We examine Commonwealth Bank of Australia Limited (“CBA”) in the fifth instalment of our series on alleged wrongdoings in the Australian financial services sector.

Before we jump into the following litany of grievances, one could imagine that CBA board chair Catherine Livingstone has one of the most unenviable positions in corporate Australia as she oversees the cleaning up of the country’s biggest bank. The bank has made considerable progress in remediation and simplification, but it’s clear that there’s plenty more hard yakka ahead for the board, new CEO Matt Comyn and the rest of the bank to rebuild shareholder and community trust.

Royal Commission

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the “Royal Commission”) was established on December 14, 2017, by the Governor-General of the Commonwealth of Australia. The Commissioner will submit an interim report by September 30, 2018 and will provide a final report by February 1, 2019.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the “Royal Commission”) was established on December 14, 2017, by the Governor-General of the Commonwealth of Australia. The Commissioner will submit an interim report by September 30, 2018 and will provide a final report by February 1, 2019.

CBA has been involved in multiple cases in the Royal Commission thus far:

  • Round 1 – Consumer lending (commenced on March 13, 2018)
    • In her closing address, Counsel Assisting stated that it was open to the Commissioner to make multiple findings of misconduct by CBA and that CBA engaged in conduct that fell below community standards and expectations in relation to CBA’s arrangements with mortgage brokers in 2017.
      • CBA did concede in relation to the third finding of misconduct that it could have disclosed the upfront commission and the rate at which the commission will be applied, and amounts of commission payable for referrals of related products. But it considered those disclosures would be redundant if the mortgage broker was complying with their own obligations. CBA accepted that improvements could be made, but that the failure to disclose information did not amount to “misconduct”.
    • Counsel Assisting also stated that it was open to the Commissioner to make multiple findings of misconduct by CBA’s wholly owned subsidiary Aussie Home Loans (“AHL”) and that AHL engaged in conduct that fell below community standards and expectations in relation to fraudulent conduct of four AHL brokers from 2011 to 2015.  Counsel Assisting also said it is open to the Commissioner to find that the misconduct arose not merely because of rogue conduct by individual brokers but because the systems, processes and culture at AHL permitted such misconduct to occur.
      • AHL has rejected all allegations directed against AHL itself, while accepting that its credit representatives’ fraudulent conduct was misleading, deceptive and unconscionable.
    • Counsel Assisting also stated that it was open to the Commissioner to make multiple findings of misconduct by CBA and/or its wholly owned subsidiaries Colonial Mutual and CommInsure and that CBA and/or these subsidiaries engaged in conduct that fell below community standards and expectations in relation to selling credit card and loan protection insurance policies to ineligible customers from 2011 to 2015. Counsel Assisting also alleged that the alleged misconduct can be attributable to culture and processes within CBA and/or these subsidiaries that permitted such misconduct to occur.
      • CBA accepted two of the open findings of misconduct, and accepted three of the four alleged findings regarding community standards and expectation.
    • Counsel Assisting also stated that it was open to the Commissioner to make multiple findings of misconduct by CBA in relation to errors within CBA’s automated decision-making system for assessing personal overdraft applications, which was undetected for four years from 2011 to 2015. Counsel Assisting also alleged that the alleged misconduct can be attributable to inadequate governance of data management at CBA.
      • CBA accepted one of the open findings of misconduct but rejected the attribution of any misconduct to poor data management governance.
    • Counsel Assisting also stated that it was open to the Commissioner to make multiple findings of misconduct by CBA in relation to CBA’s responsible lending practices with respect to the diligence and methodology applied to assessing credit card limit increases and ability to repay credit , as it related to its relationship with a single customer from 2014 to 2017 who had a gambling problem. Counsel Assisting also alleged that CBA engaged in conduct that fell below community standards and expectations by failing to take into account the customer’s gambling problem, and that this case study raised deficiencies in CBA’s systems.
      • CBA acknowledged breaching multiple statutory obligations (but rejected allegations that it had breached other statutory obligations) and engaging in conduct that fell below community standards and expectations. CBA did not directly acknowledge some systems inadequacies but acknowledged that improvements needed to be made.
  • Round 2 – Financial advice (commenced on April 16, 2018)
