Observations from recent ‘fit and proper’ disqualifications

Rise in AAT reviews

As will be seen, each of the relevant AAT decisions was delivered during or after 2005. Also, there is a least one further decision that is expected to be delivered in the near future. (A number of other decisions relating to section 120A were delivered by the AAT and the Federal Court in 2003 and 2004. However, these concerned procedural matters and, as such, are not considered here.)  

Self-evidently, the rise in AAT reviews follows an increase in challenges to APRA’s disqualifications. In my opinion, this trend is likely to continue—particularly given APRA’s increasing propensity to exercise s 120A powers.

This propensity is demonstrated by APRA’s own annual reports. In the first year after the introduction of section 120A (that is, in 2001-2002), APRA did not disqualify any directors. However, there were 16 disqualifications in 2002-03 and 34 in 2003-04. In 2005-06, APRA disqualified 22 directors. Given this trend, a review of the cases seems timely.

Section 120A of the SIS Act
Before looking at the cases, it is worthwhile setting out the relevant parts of section 120A. The section, which was inserted into the SIS Act in 2000 (and which commenced operation on 18 January 2001), provides as follows:

Section 120A — The Regulator may disqualify individuals

1. The Regulator may disqualify an individual if satisfied that:
   1. the person has contravened this Act … on one or more occasions …; and
   2. the nature or seriousness of the contravention or contraventions, or the number of contraventions, provides grounds for disqualifying the individual.
2. The Regulator may disqualify an individual who is, or was … a responsible officer of a trustee, investment manager or custodian (the body corporate) if satisfied that:
   1. the body corporate has contravened this Act … on one or more occasions …; and
   2. at the time of one or more of the contraventions, the individual was a responsible officer of the body corporate; and
   3. in respect of the contravention or contraventions that occurred while the individual was a responsible officer of the body corporate—the nature or seriousness of it or them, or the number of them, provides grounds for the disqualification of the individual.
3. The Regulator may disqualify an individual if satisfied that the individual is otherwise not a fit and proper person to be a trustee, investment manager or custodian, or a responsible officer of a body corporate that is a trustee, investment manager or custodian.

Summary of section 120A

In brief, section 120A confers on APRA the power to disqualify individuals in certain circumstances.

The relevant circumstances are where:

• an individual contravenes the SIS Act
• the individual is a responsible officer of a corporate entity at a time when the entity contravenes the SIS Act, or
• the individual is not otherwise a fit and proper person.

In the first two circumstances, APRA has to be satisfied that the nature, seriousness and number of contraventions justifies disqualification. The third circumstance allows APRA to disqualify an individual for reasons other than the nature, seriousness and number of contraventions (but where the reasons still relate to the individual’s fitness and propriety).

Rather than analyse the cases in chronological order, I have done so according to whether the AAT affirmed APRA’s decision or not. (Two of the cases were successful for APRA, two were not.)

Decisions affirming APRA’s disqualification

Mr Preuss was a suburban solicitor. He established the Australian Independent Superannuation Fund (AISF) as a fund for the employees of his law firm and of other businesses. (There were some 200 or so members.) The trustee of the fund was Broadway Fiduciary Pty Ltd (Broadway). Mr Preuss was a director of Broadway. The other director was Mr Dods, who was initially the law firm’s internal accountant and administrator.

Broadway also acted as trustee of another superannuation fund, AIP Trust. This was in contravention of Broadway’s constitution (which permitted it to act only as trustee of AISF).

Broadway entered into an investment management agreement with another company, Fairfax Holdings Pty Ltd (Fairfax), which was in turn owned principally by Mr Preuss and his wife. Fairfax was also the trustee of Mr Preuss’ family trust. Again, Mr Preuss and Mr Dods were the only directors.

Mr Dods undertook the administrative duties required of Broadway and Fairfax. From an early stage, however, it appeared that Mr Dods engaged in fraudulent transactions. In the end, it was established that Mr Dods misappropriated (for his own use) about $900,000 of AISF’s money. He was eventually convicted and imprisoned. There was no allegation of dishonesty against Mr Preuss.

In 2000, APRA used its powers under section 133 of the SIS Act to remove Broadway as trustee of AISF and appoint its own trustee. This occurred following a review of the fund.

