Thank you for the opportunity to comment on your consultation paper dated 10 December 2015 concerning a possible class designation of investment company shares to MIPs in MISs (Consultation Paper).
The issue identified by the paper is essentially one of (possible) regulatory arbitrage
- something which we agree the FMA's powers of designation under the FMCA are intended to address.
Further analysis/ consultation essential
However, we consider that, at a minimum, considerably more analysis and further consultation is required before a class designation along the lines outlined by the paper should be made. As is common in most (if not all) cases of putative
regulatory arbitrage, it is very difficult to identify a "bright line" which can be reliably and confidently regarded as accurately differentiating between:
on the one hand, an "inappropriate" arbitrage; and
on the other, a legitimate structure which addresses specific investor demand and appropriately balances risks and returns.
Typically, there is a variety of structural features and a resultant "spectrum" of structures. If a regulatory demarcation line is drawn too close to the "legitimate" end of that spectrum, investors will be unnecessarily harmed (e.g. v ia missing out on opportunities which wou ld otherwise suit them).
The Consultation Paper acknowledges this risk in the comments in paragraph 34 that any designation should not over capture shares that would not be designated if an individualised test were employed . In our view, that caution suggests that a preferable means of addressing the issue, at least at present, might be a more
detailed policy on the approach the FMA will take to individual designations of shares
to MIPs, and ongoing analysis of experience with that policy as a means for better informing the detail of any eventual class designation, rather than leading with a class designation as a first step .
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Our reasons are threefold:
We are not aware of any particular pressing need for a class (as opposed to individual) designation.
Given the variety of actual, and possible future, structures, there is considerable "devil in the detail" in properly defining any regulatory bright line, with attendant risks of over-reach (and under-reach). A cautious approach is therefore appropriate.
It is not clear how, exactly, an investment company whose shares were redesignated would operate in practice, in light of prevailing directors' duties and existing contractua l rights obligations. Again, this suggests caution is desirable.
Consequences need to be assessed fully
We also consider that the consequences of a class designation need to be considered fully, in particular the impact on directors of investment companies and the interplay between the company model and MIS governance requirements. For the reasons described above (and on which we expand below), that should logically be done in the context of individual designations, before a class approach is taken.
We are concerned that, if these consequences are not fully considered (and a class designation is implemented), market participants who may have otherwise considered using an investment company model may see the over lay of these governance requirements as a signif icant disincentive to making a retail offer. Instead, they may choose to make wholesale offers only, meaning retail investors would be deprived of the opportunity to invest in a product which may otherwise be suitable for (or attractive to) them.
The need for a designation
We agree entirely with the Consultation Paper's assessment that non-voting share investment companies with entrenched managers look a lot like MIPs and are appropriate candidates for possible designation as such. However, we are less convinced that a case has been made that the potential costs and risks of doing so are currently justified - i.e. that the issue is more than "theoretical", because there are existing or likely future structures in respect of which investors are inappropriately protected having regard to their entry price and potential return. As noted above (and discussed in more detail below), the risks of moving too quickly to a class designation are such that a compelling case should be required - not merely that there are some structures for which designation is appropriate, but that addressing them via a class designation rather than individual designations is necessary.
We acknowledge that this is one of the issues on which feedback is sought , and that other market participants may have a range of examples which incline towards a class designation rather more than the examples of which we are aware. Our point, here, is simply that we believe it is appropriate for the FMA to proceed on the basis that there is a relatively high bar for moving to a class designation rather than a policy for individual designations, accompanied by a commitment to monitor
progress with that and re-consider class designations later with the benefit of that monitoring.
Defining the scope of designation
Actual and potential future companies come in a wide variety, from those which most observers wou ld agree are MISs in all but name to those which are properly regarded as "normal" companies. However, finding the point(s) at which a distinction can be reliably drawn is not a simple matter. While we consider that the demarcation proposed in the paper is a good starting point, we think there are issues of detail w ith each of the criteria which suggest, at a minimum, that a much more detailed assessment is required.
