Alternative Investment Management Association
Henry Davis York Lawyers
The most significant and distinctive feature of the system of regulation of financial products and markets in Australia is that the law allows retail investors to be offered and to invest in any financial product, no matter how sophisticated, provided of course that there is full compliance with the substantial, "disclosure documentation" regime. The appointment of a new Chairman, Mr Tony D'Aloisio, of the Australian Securities and Investments Commission,(ASIC), together with the well-publicised failure of a few investment companies, offering sophisticated retail products (particularly debenture trusts), has heralded a new regulatory attitude towards sophisticated products and funds.
Scope of this article
In this article we shall:
• Outline the major relevant features of the Australian pattern of regulation;
• describe the "crackdown" proposal as announced by the Chairman of ASIC;
• describe the intended major initiatives desired by the Chairman; and
• consider the major implications of the proposals for hedge funds.
The Australian pattern of regulation
Hedge fund activity in Australia is regulated under Chapter 7 of the Australian Corporations Act and there are two principal regulatory organisations being ASIC, which is the government securities and financial services and markets regulator and the Australian Prudential Regulation Authority (APRA), which is the government prudential regulator and has direct responsibility for superannuation (pension) funds. Under the Chapter 7 regime, hedge funds are not governed by a separate set of laws but are regulated in the same way as other "managed investment schemes", i.e., funds generally. Hedge fund managers and other intermediaries need to hold an Australian Financial Services Licence (AFS Licence), unless exempt but there are no special licences for hedge funds and generally no special conditions attached to licences held in respect of hedge funds. Similarly, retail hedge funds need to be registered with ASIC but this requirement is exactly the same for all retail managed investment schemes (i.e., managed funds). Again, in most cases, there are no special hedge fund conditions.
This is a pattern which has worked well.
The crackdown proposal
Mr Tony D'Aloisio, the former CEO of the Australian Securities Exchange (ASX), took office as the Chairman of ASIC on 13 May 2007. On 30th May 2007, in one of his first public appearances as Chairman, Mr D'Aloisio addressed the Australian Senate Standing Committee on Economics, during which he announced six important priorities for ASIC over the following 12 months. The most significant of these was the announcement that ASIC would dramatically increase initiatives for ASIC oversight of sophisticated financial product offerings to retail investors.
The proposal in general terms
The Chairman has made it clear that ASIC will devote substantially greater resources to its regulation of "sophisticated" products. ASIC has previously made it clear that additional resources will also be devoted to the oversight of hedge funds.
The Chairman announced the establishment of a "special team" (to be led by a "senior person") to examine the risks for the retail investor and respond with specific plans to help address these risks. The Chairman forecast that these plans would include:
• Ensuring a higher quality of advice and investor education on such issues as the importance of diversifying risk through asset allocation and understanding risk and reward premiums for particular asset classes;
• better disclosure through simpler and more targeted disclosure; and
• a "blitz" (to use ASICs own term) on the advertising of complex products targeted at the retail investor.
Because of the pattern of regulatory retail offerings, as described in the opening paragraph, ASIC does pay substantial attention to the disclosure of product characteristics, risks, costs and fees relating to sophisticated products when offered to retail investors. In itself, there is nothing very surprising about the Chairman's statements. ASIC has for some time kept a watchful eye on the development of products such as CFDs and warrants and has provided a limited supply of discussion papers and other guidance in relation to the disclosure of risks for derivative products.
However, what is new is that there will be a renewed level of concentration under the Chairman's initiative and that specific reference will be made to at least the following:
• margin loans;
• other derivatives ( "derivative" is defined very broadly for the purposes of Chapter 7); and, most significantly
• hedge funds, both in their own right and as "users" of derivatives and the other products being received.
Intended ASIC initiatives
Chairman D'Aloisio has cited particular examples of the initiatives he expects to flow from the special team's work. These include:
• Insistence on better quality advice being proffered to retail investors in respect of the named products;
• possibly some ASIC requirement for a process of "investor education" in respect of those products;
• The age old problem of "better disclosure". This has been a constant ASIC theme throughout the life of the FSRA regime. We say "age old problem" because there needs to be a balance between the statutory requirements for the items to be disclosed in the product disclosure statement (PDS) on the one hand and at the same time a need to ensure that the PDS ends up as a "clear, concise and effective" document; one that can be understood and is user-friendly to retail investors.
To be optimistic, the results of the special team's work may well be additional guidance for the disclosure of risks in relation to derivatives, including specialist products such as CFDs and warrants.
• "Blitzes" on the advertising of complex products targeted at the retail investor. ASIC has been subject to occasional criticism and adverse media comment for not taking more decisive action to restrict misleading advertising of financial products. A sensible approach is called for here. It is our observation that the practice of obtaining external vetting of advertising and promotional copy seems to have become rarer, as life under the FSRA regime proceeds. It would be a wise precaution for product issuers to reinstate that practice. It is also an effective precaution; provided that ASIC can play its part by providing clear guidelines as to what it will regard as misleading or deceptive in relation to particular products.
Major implications for hedge funds
The "sophisticated products" are under review by ASIC, and many are heavily utilised by hedge fund managers.
It is now apparent that ASIC sees it as a priority, in conjunction with the crackdown proposals, to increase its surveillance of the operations of Australian hedge funds generally.
ASIC has recently flagged its intention to revise a process started in 2005, when ASIC undertook visits to about 300 small to medium licensees (that is, holders of an AFS Licence). At that time, AIMA Australia was aware that only a few of its members were subject to these surveillance visits. There is now, however, a clear indication from ASIC that under the renewed surveillance programme, hedge funds will be specifically targeted. At this stage ASIC has made it clear that they will be concentrating on the "organisational capacity" of those businesses; that is, the qualifications and experience of the responsible officers of the business and the human and other resources and systems available for delivery of the financial services i.e., hedge fund investments.
ASIC has also recently been investigating the sub-prime mortgage market and its impact on Australia. They have been investigating hedge funds and how they have been impacted.
As a result of all this ASIC has focused on the extent of retail involvement in hedge funds in Australia and have given an informal indication that they are surprised at the extent of retail involvement.
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Likely further action
In our view hedge fund intermediaries and other issuers of derivatives and sophisticated products, should not be unduly concerned by the announcements by Chairman D'Aloisio or ASICs increased surveillance of hedge fund businesses in Australia. There is simply no indication that ASIC intends to press the government for alteration of the basic pattern of regulation, as described in the opening paragraphs above. It is simply a matter of ASIC concentrating more resources on understanding hedge funds and by enhancing its understanding by means of surveillance visits to hedge fund managers. At this stage, no written proposals or guidances have been issued by ASIC or by APRA.
However this is clearly a "space to watch".