Some two years later, APRA decided, under section 120A(3) of the SIS Act, to disqualify Mr Preuss. When Mr Preuss commenced the AAT proceedings in 2004, APRA added sections 120A(1) and (2) as grounds justifying Mr Preuss’ disqualification. Under section 120A(1), APRA alleged that Mr Preuss contravened the covenants in sections 52(2)(b), (c), (d), (e) and (f) of the SIS Act and that those contraventions were serious and numerous.

Under section 120A(2), APRA alleged that Broadway contravened the same covenants, that Mr Preuss was a responsible officer at the time of those contraventions and that the contraventions were serious and numerous. Under section 120A(3), APRA alleged that Mr Preuss was not a fit and proper person on account of his disregard and recklessness in failing to protect AISF’s assets (which amounted to a breach of his fiduciary and directors’ duties).

The tenor of APRA’s case was twofold. First, it said that the structure of the fund and its relationship with Broadway and Fairfax was fundamentally flawed. Second, APRA said that Mr Preuss failed to put in place internal management arrangements and failed to be sufficiently involved in Broadway’s performance. These two factors, said APRA, created the potential for fraud that was allowed to go undetected for some time.

The AAT held that the contraventions of the relevant covenants alleged by APRA overlapped and were duplicated to a significant extent. However, dealing with the broad issues, the AAT held that the relationship between AISF, Broadway, Fairfax, Mr Dods and Mr Preuss was inherently risky and, therefore, required stringent systems and controls.

According to the AAT, Mr Preuss gave no consideration to those requirements and failed to have any significant input in the operation of the entities. Mr Preuss relied entirely on Mr Dods and did not exercise any measure of control or any independent judgment himself. Indeed, in some cases, Mr Preuss was either recklessly or intentionally culpable—for example, by allowing Fairfax to increase its fees (over and above those that a professional manager might charge) without the fund members’ knowledge. This was to Mr Preuss’ own, personal advantage.

The AAT held that both Mr Preuss and Broadway contravened the covenants in:

• sections 52(2)(c) and (e) because Fairfax was appointed in circumstances where Mr Preuss (and Mr Dods) had a personal financial interest in the arrangements
• sections 52(2)(c) and (d) because Broadway acted impermissibly as trustee of the second superannuation fund, AIP Trust, and money and assets of the two funds were not separated
• section 52(2)(f) because the fund’s investment strategy (which was unwritten) did not have regard to the whole of the fund members’ circumstances, and
• section 52(2)(b) because Mr Preuss thought it was sufficient to do no more than establish the relevant entities, leaving Mr Dods alone to do all necessary things; as such, the AAT held that Mr Preuss failed to take the precautions that an ordinary prudent person would have taken when dealing with others’ property.

In the end, the AAT held that the contraventions were numerous, occurred over many years and continued despite warnings from APRA. The contraventions were also serious in that they provided the circumstances for substantial fraud, for the fraud to go unnoticed and for it to end in a loss of members’ funds. So, the contraventions by Mr Preuss and Broadway were by their number, nature and seriousness enough to justify disqualification under sections 120A(1) and (2). Further, according to the AAT, Mr Preuss was incompetent and exhibited a lack of contrition or acceptance of responsibility.

The AAT held that there was no need to consider whether Mr Preuss ought to be disqualified under section 120A(3), but if it were necessary, the AAT considered that section 120A(3) would justify his disqualification in any event.

Applicant v APRA [2006] AATA 918 (30 October 2006)

The applicant was an accountant. He was appointed in 2001 as one of six directors of KLA Australia Investments (No 2) Pty Ltd, which was the trustee of the KLA Australia Superannuation Fund. The applicant was also a director of the fund’s employer-sponsor.

In 2002, APRA conducted a review of the fund and identified a number of concerns (for example, the trustee’s failure to satisfy the equal representation rules, the trustee’s failure to formulate an investment strategy, a breach of the in-house asset rules, etc). In early 2004, APRA wrote to the applicant (and each other director) pointing out that:

• the issues identified in its 2002 review had not been addressed
• the fund had not lodged annual returns for the 2001, 2002 and 2003 years, and
• APRA had formed the preliminary view that the applicant should be disqualified under sections 120A(1), (2) and (3).

