Contributed by Noel Davis, Barrister, Sydney
The way in which operational risk reserves can be utilised in superannuation funds was the subject of analysis in the recent IOOF Federal Court decision of Australian Prudential Regulation Authority v Kelaher 19 ESL 06;  FCA 1521.
After lobbying by parts of the superannuation industry, the requirement for such a reserve in each superannuation fund was imposed by the Superannuation Legislation Amendment Trustee Obligations and Prudential Standards Act 2012. The legislation was supplemented by prudential standards issued by APRA, which defined operational risk as the risk of loss from inadequate or failed internal processes, people and systems or from external events.
The amount of the reserve must be at least 0.25% of the total amount in the fund.
The trustee is required to have a strategy for determining when and how the operational risk reserve can be applied.
Over three years, from 1 July 2013, the reserves of superannuation funds were brought up to the required level, largely by redirecting earnings to the reserve that would otherwise have been credited to those who were members during those three years and by debiting members’ accounts. Thus, those members were deprived of some of the earnings that would have otherwise been credited to their accounts. They will never recoup the lost earnings if they have since left the fund or if they don’t obtain any benefit from the reserve during their future membership.
It is arguable, therefore, that the legislation is unfair because the effect of it is that earnings were taken off those who were members of a particular fund between 2013 and 2016 to create a reserve which will be utilised for the benefit of future members, at least some of whom did not contribute to the creation of the reserve. It will be applied to the members, at the latest, on termination of the fund, if it isn’t needed beforehand, as was acknowledged by the judge in her judgement in the IOOF case.
An issue in this case, was whether, where 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?
In the IOOF case, 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 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 who decided the case who 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.
In my view, it is understandable that APRA argued the way that it did as 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. That is because any payment out of a reserve that reduces it below the minimum required level will cause the trustee to have to deduct money from the members’ accounts or earnings and pay that money into 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 before the trustee accesses the reserve.
Regardless of whether APRA’s arguments on this point should have succeeded or not, it is strongly arguable that superannuation members should be entitled to expect that if losses occur in their fund, the trustee will take all reasonable steps to recover the loss from those responsible for the loss before the reserve is raided to compensate members. That includes the trustee itself paying compensation if it caused the loss.
Section 56(2A) of the Superannuation Industry (Supervision) Act 1993 is relevant to a trustee indemnifying itself for losses incurred in the fund. It says, in relation to a loss, that a trust deed provision is void if it would have the effect of allowing the trustee to indemnify itself out of any of the fund assets that do not form part of the operational risk reserve without first exhausting the reserve. Therefore, if a trustee is entitled to indemnify itself out of the fund assets for a loss that has been incurred by the trustee on behalf of the fund, it must first exhaust the amount in the reserve, before it exercises the indemnity in relation to other assets of the fund, and any trust deed provision that allows otherwise is void.