clear that the intention of Parliament was in fact to change to law.
The intention of Parliament appears to have been to add a new dimension to the best interests duty that draws on the sole purpose test and adds a purposive aspect. This echoes the doctrine of powers in the law of equity, which requires that trustee powers are exercised in a manner consistent with the purpose for which they were granted.
The explanatory memorandum is also clear in that the change is focused on expenditure, and expenditure that is non-essential to the prudent operation of the superannuation fund in particular. It clearly states that trustees are required to give determinative consideration to how any action will yield financial benefits to the beneficiaries. In practice, this is likely to require a clear business case and some quantitative analysis which gives evidence to a reasonable expectation of financial benefits such as reduced member fees.
Of particular interest will be initiatives that are intended to attract new members of retain existing members. In these circumstances, trustees should ensure that reliable and quantitative analysis has been completed which supports the position that the resulting increase in members or assets will result in demonstrable scale efficiency which could flow through to reduced fees (or even mitigate risks of fee increases).
Caution may also be warranted to ensure that a literal reading of the best financial interests duty doesn’t limit the breadth of the duty to the exercise of powers and performance of duties which affect a beneficiary’s financial interests. Such circumstances aren’t uncommon and include situations such as determining whether members are eligible for disability benefits or deciding on the human and digital resources required to provide levels of service that members expect.
The flexibility that VC Megarry was careful to protect in Cowen v Scargill could be interpreted to be diminished if not interpreted in context. Rather than providing clarity, there is some risk that the changes create uncertainty as to the application of the duty.
What does the change mean in practice?
The change to the best interests duty isn’t merely something of theoretical or academic interest. Trustees will need to consider making some changes to adapt to the change and manage the risks of non-compliance.
This is particularly true in an environment where regulators are likely to want to test the revised duty in the courts, and where civil penalties could flow from a proven breach. There are some sensible places to start:
Essential and non-essential expenditure should be identified in budgeting and accounting procedures to assist in identifying the appropriate approach to expenditure management where the expenses will be incurred by the fund (including reserves).
Expenditure management policies (as required by SPS515) should be reviewed with the intention of extending coverage to all expenditures (not just material expenditure) and outlining the approach for determining and documenting decisions concerning essential and non-essential expenditure. It would be expected that non-essential expenditure will require sound business case analysis and documentation which includes quantitative analysis.
Business case and board paper templates may need to be updated to ensure that expenditure management policies are facilitated, such as including consideration of the financial benefit (or mitigation of financial detriment) when making decisions. This will be particularly important in relation to non-essential expenditure.
The procurement and legal review process concerning new contracts, amendments, and renewals should be revised to ensure that evidence is retained demonstrating the consideration of the factors required under the expenditure management policy.
Quantitative analysis should be undertaken demonstrating how growth or retention in membership or assets is likely to result in scale efficiency and flow through to member fees and costs.
Investment objectives should be considered as part of the trustee’s investment strategy review cycle in the context of the new best financial interests duty. Existing investment due diligence policies and procedures should then ensure that transactions remain consistent with the investment objectives and therefore best financial interests duty.
Legal advice and review of proposed significant expenditure and new investments may also be valuable for trustees, particularly in relation to non-essential expenditure.
Most existing expenditure and investments are likely to be consistent with the new financial best interests duty, yet it is important for trustees to take steps to uplift their existing policies and procedures to manage the heightened risks arising from the change.
Jonathan Steffanoni - Partner
QMV Legal
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