The investment industry is global and US and European laws are increasingly having global effects. Australian fund managers and superannuation trustees should be managing the risks arising from overseas regulatory changes just as much as they should be focusing on the raft of Australian changes.
Are you ready to trade OTC post-Dodd-Frank?
The OTC derivative sections of the US Dodd-Frank Act are now moving towards implementation. Like many of their overseas counterparts, Australian banks are expected to register as “Swap Dealers” from the end of this year. But even though they may escape registration, Australian funds and their managers may not escape Dodd-Frank’s impact. As counterparties to Swap Dealers, Australian funds and fund managers are likely to become involved in the Swap Dealers’ compliance.
Australian funds and their managers are already becoming aware of this, but it is difficult to get a clear view of what is happening (even for those deeply involved in the Dodd-Frank compliance process). However, it gets more complicated still, with different layers of the Dodd-Frank regime applying to Swap Dealers differently depending on the location of the particular Swap Dealer and its counterparty.
There are two areas of derivatives reform which Australian funds and their managers are likely to initially experience in this way: the Dodd-Frank business conduct rules and central clearing of OTC derivatives.
The business conduct standards rules impose a number of additional requirements on Swap Dealers when transacting with counterparties. These include the requirement to obtain additional information from counterparties prior to trading and a number of other exchanges of information. Australian funds and their fund managers are likely to receive requests for this information by Swap Dealers. However, because of the cross-jurisdictional application of Dodd-Frank, such requests are likely to be from US Swap Dealers primarily (unless the Australian fund or manager is also a US person). This process is document intensive but fortunately the International Swaps and Derivatives Association (ISDA) has prepared a “DF Protocol” to facilitate this, which also includes a questionnaire to identify which requirements will apply.
There is no immediate mandate to compel central clearing of OTC derivatives. However, there are already commercial drivers for obtaining access to clearing if needed before a regulatory obligation arises. These include pricing, capital and margin implications. Accordingly, a range of Australian “buy-side” entities are considering clearing – usually through clearing participants. A range of choices exist here for the Australian fund or fund manager, from which clearing houses to access, to how many clearing participants are needed, to the type of client clearing to utilise.
These are just the beginning. The interconnected nature of the global derivatives market means that international regulatory reform has an impact on market participants in Australia, even if those participants are not directly caught by the regulation. So the future is not only a question as to whether the overseas regulation applies to an Australian fund or manager, but it is also whether it could change the Australian fund’s or fund manager’s business even if it does not.
STOP PRESS: Yesterday the Australian Parliament passed the Corporations Legislation Amendment (Derivative Transactions) Bill 2012 and it now awaits Royal Assent. The Bill’s passage is an important step toward the Government complying with its obligations to the G20 to regulate Australian OTC derivative markets. We explained the regulatory structure implemented by the Bill in August. The latest changes to this Bill were explained in our earlier alert (which also discussed contextual developments in derivative regulation abroad).
Will your investments be subject to a 30% FATCA withholding tax?
If your fund invests in the US, holds US assets, contracts with US counterparties (for example, under an ISDA) or generally deals with US withholding agents or other foreign financial institutions (FFIs), you should make sure that you are ready for the US Foreign Account Tax Compliance Act (FATCA). FATCA commences on 1 January 2013 and it has been announced that some, but not all, of the key dates will be extended. For further information on the extensions see our alert here.
FATCA will require FFIs to report detailed information to the Internal Revenue Service (IRS) about financial accounts held by US persons. FFIs that don’t comply with the reporting obligations, and cannot rely on an exemption, will have a 30% withholding tax deducted from “withholdable payments” made to them, being payments of US source income and payments of gross proceeds from the sale or disposition of property that can produce US source interest or dividends. What’s more, FATCA withholding may also be deducted from receipts of “foreign pass-thru payments” by such FFIs (being payments attributable to a withholdable payment). In the managed funds and super funds sectors, the imposition of FATCA withholding could have a significant effect on fund returns and on market competitiveness.
The Australian Treasurer’s announcement on 7 November 2012 that the Australian government has entered into formal discussions with the US in relation to a FATCA intergovernmental agreement (IGA) is a positive development for Australian financial institutions. There are many benefits to the Australian financial services industry if Australia signs an IGA, details of which are summarised in our Treasury submission. One of the key advantages is that under an IGA, Australian financial institutions would be deemed to comply with FATCA and so would not generally be subject to FATCA withholding. In the super space, it is expected that Australian super funds would be specifically exempted under an IGA from FATCA as “exempt beneficial owners”. However, the content and timing of a signed IGA between the US and Australia, together with implementing domestic legislation, remains uncertain.
In the managed funds context, even with an IGA, there will still be some significant impacts. For example:
- Trustees will need to undertake the prescribed FATCA due diligence procedures and report to the IRS (or the ATO under an IGA) on their US account holders, unless they can rely on a “deemed compliance” exemption. For example, a managed fund may be able to rely on the “restricted funds” deemed compliance exemption, or, potentially, on the “local FFI” exemption (assuming an Australian IGA amends such exemption in line with the amendments contained in the IGA entered into between the US and the UK). To rely on such exemptions, the fund’s constitution would need to contain certain prescribed provisions (e.g. limiting the types of investors who may hold units in the fund).