Shortly after receiving this letter, the applicant did two things. First, he conducted the 2004 audit of the fund himself. Second, he arranged for one of his employees to lodge with the Australian Securities and Investments Commission (ASIC) a notice that he had resigned as director of the trustee company some three years earlier. In fact, the applicant was not in a position to be an independent auditor (as he was a director of the employer-sponsor). Moreover, the audit reports he prepared and signed were fundamentally flawed. Also, the AAT held that he deliberately falsified his resignation to deceive APRA and ASIC.

Further, during the hearing in the AAT, the applicant said he had very little input into the management of the trustee company. However, in cross-examination, this was found to be false; he had an active management role, but endeavoured to minimise this in representations to APRA and the AAT.

The AAT was satisfied that the applicant’s conduct was such as to require action to protect the public and the integrity of the superannuation system. The applicant failed to comply with his duties as a director and repeatedly failed to comply with APRA’s requests and warnings. When he did take action, he took deliberate steps to deceive APRA and ASIC. This was done to enable him to carry out an audit which he knew he should not have undertaken. When he did carry out the audit, he failed to exercise reasonable care.

In the end, the AAT affirmed APRA’s decisions to disqualify the applicant under sections 120A(1) and (2).

No mention was made by the AAT of section 120A(3), despite APRA’s reliance on it. However, it seems at least implicit in the decision that the AAT would have considered the applicant an unfit and improper person for section 120A(3) purposes in any case.

Decisions setting aside APRA’s disqualification

Auton v APRA [2005] AATA 32 (14 January 2005)

APRA disqualified Mr Auton under each of sections 120A(1), (2) and (3) of the SIS Act.

Mr Auton was a director of Beacon Funds Management Ltd (Beacon), an approved trustee of a number of superannuation funds. He was also a director of Commercial Nominees of Australia Ltd.

APRA’s central allegation against Mr Auton was that he was a director of Beacon at a time when it engaged in speculative derivatives trading:

… that was inherently high-risk, contrary to both the spirit of the covenants in section 52 of the SIS Act and the clear intent of the IID7 Derivatives Circular, and was run in less than prudent fashion.

According to APRA, the derivatives strategy put the superannuation funds under Beacon’s trusteeship at risk of becoming unsatisfactory. Mr Auton was alleged to have had ‘major responsibilities which he failed to discharge with the required degree of reasonable skill, care and diligence’ and to have ‘failed to exercise an appropriate degree of caution to ensure member interests came ahead of others’.

APRA also alleged that Mr Auton was a director at a time when the eligible assets of Beacon fell below the $5 million required by its instrument of approval.

In December 2001, APRA conducted a review of Beacon. As a result of Beacon’s own earlier decision to cease derivatives trading, APRA indicated that it did not propose to suspend Beacon as trustee and that it was confident Beacon was addressing its concerns. Also, as part of the December 2001 review, APRA stated that it had no intention of prohibiting Mr Auton from acting as Beacon’s chief operating officer (by then, Mr Auton had resigned as director of Beacon).

The AAT held there was no link between the systems failures (relating to the derivatives trading) and any loss of money (which, in any case, was not suffered by fund members). Further, the AAT said that it was debatable that the derivatives trading was ‘speculative’ in the sense APRA contended. Moreover, after conducting its own review, APRA declined to suspend the trustee.

Finally, as to the breaches of Beacon’s instrument of approval, the AAT described them as ‘inadvertent’, mainly because APRA itself seemed to contribute to confusion over the meaning of the term ‘eligible assets’. Indeed, in this respect, the AAT held that APRA ‘condoned the inadvertent breach’.

As such, the AAT could not see how the perceived breaches by Mr Auton and Beacon were such as to render him unfit and improper—especially when, after APRA’s own review, it found that he was fit and proper. In the final analysis, the AAT held there was no evidence of Beacon failing to act in members’ best interests or of a failure to act with the required care, skill and diligence. Although Mr Auton’s position as director of Commercial Nominees was said to have had no relevance to APRA’s disqualification, the AAT expressed concerned that Mr Auton’s links with Commercial Nominees influenced APRA’s decision.

