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Morningstar | IOOF’s Unconvincing Evidence Increases Royal Commission Risks

The Royal Commission put narrow-moat IOOF under the blow-torch at the end of last week, and while there wasn't the same level of fallout as after AMP's appearance a few months ago, we still believe it was a weak performance. Christopher Kelaher, IOOF CEO and Mark Oliver, IOOF's general manager distribution provided unconvincing testimony. This may come back to haunt IOOF when senior counsel gives his closing submission and/or when the Commission publishes its Interim Report on Sept. 30, 2018. IOOF is currently trading below our fair value estimate of AUD 9.80, but given these near-term catalysts, a high margin of safety is warranted.

Although Kelaher did not admit to IOOF breaching its trustee's best interest duty, we believe the Commission hearings revealed this may have occurred. This includes conduct by the now non-operational IOOF subsidiary Questor Financial Services Limited, or Questor. Questor held the dual role of being a registrable superannuation entity, or RSE, trustee for its superannuation funds and a responsible entity, or RE, for its cash management trust, or CMT. Evidence showed Questor reduced the distribution from the CMT to recoup a previous overdistribution without telling unit holders, including its superannuation members. Questor then used the super fund's reserve fund to compensate members. While Kelaher recognised an error in distribution, he maintained members were compensated in full. This was even after senior counsel put it to Kelaher this was inaccurate because an asset of the fund was used to compensate them.

We do not believe IOOF's position is sustainable or passes what it refers to as the "pub test," which Kelaher described as acting within community expectations. We think community expectations would require IOOF to compensate members out of their own funds and not use the trust's assets, which is what we expect will be the Royal Commission's position.

Although the sums of money identified from the issues revealed at the Royal Commission are not likely to be material to IOOF, more of a concern is the potential reputational damage to IOOF. Not only did the evidence reveal potential breaches of duties, the Commission also appeared concerned about the lack of understanding of IOOF of these duties. At the end of Kelaher's somewhat combative testimony, senior counsel assisting the Commission submitted to Kelaher that Questor has never displayed any understanding of a trustee's best interest duty to super fund members with respect to the Questor CMT issue or put the interest of members always over the interest of Questor and its related parties. Counsel also put it to Kelaher that even now he still does not recognise the problem. The testimony also increases the risk of regulators such as ASIC and APRA more proactively regulating IOOF and it may also negatively impact IOOF's relationship with its financial advisors, a key relationship in its advice-led strategy. We had already reduced IOOF's fair value estimate due to these concerns and will continue to monitor the fallout from the most recent round of hearings.

The Commission also revealed that APRA was particularly concerned about IOOF's governance structures among several other matters and was not satisfied with IOOF's responses. One of the primary concerns was the dual role held by now nonoperational Questor as well as by currently operational IOOF Investment Management Limited, or IIML. Like Questor, IIML has the dual role of RSE, as trustee of IOOF's superannuation funds as well as being the RE of its investment management funds. The potential for conflicts arose from IIML as RSE investing in funds where it was also the RE. Consequently, APRA wanted IOOF at a minimum to dissolve this dual structure.

While Kelaher did not agree that there were legitimate governance concerns with this structure, he indicated IOOF would investigate separating the RSE and RE roles as well as testifying that the board structure of the RSE would change to have more independent directors. Kelaher gave evidence these changes were made because of APRA's concerns, not because he saw an issue with this structure and that he was ultimately indifferent towards the structure. Notably, the Commission seemed concerned with Kelaher's indifference and was also concerned there were no type-written minutes of the IOOF board meeting on Aug. 1, 2018 provided to it which considered these issues. The only provided notes were hand-written and difficult to decipher, and the Commission rightly questioned whether it was an appropriate governance procedure for a public company the size of IOOF to take hand-written notes at board meetings.

The Commission also heard evidence suggesting the recent repricing of IOOF's Choice superannuation products on its Pursuit Platform may not have met the best interest duty. IOOF took the decision not to move all existing members to the new reduced pricing even though Oliver agreed that about 29,000 existing members would have been better-off if they had done so. The evidence suggests the conflict between the interest of these members to be charged a lower price and the interest of the trustee to have them remain on a higher price was resolved to benefit the trustee over these members. Oliver's testimony also indicated that in setting the reduced pricing, IOOF assumed unengaged members who are not advised by a financial advisor and about 16,000 members advised by a financial advisor who benefits from grandfathered commission were unlikely to move to the new reduced pricing. Furthermore, the board papers of the meeting of the trustee board in which the repricing and implementation decision was made did not include details of this assumption, suggesting the independent directors who ultimately made the decision did not have all relevant information before making it.

The Commission also heard evidence of potential breaches of the Future of Financial Advice, or FOFA, legislation. Part of the grandfathered provisions under FOFA prohibited volume-based shelf-space payments to platform operators such as IOOF except to the extent they covered actual costs to the operator of providing the platform services. Testimony by Oliver revealed that IOOF still charged percentage-based platform fees to fund managers such as Aberdeen under these grandfathered provisions. He was also forced to accept senior counsel's proposition that IOOF's shelf space fee could "vastly exceed the value of any service" provided by IOOF given that it was percentage-based and unlinked to the services provided. Furthermore, Oliver accepted senior counsel's proposition that any money received by such fees should be returned to members and not retained by any part of IOOF to meet its best interest duty.