    • In her closing address, Counsel Assisting stated that it was open to the Commissioner to make multiple findings of misconduct by CBA’s financial services licence-holding subsidiaries (Commonwealth Financial Planning (“CFPL”), Financial Wisdom, Count Financial and BW Financial Advice) in relation to charging fees for no service. Counsel Assisting also stated that the causes of the alleged misconduct could be attributable to remuneration practices at CFPL, the culture at CBA or at least at CFPL,, the manner in which CBA’s practice for considering whether to notify a breach takes into account the size of CBA’s advice licensees, and inadequate internal systems.
      • CBA acknowledged that the circumstances covered in this case study were “unacceptable and have impacted a large number of customers.”
      • CBA accepted multiple open findings of misconduct and that CFPL’s internal systems had been inadequate to identify and report contravening conduct, but stated that those internal systems had been improved. However, CBA rejected the Counsel Assisting’s attribution of the causes of the alleged misconduct.
  • Round 3 – Loans to small and medium-sized enterprises (commenced on May 21, 2018)
    • In his closing address, Counsel Assisting stated that it was open to the Commissioner to make multiple findings of misconduct in relation to CBA’s overcharging of overdraft interest, and conduct falling below community standards and expectations in relation to the Bankwest (a CBA subsidiary) business lending book, through 2018.
      • CBA accepted one of the open findings of misconduct on a narrow basis, and accepted that, in limited respects, the quality of its communications with, or the level of transparency shown towards, the individuals who were subjects of the Bankwest case studies, fell below community standards and expectations.
  • Round 4 – Financial services in rural and remote communities (commenced on June 25, 2018)
    • In her closing address, Counsel Assisting stated that it was open to the Commissioner to find multiple findings of misconduct and conduct that fell below community standard in relation to Bankwest’s treatment of a farming family from 2011 to 2013 that was the subject of a case study. Counsel Assisting also stated that the causes of the alleged misconduct could be attributable to Bankwest’s remuneration practices and inadequate internal systems.
      • CBA/Bankwest accepted many of the open findings. Bankwest rejected the potential finding that its remuneration system contributed to the misconduct, but accepted that its internal systems did not provide adequate control at the relevant time. It submitted that those systems have subsequently changed and are now adequate.
    • Counsel Assisting also stated it was open to the Commissioner to make multiple findings of misconduct in relation to CBA’s failure to apply fee waivers and ongoing package benefits to eligible agribusiness customers from approximately 2005 to 2014, and to attribute that misconduct to inadequacy of CBA’s “control environment”.
  • Round 5 – Superannuation (commenced on August 6, 2018)
    • In his closing submission, Counsel Assisting stated that it was open to the Commissioner to make multiple findings of misconduct, conduct falling below community standards and expectations, and misleading or deceptive conduct by at least one of CBA’s wealth management subsidiaries, Colonial First State Investments Limited (“CFSIL”) and Avanteos Investments Limited (“Avanteos”), in relation to the transition of accrued default superannuation accounts, trailing commissions and grandfathered commissions, contribution fees, adviser service fees charged to deceased member accounts, cash returns, related party benchmarking, distribution and selling practices, and intra-fund advice and a banned advisor.
      • CBA/CFSIL/Avanteos accepted some of the open findings of misconduct, including some of the misconduct findings in respect of charging advice fees to deceased member accounts, and accepted some of the open findings of conduct falling below community standards and expectations, including but not limited to failing to rebate members after ceasing paying commissions in relation to superannuation products (though noting that such conduct is legally permissible).
  • Round 6 – Insurance (commenced on September 10, 2018)
    • In his closing address, Counsel Assisting stated that it was open to the Commissioner to make multiple findings of misconduct and conduct falling below community standards and expectations by CBA’s soon-to-be former subsidiary, The Colonial Mutual Life Assurance Society Limited (“CommInsure”), in relation to CommInsure’s handling of claims made under life insurance policies that provided trauma cover, in one case denying a claim by a policy holder who suffered a heart attack in 2014 because the policy holder did not meet the relevant policy definition (which had not been updated since 2005), and in another case denying a claim by a policy holder who was diagnosed with breast cancer in 2016 because the policy holder did not meet the relevant policy definition (which had not been updated since 1998).
      • CBA/CommInsure accepted some of the open findings of misconduct, including misleading the Financial Ombudsman Service (“FOS”), an independent dispute resolution service, contravening FOS’ Terms of Reference, making false and misleading representations in publications, as well as other breaches of the law that constituted misconduct. CBA/CommInsure also accepted some of the open findings of conduct falling below community standards and expectations.