VBN v APRA [2006] AATA 710 (25 July 2006)

APRA disqualified seven directors of a staff superannuation fund trustee. All were disqualified under section 120A(2) on the basis that they were directors at times when the trustee entity allegedly contravened sections 52(2)(b), (c) and (g) of the SIS Act and that those contraventions were of such nature and seriousness as to justify their disqualification. Two of the seven directors (Special Directors) were also disqualified under section 120A(3) on the basis of alleged conflicts of interest.

There were two main issues for the AAT to consider in its review of APRA’s decisions. First, there was the question whether the trustee breached the covenants in sections 52(2)(b) and (c) of the SIS Act (respectively called the ‘prudent person’ and ‘best interests covenants’). This, in turn, raised the question as to the meaning of those covenants. Second, there was the question whether the Special Directors had conflicts of interest which they failed to manage.

Broadly, APRA’s case hinged on two events. The first event was the trustee’s decision in about August 2002 to:

• cease the then-existing three-year smoothed crediting rate policy (which applied in respect of the accumulation balances of defined benefit members), and
• implement, with effect from 1 July 2001, a crediting rate based on actual (then negative) returns.

This decision had a significant impact on deferred benefit members, who complained about a change which they believed was retrospective. APRA alleged that the trustee made this decision so as to deprive the deferred benefit members of their rightful entitlements.

The second event was the trustee’s decision in early 2003 to communicate to members an offer which the employer-sponsor made to deferred benefit members. The employer offered to pay deferred benefit members 110 per cent of their lump-sum benefit if they agreed to take their money out of the fund (and, thereby, forego their entitlement to a pension at fixed conversion rates). APRA said that the trustee failed to provide certain information to members, with the effect that members did not appreciate the true value of the pension entitlement. It was only in relation to this matter that the Special Directors were said to have had conflicts of interest. Both of the Special Directors were also officers of the employer-sponsor and were alleged by APRA to have promoted the employer’s interests over the interests of plan members.

It is notable that APRA did not, in any substantive way, allege that any of the directors had been dishonest, careless or incompetent. Nor did APRA suggest that the decisions made by the trustee were arbitrary, capricious or infected by an improper purpose.

On the crediting rate issue, the AAT held that it was not in deferred benefit members’ best interests not to be told of the change to the policy in advance. Nonetheless, the AAT held that this decision was in the best interests of the plan members as a whole. Had the trustee’s decision not been implemented, future members would have been required to shoulder a significantly greater burden of the prior over-crediting. As such, the AAT held there was no breach of the prudent person or best interests covenants in relation to this issue.

On the employer offer issue, the AAT held that the communication provided by the trustee to members contained adequate information regarding the value of the pension option. The AAT confirmed that it would have been inappropriate for the trustee to provide members with guidance as to whether or not to accept the employer offer. That was a matter each member could decide only after taking into account their own personal (financial and other) circumstances. Indeed, this is precisely what the trustee told members in its communication regarding the employer offer. Hence, the AAT held that the trustee had not contravened the best interests or prudent person covenants in relation to this issue.

Further, on the question of conflict, the AAT held that neither of the Special Directors were in breach of their fiduciary duties. Both Special Directors disclosed to the other directors their involvement in developing the employer offer. Indeed, the other directors had asked them to be involved in this way. Moreover, when it came to a consideration of the terms of the relevant member communications, the AAT held that neither of the Special Directors sought to influence the outcome of the trustee’s deliberations. In the AAT’s view, both Special Directors acted properly.

In the end, therefore, each of APRA’s disqualifications was set aside (vindicating the directors), with the effect that each decision was rendered void from the outset.

Observations

Fitness and propriety — the key ground of disqualification

In most of the cases referred to above, the AAT seems to have accepted that each of sections 120A(1), (2) and (3) provides a separate and distinct ground of disqualification.