Main purpose is to make investments
In some cases it wi ll be clear that a company is appropriately regarded as a MIS -
e.g. it does nothing but portfolio investment in a number of assets. For others, however, the main purpose of the company may be investment- but of a very different nature to that typical of a MIS.
For example, a company's business may be to acquire a range of similar assets, improve their operations by active management, combine and restructure them, and then either run them or sell them, depending on what the board considers wil l deliver the best va lue. While such activities could also be conducted using a
"proper" MIS, there wil l come a point at which the degree of active involvement in the operation and structure of the businesses held is more typically associated with a company than with a MIS.
Name includes "Fund"
We do not think this criterion should be elevated to the point of bright line - if only because it is so easily avoided. In addition, if the word "fund" is a bright line, consideration would need to be given to terms like "scheme", "opportunity", "investment", "growth", "balanced" and other terms typically associated with MISs.
We agree that the presence or absence of "genera l" voting rights on important matters, such as those identified in the paper, may often be an indication of the extent to which the shares have MIP characteristics . But, again, we urge caution in putting too much weight on an overly simplistic approach to voting rights, as matters may be considerably more nuanced. By way of example only:
What about shares which confer rights to vote on some directors only- e.g. a minority of "independent" directors - or only confer such rights in specific circumstances?
What about shares which have the right to vote on some, but not all, constitutional changes?
It is worth noting, in this context, that the practical difference between a share which confers no or limited voting rights on, for example, director appointment and a share which does confer such rights but in circumstances where there is a
controlling shareholder with more than 50% of the votes is small. In both cases, the
holder of the share has no real ability to determine or meaningfully influence the outcome. (This may be the case even if the controlling shareholder has not contributed more than half of the company's capital - for example, as a result of holding "founder shares" or shares with enhanced votes relative to capital contributed.)
A company may have several classes of share on issue - voting and non-voting. It is not clear that a company with widely held voting shares which then issues non voting shares (as a means of raising additiona l capita l) should, at least in respect of those non-voting shares, be regarded as a MIS. Where the voting shares are closely held by associates of a manager this may be more appropriate. But what if, for example, a significant number but not all are held by such associates?
"Entrenched" or "expensive" manager I service provider
As with other features of the proposal, while this criterion initially appears appropriate, on closer consideration it appears that a number of issues could arise with a bright line of this nature.
The suggested remuneration test may have different implications for different companies. Compare, for example, a company which has high revenue relative to its assets, as opposed to a company which has low earnings relative to assets. Companies could a lso influence earnings by, for example, revaluing assets.
Service provider remuneration can come in a variety of flavours. For example, a service provider may accept a relatively modest fee unless and until a performance hurdle is cleared, at which point the reward may be
significant. It is not clear that the possibility of significant reward in the event of successful results should be sufficient to result in a designation, particularly given the range of different hurdles which might apply. Compare, for
example , a hurdle rate of 5% for a bonus of an additional 10% of base fees with a hurdle rate of 12% for a carried interest entitlement of 20% of the excess over the hurdle.
Similarly, a service provider may provide a specific service which is not at all easily analogised to a broad MIS manager role, yet be rewarded (or potentially capable of being rewarded) above a specified threshold. For
example, an outsourcing contract which sees IT and administration carried out by a third party may well have an annual cost greater than the threshold suggested (or any comparable balance sheet threshold), but should quite clearly not be something which results in the company's shares being considered MIPs. (By way of MIS comparison, consider the difference
between a manager, on the one hand, and a provider of back office, middle
office and support functions on the other .)
In the context of remuneration, in a number of private equity and venture capital structures, carried interest return is typically earned not by the manager but by a separate (though associated) entity. The same could be achieved for an investment company - and likely would be, were the designation to identify only direct manager remuneration as the relevant
criterion. However, any attempt to bring associated party carried interest return within the test would need to be carefully considered to avoid inadvertently being over-inclusive.
