Part I: The parity myth and regulatory dissonance
On 30 June 2011 the Corporations and Markets Advisory Committee (or CAMAC) published a Discussion Paper titled ‘Managed Investment Schemes’. This was the latest in a long line of reports, reviews and recommendations by various committees and law reform bodies to consider the many legal issues in this difficult area, stretching at least as far back as the 1980s. These reports have identified some (though by no means all) of the critical issues and have offered recommendations for reform. Many of those recommendations have been ignored. In 2011 the issues live on.
This is the first in what will be a series of occasional articles on commercial unit trusts and the risks faced by their investors and creditors. Many, but not all, such trusts will be ‘managed investment schemes’ for the purposes of the Corporations Act 2001. In this article, I focus on the critical differences between companies and unit trusts so as to build the foundation for later discussion of specific risks faced by trust investors and creditors (and, for that matter, trustees and responsible entities).
The growth in the use of the trust vehicle for carrying on large scale commercial enterprise (including raising and pooling billions of dollars in equity and debt funds, and even listing on the ASX) is a uniquely Australian development, and can be attributed to advantages over the company including pass-through or ‘transparent’ tax status if certain conditions are satisfied, structural flexibility, ease of injection and return of capital and, generally, a lighter regulatory environment. No other country has seen the trust be used for these purposes on this scale.
There are fundamental structural weaknesses in the way Australian law regulates commercial unit trusts. They look and behave a lot like companies, and some investors and creditors are under the impression that when they deal with them they have similar rights and risks, particularly in insolvency. I describe this as ‘parity myth’. In fact, despite their evident functional similarities and the fact that they are permitted to raise funds and take commercial risks just like companies, trusts are quite different from companies and are not regulated by company law but rather a much less prescriptive and less certain body of laws. I describe this as ‘regulatory dissonance’. Practically speaking, these differences are of little consequence while things are going well, but they leap to prominence when the shadow of financial distress looms.
The parity myth has not arisen by accident. There are genuine similarities between companies and unit trusts. To a non-lawyer investor or creditor, their similarities are more apparent than their differences. Further, promoters and their advisers in the Australian market have quite consciously striven to make the unit trust mimic the company as far as legally possible through structuring and documentation techniques. Finally, legislators and regulators have blurred the distinction between them, both actively and by omission.
However valid a perception of parity may be from a commercial or economic perspective, it is not supported by Australian law. On an analysis where the emphasis is on legal risk, it can be demonstrated that both investors in, and creditors of, trusts (including those which are managed investment schemes) are worse off than their counterparts in companies. Attempts to mimic the company yield imperfect outcomes due ultimately to the very different legal frameworks within which the company and the trust are located.
Parties who choose the trust over the company are, in effect, accepting a trade-off between perceived advantages and certain risks. While the advantages are relatively well-known, largely because they are used actively to promote investment in unit trusts, what is not clear is whether the full extent of the risk side of the trade-off is in all cases appreciated.
The fundamental defining characteristics of the trust which distinguish it from the company are two: (1) the absence of separate legal personality; a trust is not a separate legal person like a company and so, in many respects, is ‘invisible’ to company law; and (2) the partially discretionary and predominantly non-statutory regulatory regime which governs them, sourced in equity and the general law of trusts. All other differences flow as a consequence of one or both of these.
On the latter point, while it is apparent that, over time, the law governing companies moved from predominantly common law to predominantly statute so that today the Corporations Act is a comprehensive regulatory code, no such evolution has occurred in relation to commercial trusts. This is so despite the enactment in 1998 of the managed investment scheme provisions in Chapter 5C of the Corporations Act and the extension of other provisions of the Act to schemes; the Act governs trusts only in limited circumstances. The key structural criticism of Chapter 5C as a governing regime is that it leaves much of the supervision and administration of managed investment schemes to the general law of trusts, including in relation to insolvency. This last point is a breathtaking irony - there is no body of general law dealing with the insolvency of trusts. In that regard, we have fallen between two stools.
It has been argued that the general law of trusts offers a regulatory regime of sorts in that it supplies a ready-made set of default rules and an ethical regulatory framework (eg fiduciary duties) which fill gaps left by the trust instrument. While that is true up to a point, as a regime for regulating sophisticated large-scale enterprise entities, trust law suffers several quite fundamental weaknesses: (1) it is not comprehensive or adequate in the commercial context because it was not developed specifically with the commercial enterprise in mind; (2) with some exceptions, it is neither statutory nor readily accessible to the non-expert; (3) its traditional ‘regulator’ is the court of equity which cannot act on its own initiative; (4) being based in equity, important remedies are in the discretion of the court, thus exposing the potential for uncertainty; and (5) it is not monitored, policed and enforced by executive government in the way that compliance with companies legislation is supervised through the agency of the primary regulator ASIC. While ASIC has issued a prodigious volume of guidance on companies and managed investment schemes, none of it addresses comprehensively the shortcomings of trust law when compared to companies law (and, of course, none of it deals with commercial trusts which are not managed investment schemes).
In the next article, I will consider how this affects financiers and other contract creditors of trusts.