On its face, this seems axiomatic. But, dig a little deeper and it becomes potentially harmful. What it means, for example, is that under section 120A(2) an individual could be disqualified solely because he or she was a responsible officer at times when the corporate trustee (seriously and frequently) contravened the SIS Act — that is, solely because of chronological coincidence. This has obvious implications for innocent directors and other responsible officers. For example, it means that directors who do everything right but are defrauded by their colleagues could be disqualified. Also, it means that directors who take no part in any contraventions (for example, because they are absent on account of illness when relevant decisions are made) could similarly be disqualified. Clearly, the purpose of section 120A would not be served by an interpretation of this kind.

Instead, it seems to me that ‘fitness and propriety’ is the key ground on which each of the subsections in section 120A hinges.

Among other things, this is the effect of the word ‘otherwise’ in subs (3). Reading subs (3) sensibly results in the necessary inference that sub sections (1) and (2) confer on APRA a power to disqualify where, for reasons relating to the nature, seriousness and number of contraventions, it considers the alleged offender to be unfit and improper (subs (3) allows ‘other’ grounds to feature in the determination of fitness and propriety). The corollary of this interpretation is that it is the alleged offender’s personal involvement or culpability that is important.

In other words, it is not the fact that a person has contravened the SIS Act nor the fact that they were a director at a time when the trustee contravened the SIS Act that alone is important (although these are clearly necessary). The most important factor in determining whether an alleged offender should be disqualified is their personal fitness and propriety.

Indeed, although not mentioned expressly in the cases referred to above, this is borne out by their result. Take, for example, the cases of Auton and the Applicant. In both cases, very little attention is given by the AAT to the operation of the separate subsections (even though APRA relied on each of them). Clearly, however, in both cases fitness and propriety (that is, the presence or absence of dishonesty) feature prominently.

In my view, it would have been more helpful for the AAT to make express that which it left unsaid. For the moment, however, we are left to inferences.

A similar problem arose in the case of VBN. There, each director was involved equally in the decisions which formed the focus of APRA’s concerns. Yet, no allegation relating to the directors’ personal integrity or culpability (that is, fitness or propriety) was made. The substance of APRA’s complaint was that each director played a role in decisions which were difficult and necessarily controversial. There is no doubt that the directors inherited difficult problems, the resolution of which would always be unpopular. Still, despite the absence of any allegation challenging their personal integrity, APRA disqualified each of the directors under section 120A(2). In the end, however, the AAT confirmed that the directors steered the fairest course they could in the circumstances.

If the purpose of section 120A(2) is protective (as it must be), there is little point in disqualifying responsible officers unless they are themselves unfit and improper. Determining fitness and propriety requires an analysis of each person’s particular conduct and characteristics. Such things as honesty, integrity and competence are relevant in this respect, as are personal involvement and culpability in any contraventions.

This is consistent with the new fit and proper operating standard imposed on RSE licensees by the SIS Act and Regulations (see, in particular, section 31(2)(ma) and reg 4.14). Under the new standard, RSE licensees are required to possess certain attributes, including competence, diligence, honesty and integrity. It seems, therefore, that ‘fitness and propriety’ under both s 120A and the new operating standard is to be assessed against similar criteria.

In my view, therefore, fit and proper disqualifications should occur only where an alleged offender is unfit and improper — not merely because they happen to make unpopular decisions in the face of difficult circumstances. Otherwise, there is a strong risk that directors will, when faced with difficult issues, resign precisely when their expertise is needed most.

Legislative intent behind section 120A

The use to which section 120A has been put by APRA does not seem consistent with legislative intention.

Originally, section 120A was seen as giving APRA the power to deal with persons who attempted to evade the removal or suspension of a trustee company. In other words, removal or suspension of a trustee company (under section 133 of the SIS Act) was seen as APRA’s primary enforcement tool; section 120A was to be used only where section 133 orders proved ineffective. (Section 133 has been in place since the introduction of the SIS Act; as mentioned above, section 120A was inserted much later.)

Put another way, section 133 of the SIS Act conferred on APRA the power to protect the public from unscrupulous trustee companies and was to be exercised only in the public interest (as evidenced by the need for ministerial consent). Section 120A was intended merely as a mechanism to support section 133 (that is, by allowing APRA to remove unscrupulous individuals who evaded s 133 orders).