On September 28, 2018, the Interim Report of the Royal Commission was submitted to the Governor-General of the Commonwealth of Australia, His Excellency General the Honourable Sir Peter Cosgrove AK MC (Retd) and tabled in Parliament. The Interim Report “records the conclusions reached about the particular case studies that were examined in the first four rounds of hearings. [The Interim Report] seeks to identify the issues about banking, loan intermediaries and provision of financial advice that [the Commissioner considers] arise out of the matters examined in those hearings. [The Interim Report] poses a series of questions, directing attention to considerations that may bear upon what conclusions I should reach, and what recommendations [the Commissioner] should make, about banking, lending intermediaries, and financial advice…

However, the Interim Report does not include any definitive findings or recommendations—for that, investors will need to wait until the Final Report, which is due February 1, 2019.

Other issues

CBA has otherwise been under heavy regulatory and legal scrutiny for various practices in the past year:

Money laundering

On August 3, 2017, Australian Transaction Reports and Analysis Centre (“AUSTRAC”) launched civil court proceedings against CBA for serious and systemic non-compliance with the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (“AML/CTF Act”). In a statement of claim filed in Federal Court, AUSTRAC outlined the apparent lack of response from CBA to various requests from regulators. In addition, AUSTRAC alleged that CBA should have been doing more to detect and report on potentially fraudulent activity prior to the arrests stemming from the money laundering scheme.

On June 4, 2018, CBA announced that it had entered an agreement with AUSTRAC, which was subsequently approved by the Federal Court. As part of the agreement:

  • CBA would pay a civil penalty of $700 million together with AUSTRAC’s legal costs of $2.5 million.
  • CBA admitted further contraventions of Australia’s AML/CTF Act, beyond those already admitted, including contraventions in risk procedures, reporting, monitoring and customer due-diligence.
  • AUSTRAC’s civil proceedings were otherwise dismissed.

Prudential Inquiry

On August 28, 2017, the Australian Prudential Regulation Authority (“APRA”) launched an independent prudential inquiry into CBA’s governance, culture, and accountability. APRA appointed three panel members, John Laker, Graeme Samuel and Jillian Broadbent, to undertake the inquiry.

On May 1, 2018, APRA released the final report of the prudential inquiry and announced it had accepted an enforceable undertaking from CBA. The report laid out shortcomings in governance, culture and accountability at the company. One such example is APRA’s observation that “[u]ndue focus was placed on allocating blame to specific individuals responsible for specific tasks, without appropriate focus on overarching accountability of CBA senior leaders.

The final report contains a large number of findings and recommendations, which outlined five key areas for improvement:

  • Governance: more rigorous board and executive committee level governance of non-financial risks.
  • Accountability: exacting accountability standards reinforced by remuneration practices.
  • Capability: a substantial upgrading of the authority and capability of the operational risk management and compliance functions.
  • Customer: injection into the company’s DNA of the “should we?” question in relation to all dealings and decisions on customers.
  • Culture: cultural change that moves the dial from reactive and complacent to empowered, challenging and striving for best practice in risk identification and remediation.

APRA also applied a capital adjustment to CBA’s minimum capital requirement by applying an add-on of $1 billion to the company’s operational risk capital requirement.