- Although Australian financial institutions would not generally have to deduct FATCA withholding in respect of payments made to non-participating FFIs under an IGA, they will be required to report this information so that the withholding can be deducted further up the payment chain. In the context of an Australian managed fund, the trustee would be required to report information about any non-participating FFI investor’s unitholding to the payor of the relevant withholdable payment, which in turn would be required to deduct FATCA withholding from the distribution payable to such investor. Your trust constitutions would most likely need to be amended to permit such a deduction at source to be allocable to a particular unitholder.
- We are already seeing FATCA clauses being included in transactional documentation (e.g. under ISDAs and lending agreements), and trustees should consider their approach with respect to the negotiation of these clauses.
We have produced a number of articles and alerts about FATCA which you can see via our FATCA website.
Are you registered as an investment adviser with the SEC or do you fall within an exemption?
Recent changes brought about to the Investment Advisers Act by the Dodd-Frank reforms mean that Australian fund managers with US clients must register with the Securities and Exchange Commission (SEC) as an investment adviser (a compliance and legal headache), or seek to rely on one of three very limited exemptions from registration.
The Dodd-Frank Act replaced the exemption from registration as an investment adviser with much narrower exemptions. The foreign private adviser exemption is likely to be of limited use. For example, under the exemption the aggregate assets under management attributable to US clients and investors is US$25 million and the maximum number of clients and investors is 15. Even Australian funds that are not marketed to US investors may have difficulty meeting this test given the very low threshold and broad categories of who is considered a US person.
The private fund adviser exemption, available for private fund advisers with no more than $150m of assets under management in the US, should permit each fund sponsored by the fund manager to have up to 100 US investors but requires the fund manager to comply with certain reporting and a number of substantive requirements imposed by the SEC.
There is also a separate exemption available to venture capital funds, although this is likely to be of limited use for Australian fund managers.
The narrowing of the registration exemptions will have two negative impacts for Australian managers. First, Australian and other offshore managers wanting to access US capital will most likely need to register as investment advisers with the SEC unless they can rely on one of the above-mentioned exemptions (see below). Secondly, more US managers will be able to manage Australian capital without obtaining an Australian financial services (AFS) licence. This is because when a US manager registers as an investment adviser with the SEC, they can rely on an AFS licensing exemption by lodging straightforward documents with the Australian Securities and Investments Commission (ASIC). Obtaining and maintaining the AFS licensing exemption is much less onerous than obtaining and maintaining an AFS licence.
The ongoing obligations of an investment adviser registered with the SEC will be different to being an AFS licensee. Under the Dodd-Frank Act, the obligations include:
- a fiduciary duty;
- a duty not to include certain terms in contracts with clients (e.g. certain types of compensation);
- more detailed record keeping and reporting obligations including the use of leverage (including off-balance sheet leverage) and counterparty credit exposure;
- a duty to take steps to safeguard client assets including verification by an independent public accountant;
- an obligation to adopt policies and procedures in relation to voting proxies; and
- a requirement to have a written code of ethics that satisfies minimum requirements including a standard of business that reflects the adviser’s fiduciary duty.
One silver lining is that many of the due diligence processes required by FATCA will also be appropriate for ensuring compliance with the Investment Advisers Act exemptions, as fund managers will need to identify any US investors in their funds on an ongoing basis. Both Acts may necessitate changes to fund documentation if the fund relies on an exemption, including constitutional changes to permit the fund to redeem the interests of investors whose investment could threaten the manager’s or the fund’s reliance on an exemption or compliance with the legislation.
Will any of your funds be subject to the Volcker rule and if so, are you ready to comply?
The Dodd-Frank Act introduces what is known as the Volcker rule for banking entities. It prohibits a banking entity from engaging in proprietary trading or acquiring or retaining ownership interests in, or sponsoring, a “hedge fund” or “private equity fund”. The Volcker rule was expected to be implemented by 21 July 2012, but its implementation has been deferred and there is currently no definitive timeframe for its implementation. Once the Volcker rule is in place, banks will have until 21 July 2014 to fully comply with it.
“Hedge fund” and “private equity fund” are very broadly defined and might loosely be described as wholesale funds in Australia. However it is not clear whether publicly offered Australian registered managed investment schemes will also be hedge funds or private equity funds for these purposes.
Some Australian banks and other financial institutions are likely to be banking entities for the purposes of the Volcker rule and so should be carefully considering how their funds business will be affected.
The rule covers acquiring or retaining ownership interests in a “hedge fund” or “private equity fund”. Unless an exception applies, this can limit the ability of sponsors to seed funds and may even affect some interfunding arrangements.
The rule also covers “sponsoring” a hedge fund or private equity fund. A term “sponsor” includes serving as a general partner, managing member or trustee, or in any manner selecting or controlling a majority of the directors, trustees or management of the fund. It also includes sharing the same name for marketing or promotional purposes with the fund. In the very least, some funds will need to change their names.
There are a range of exceptions to the Volcker rule. An exception for sponsoring a fund includes several conditions including that the banking entity does not guarantee performance and does not hold an interest in the fund unless it complies with rules on de minimus investments. There is also another exemption for holding interests in or sponsoring a fund by a banking entity solely outside the US if no interest is offered or sold to a US resident.