The implication is that the same caution should be exercised in disqualifying individuals as is (demonstrably) exercised in removing or suspending trustee companies. Indeed, in Auton’s case, the AAT’s decision to set aside Mr Auton’s disqualification was influenced by APRA’s earlier decision not to remove or suspend the relevant entity.

It is notable that APRA has exercised its power in section 133 only rarely. According to its annual reports, APRA replaced four superannuation trustees in 2000-2001 and only one in 2001-2002. It did not replace any trustees in 2004-2005. Owing to a change in its reporting scheme, it is unclear whether APRA replaced any trustees in 2005-2006, although it certainly removed no more than one in that period.

True meaning and effect of the prudent person and best interests covenants

Owing to their broad nature, the prudent person and best interests covenants are clearly important, particularly in the context of APRA’s powers under section 120A.

Except in VBN’s case, the AAT has to date given little consideration to the meaning and effect of the relevant covenants. A few comments appear in Preuss’ case regarding the prudent person covenant, but little in the way of practical guidance is offered.

In VBN’s case, however, the AAT turned its mind specifically to the meaning and effect of both the prudent person and best interests covenants. There, the AAT stated that the covenants were intended to go beyond a mere restatement of the general law. In particular, the AAT stated that the best interests covenant requires a trustee to consider ‘what is to members’ benefit or advantage’.

This led the AAT to conclude in VBN’s case that the trustee’s failure to inform deferred benefit members prospectively of the change to the crediting rate policy was not in their best interests. In other words, according to the AAT, the trustee breached the best interests covenant because its failure disadvantaged the deferred benefit members. However, in deciding whether a breach of the best interests covenant took place overall, the AAT held that the trustee ‘steered the fairest course that it could among all of the members’.

On the one hand, therefore, the AAT said the best interests covenant requires a trustee to act to the advantage of members. On the other, the AAT said that some members could be disadvantaged by the same decision. On its face, the AAT seemed to be saying that the trustee was obliged to give with the one hand, but was allowed to take with the other: two apparently irreconcilable positions.

In fact, it is arguable that the AAT’s decision involved little more than a textbook application of the general law requirement ‘to hold the scales impartially between different classes of beneficiaries’ (Cowan v Scargill [1985] Ch 270 at 286-89 (Megarry V-C).

Where there is a divergence between the interests of different groups of members (such as the divergence between the interests of existing and future deferred benefit members in VBN’s case), a trustee’s duty is to resolve the divergence fairly (that is, within its powers and for proper purposes). In such cases, a trustee must act like an impartial umpire and, as long as it does so, its decisions cannot and should not be criticised, even if the outcome disappoints one party.

This is precisely the role that the trustee in VBN’s case played when it steered the fairest course it could among all of the members. As such, even though the AAT said in VBN’s case that the covenants embody more than the general law, the AAT in fact did little more than apply the general law.

So, on the one hand, it could be said that the true meaning and effect of the covenants is now clear (in that they represent an embodiment of the general law). But, on the other hand, it could be argued that the AAT’s express words (that is, that the covenants do more than embody the general law) should be given prominence. In the end, it seems there is still uncertainty.

Conclusion

In my view, there are errors in the way the disqualification power and the covenants in the SIS Act have been interpreted. Interestingly, however, this has not yet led to incorrect or perverse outcomes, at least not in relation to the disqualification decisions reviewed by the AAT.

Irrespective of outcomes, however, such errors could cause other difficulties. For instance, they could result in irreparable harm to reputations and the imposition of irrecoverable legal costs—both of which, in the case of exonerated officers, would be unnecessary and unjustified.

Also, until the law in relation to section 120A and the covenants is clarified, there remains (at least) the potential for inappropriate outcomes. It seems clear, however, that the necessary clarification will not to come from parliament. Rather, clarification will probably be the result of judicial review of an AAT decision. For the time being, however, judicial review is unlikely to happen while merits reviews continue, despite errors in the law, to produce correct or preferable outcomes.

Freehills acted for the trustee in the case of VBN v APRA. This article is reprinted with permission from Superannuation Law Bulletin, Vol 18, No 6, published by LexisNexis. This article was published in Chartered Secretaries Australia.

This article was written by Andrej Kocis, Senior Associate.

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