Importantly, remuneration is only one side of the coin. A service provider which bears all the management cost and overhead can be expected to charge more than one whose arrangements involve the company paying all costs and expenses (including, potentially, employee costs by direct employment). A simple "size of fee" test will simply result in management
and service provider arrangements being designed to load as many costs onto the company as possible - something which may well not be in the interests
of shareholders, who may prefer the certainty of a more all-inclusive fee to the uncertainty of costs being born by the company without a matching degree of ability to control them.
Likewise, degree of entrenchment is, in practice, very difficult to make work appropriately. A simple duration test risks failing to pick up arrangements which can in theory be terminated but in respect of which there are powerful incentives not to do so - e.g. loss of expertise and information adverse consequences under other contracts, triggering of investor rights (e.g. to liquidate, to remove the board, etc).
A simple termination compensation test is similar ly susceptible to circumvention in a range of ways which would not be simple to catch without over-reach. In this context, it is worth noting that the ability of a company to divest itself of staff without material cost is heavily constrained. Any assessment based on degree of entrenchment and cost of termination should be made in the context of an equivalent assessment of these features for "normal" companies - particularly when the incentive for potential managers, should the designation be introduced, would be to have the company employ relevant staff directly .
The fundamental difficulty with seeking to establish a bright line test based on easily-observed objective features such as remuneration and entrenchment is that they ignore probably the most significant differentiator- the actual role played by
the manager. Some management arrangements can vest considerable power in the hands of the manager, very much akin to the role of an MIS manager- particularly if the board comprises a majority of associates of the manager. Other management arrangements, however, leave a considerable amount of control with directors - for
example, leaving all major decisions (such as acquisitions, dispositions, and material
contracts) to the board (in addition to the board's non-delegable powers in relation
to matters relating to the company 's capital structure) . Any designation which is not responsive to the substance of the management arrangements risks not being fit for purpose.
Consequences of a class designation
Finally, it is not clear what, in practice, the consequences of class designation would be - and, in particular, how this would affect the role and duties of the directors of the company. This is particularly problematic if the designation is made in respect of newly issued shares but affects a company which already has shares on issue, or
the designation occurs with an insufficient transition. We expect that there would be all manner of issues which would need to be navigated to ensure there were not unintended consequences for managers, directors, companies and investors. The importance of assessing those consequences supports approaching designations in this context on an individual, rather than class, basis.
Equally fundamenta lly, the overlay between MIS governance requirements and the
company model would need careful consideration:
How wou ld the role of licensed supervisor interrelate to the role of the board
of the investment company?
Wha t would be the relationship between the governing document (between the manager and the supervisor) and the company's constitution?
How would the other governance requirements operate (e.g. custody, related party rules, reporting etc)?
Would there be some categories of companies for which the majority of these governance requirements are inappropriate or disproportionate to the risk involved?
We agree that listed companies should not be subject to the proposed class designation, for much the same reasons as are articulated in the paper - and note that, in relation to listed companies, the difficulties identified in the previous paragraph would be even greater, in light of the extensive listing rule overlay on listed companies.
An alternative way forward
As noted at the outset of this letter, we accept that there is a potential case for designations - and, conceivably, a class designation. However, for the reasons we have noted, we are not persuaded that the benefits of doing so are outweighed by the risks. The complexity of the issues involved means that there is a real risk of foot-fault. In our view, this risk could be addressed by not making a class designation at present but, rather:
preparing, consulting on and publishing a policy on the FMA's approach to individual designation, taking account of the feedback received on the current Consultation Paper and articulating a range of factors to which the FMA will have regard;
2 monitoring progress with that policy - both in the issues the FMA then finds itself dealing with when it comes to apply it and in the market reaction to it (to the extent that is observable); and
then re-assessing (in, say, three years) whether, in light of the experience gained as a result of formulating and applying that policy, there is a potential class designation which all market participants are confident articulates the correct bright line in a way which is clear and effective.
Given our views above, we have not attempted to answer all of the questions in the Consultation Paper, although many of our responses will be relevant to the issues raised by those questions. We would be happy to discuss the issues raised in this letter with you, if that would be of assistance.
Yours sincere ly
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