In response the company developed a Remedial Action Plan to address the 35 recommendations outlined in the report. The plan was endorsed by APRA on June 29, 2018. In addition, CBA has advised APRA how the findings of the prudential inquiry will impact remuneration outcomes for current and former executives.

Work to ensure delivery of the plan is now underway, and is being managed under a dedicated Better Risk Outcomes Program (“BROP”). A centralised BROP team, reporting directly to the MD/CEO, will govern implementation of the plan.

Inappropriate distribution of superannuation products

On July 6, 2018, ASIC announced that it had accepted an enforceable undertaking from CBA in which CBA had agreed to change the way it distributes superannuation products to its customers. An ASIC investigation found a common practice among CBA’s branch staff to offer CBA’s Essential Super product to customers at the end of a fact-finding process about customers’ overall banking arrangements (a so-called “Financial Health Check”). ASIC was concerned that the proximity between the fact-finding process and the discussion about the superannuation products was leading staff to provide personal advice to customers about their superannuation. Branch staff for CBA were only authorised to provide general advice. ASIC was concerned that customers may have thought, due to the proximity of the fact-finding process to the offer of Essential Super, that CBA’s branch staff were considering risks specific to the customer when this was not the case. The court enforceable undertakings prevent CBA from distributing Essential Super in conjunction with Financial Health Check. They also require CBA to make a A$1.25 million community benefit payment.

BBSW manipulation

On January 30, 2018, ASIC launched legal proceedings in the Australian Federal Court against CBA for unconscionable conduct and market manipulation in relation to its involvement in setting the bank bill swap reference rate (“BBSW”) between January 31, 2012 and October 2012.

During the relevant period CBA had a large number of products which were priced or valued based on BBSW. ASIC alleged that on three specific occasions the company traded with the intention of affecting the level at which BBSW was set so as to maximise its profits or minimise its losses to the detriment of those holding opposite positions.

On May 9, 2018, CBA announced that it had reached an in-principle agreement with ASIC, later approved by the Federal Court in June 2018. As part of the settlement, the company acknowledged that, in the course of trading on the BBSW market in Australia on five occasions between February and June 2012, there were attempts to engage in unconscionable conduct in breach of the ASIC Act. CBA has also acknowledged that it “did not have adequate policies and systems in place to monitor the trading and communications of [its] staff in order to prevent that conduct from occurring.”

The settlement included a A$5 million penalty, a payment of A$15 million to a financial consumer protection fund, and a A$5 million payment towards ASIC’s litigation and investigation costs. The company also entered into an enforceable undertaking with ASIC, under which an independent expert would be appointed to review controls, policies, training and monitoring in relation to our BBSW business.

Financial planning

On January 23, 2018, ASIC announced an update of CBA’s compensation scheme for customers of its financial planning subsidiaries Commonwealth Financial Planning Ltd (“CFPL”) and Financial Wisdom Ltd.

In August 2014, ASIC imposed additional conditions on the Australian Financial Services licences of Commonwealth Financial Planning Ltd and Financial Wisdom Ltd, with the licensees’ consent. Under the additional licence conditions, ASIC appointed KordaMentha Forensic to assess the adequacy of CBA’s 2012 review of potentially high-risk advisers. As at January 10, 2018, CBA reported to ASIC that approximately A$1.9 million of compensation is due to customers of the five advisers. Compensation is likely to increase as CBA reviews further customer files. The current round of compensation is in addition to A$4.97 million including interest already offered to customers of different advisers under the additional licence conditions compensation scheme

Poor financial advice

On April 13, 2018, ASIC announced that it had accepted an enforceable undertaking from CFPL and BW Financial Advice Limited (“BWFA”), following ASIC’s findings that CFPL and BWFA failed to provide, or failed to locate evidence regarding the provision of, annual reviews to approximately 31,500 ‘Ongoing Service’ customers in the period from July 2007 to June 2015 (for CFPL) and from November 2010 to June 2015 (for BWFA).

The enforceable undertaking requires, among other things:

  • CFPL and BWFA to pay a community benefit payment of A$3 million in total;
  • CFPL to provide an attestation from senior management setting out the material changes that have been made to CFPL’s compliance systems and processes in response to the misconduct; and
  • CFPL to provide further attestations from senior management, supported by an expert report, that:
    • CFPL’s compliance systems and processes are now reasonably adequate to track CFPL’s contractual obligations to its Ongoing Service clients; and
    • CFPL has taken reasonable steps to identify and remediate its Ongoing Service customers to whom CFPL did not provide annual reviews in the period from July 2015 to January 2018.

As at the end of February 2018, CFPL and BWFA have paid or offered to pay approximately A$88 million (plus interest) to these customers (with the total compensation estimated at A$88.6 million (plus interest)).

More broadly, as at June 30, 2018, CBA has reported to ASIC that its estimates of total compensation (including paid or offered plus estimated future compensation) for ‘fees for no service’ refunds to be approximately A$143.31 million.

Delays in reporting, addressing and remediating significant breaches

On September 25, 2018, ASIC released a report in which it had identified “serious, unacceptable delays in the time taken to identify, report and correct significant breaches of the law among Australia’s most important financial institutions” including but not limited to CBA. CBA fared as follows:

  • Median length of time between the first instance of a significant breach to identification of the incident:
    • CBA: over 800 days
    • Industry: 925 days
  • Median length of time between the start of the investigation into whether a significant breach has occurred and the date the significant breach report is lodged with ASIC:
    • CBA: approximately less than 40 days
    • Industry: 69 days
  • Median length of time between the end of the investigation into whether a significant breach has occurred and the first communication with affected consumers
    • CBA: approximately 175 days
    • Industry: 143 days
  • Median length of time between the end of the investigation into whether a significant breach has occurred, the first payment to affected consumers
    • CBA: approximately 320 days
    • Industry: 201 days
  • Median length of time between the end of the investigation into whether a significant breach has occurred and the first process change, as well as first system change
    • CBA: less than 30 days (process change); approximately 60 days (system change)
    • Industry: approximately 25 days (process change); approximately 35 days (system change)

ASIC Chair James Shipton said, “…there is an urgent need for investment by financial services institutions in systems and processes as well as commitment and oversight from boards and senior executives to address these significant failings.

Glass Lewis commentary

In relation to the Royal Commission, we note that the Royal Commission is ongoing and that many of the open findings regarding CBA are in dispute. However, shareholders may wish to assess the materiality of the open findings that CBA has accepted.

In relation to the AUSTRAC proceedings, while we acknowledge CBA’s subsequent investments to improve its compliance capability with a focus on improving its risk culture, we believe the inadvertent nature of the offenses should not excuse the board and KMP from responsibility for the breaches.

This issue ties into APRA’s prudential inquiry into CBA, which found multiple governance, culture and accountability shortcomings at the bank. APRA’s report does not paint a flattering picture of CBA, and we are aware that it has become required reading in many boardrooms across the country, and not just in financial services. We understood CBA has welcomed APRA’s report and the “clear roadmap” it provides the bank. The proof is in the pudding—the bank’s FY2018 remuneration outcomes are one such indicator of emerging accountability.

The inappropriate distribution of superannuation products reflects the inherent risks and potential conflicts presented by a vertically integrated financial services model—the cross-selling opportunities for retail branch staff are fraught with peril. As with ANZ, which was caught up in the same issue, it is no wonder that CBA has been in the process of de-integrating.

The BBSW outcome is concerning and, like at the other big Australian banks who were also caught up in this scandal, speaks to the historic acceptable risk tolerance at CBA’s trading desks.

The fees-for-no-service scandal is particularly problematic because of the nature of the infringement as well as the number of customers and the size of the fees taken. We note that this practice artificially inflated revenue in the reporting periods in which the practices occurred.

As with other Australian financial institutions, investors will want to assess the materiality and the totality of these practices and determine where accountability should lie when considering how to vote at CBA’s AGM in November 2018.

Daniel J. Smith is General Manager, CGI Glass Lewis.