In a recent case, the AAT overruled a decision of ASIC cancelling the Australian financial services licence (AFSL) of a responsible entity (RE) that was the operator of a number of property trusts. ASIC had cancelled the REs AFSL on the basis that the RE had failed to maintain the condition of its licence requiring the RE to maintain the required level of net tangible assets (NTA).

There a number of circumstances when the holder of an AFSL must meet an NTA requirement. REs, IDPS operators, providers of custodial or depository services (other than incidentally), issuers of margin lending facilities and Trustee companies providing traditional services will have a condition of their AFSL requiring them to maintain the relevant amount of NTA.

The general requirement for an RE is that it must hold an NTA of 0.5% of funds under management subject to a minimum of $50,000 and a maximum of $5 million. However this is subject to a proviso that the NTA must be $5 million in lieu of this amount unless, in relation to all of the registered schemes operated by the RE, one of the following applies:

  • all the scheme property and other assets of the scheme not held by members are held by a custodian appointed by the RE that has $5 million NTA or is an eligible custodian  
  • all the scheme property or assets of the scheme not held by members are special custody assets or tier $500,000 class assets, each of which are held by the RE or a custodian appointed by the RE (or a sub-custodian appointed by that custodian) and the RE has an NTA of $500,000 if the RE holds the scheme property or assets or the custodian has an NTA of $500,000 if the custodian or sub-custodian holds the scheme property or assets or the custodian is an eligible custodian  
  • the only scheme property and other assets of the scheme not held as per the above bullet points are special custody assets, each of which is held by the RE or a custodian that has the level of NTA that the RE is required to have or is an eligible custodian or the members of the scheme.  

NTA is adjusted assets less adjusted liabilities. Basically the RE must start with the total assets and the total liabilities contained in its financial statements as they would appear on a balance sheet made up for lodgement as part of a financial report under Ch 2M, on the basis that the licensee is a reporting entity and then make certain adjustments to the amount of those total assets (adjusted assets) and total liabilities (adjusted liabilities). One of the items that must be deducted from the amount of the total assets is intangible assets (i.e. nonmonetary assets without physical substance). In the case before the AAT, the RE argued that it had met the NTA. The reason for this was that the RE claimed that it was entitled to include in the calculation of its NTA, deferred tax assets and sale and performance fees. ASIC argued that the RE could not include either of these amounts in its NTA because they were intangible assets and therefore required to be deducted from total assets in working out the NTA.

The AAT, by reference to the accounting standards and evidence of likely future profitability of the RE, held that a deferred tax asset was a monetary asset and not an intangible asset because a deferred tax asset has a precise and determinable value once the judgment has been made that there is a probability of future taxable profits. Therefore in those circumstances, the NTA calculation did not require the exclusion of deferred tax assets.

The AAT did not therefore consider whether sale and performance fees should be excluded because it did not have to do so. Once deferred tax assets were included, the NTA for the RE was satisfied.

Responsible Entity Prudential Requirements – Proposed Changes

ASIC has issued a consultation paper for comment on proposed changes to the prudential requirements for responsible entities of registered schemes. This will affect the use of assets such as deferred tax assets in the NTA calculation because of the requirement of the sort of assets in which the NTA must be held.

The proposals are in summary are that a responsible entity:

  • will be prohibited from providing guarantees in its capacity as the responsible entity of a scheme  
  • will be prohibited from providing guarantees in their personal capacity where the RE manages more than one scheme  
  • will be restricted from providing indemnities in its capacity as the responsible entity of a scheme other than indemnities in relation to that scheme’s default, and  
  • who is a member of a tax consolidation group must execute a tax sharing agreement that ensures that the responsible entity can only ever be liable for its portion of any group tax liability  
  • be required to prepare, and make available to ASIC upon request, rolling cash flow forecasts with anticipated revenue and expenses over at least 12 months, to be approved by the directors of the responsible entity  
  • must have an NTA of either:  
    • the greater of: $150,000, 0.5% of the average value of scheme property (capped at $5 million), and 10% of its average gross revenue (with no maximum) or  
    • 10% of its average gross revenue with a minimum of $500,000 and no maximum  
  • must submit to ASIC on an annual basis the amount of funds under management and its NTA  
  • must hold 50% of the required NTA in cash or cash equivalents with a minimum of $150,000 and with the balance to be held in liquid assets.  

The provisions are proposed to apply to new responsible entities from 1 July 2011. Existing responsible entities will have a transition period of either 12 or 24 months from that date (still to be decided).  

Market Manipulation – Security Lending Arrangements - Special Crossings – Banning Order

In a recent case, the AAT overruled ASIC in relation to a banning order made against the managing director and responsible officer of the holder of an AFSL that was also a trading participant on the ASX. The managing director had been banned by ASIC from providing any financial services for a period of 4 years. He was banned on the basis of an alleged breach of section 1041B(1) of the Corporations Act

The problem in this case arose out of certain security lending arrangements pursuant to which a lender had lent certain monies to the AFSL holder in return for a portfolio of securities “borrowed” from the AFSL holder. The managing director of the AFSL holder became concerned about the solvency of the lender and therefore wanted to secure the return of the securities on-lent by the AFSL holder to the lender before administrators were appointed to the lender. It was suggested to the managing director that this could be effected by the AFSL holder selling the on-lent securities held by the lender and reporting the sales as special crossing trades.

The ASX market rules permit a transfer of marketable securities to be effected by special crossings i.e. if the stockbroker is acting on behalf of two clients it may be effected at a price negotiated on behalf of the clients, or if the stockbroker sells or buys, relevantly, securities as principal, at a price agreed between the client and the stockbroker. The price agreed for a special crossing need bear no relation to the market price for the security. Therefore it is possible for the price agreed between the parties for the transfer of securities to be the result of what has been agreed as part of some other transaction from which the parties derive some benefit. The AAT noted that the ASX Website states: “Special Crossings take place with no reference to the current market and may be at any agreed price, regardless of the market price”.

In this case the managing director placed buy and sell instructions for 12 special crossings. The AFSL holder was both the seller and the buyer. The reason for this was that this created an obligation under the ASX market rules on the AFSL holder to deliver the securities to itself as the purchaser at the settlement date being T+3 which in turn served as a recall notice/instruction to its corporate lender, to which it had on-lent the securities, to redeliver the on-lent securities to the AFSL holder. At the same time, the AFSL holder had an obligation requiring simultaneous repayment of the loan. Whilst benefitting the AFSL holder, the transaction also benefitted the lender as a result of the AFSL holder repaying the loan that had been secured by the on-lent securities.

This action by the managing director was found by ASIC to be an act that had or was likely to have the effect of causing the creation of a false or misleading appearance on the ASX of active trading in the securities the subject of the special crossings and with respect to the market for and the price for trading in those securities in breach of section 1041B(1) of the Corporations Act. He was therefore banned from providing any financial services for a period of 4 years.

Did the special crossings amount to a breach of 1041B(1)(a) of the Corporations Act? - No

The first question to be considered by the AAT was whether by placing the buy and sell instructions for the 12 special crossings, the managing director had committed an act which had or was likely to have the effect of creating or causing the creation of a false or misleading appearance of active trading in financial products on a financial market operate in Australia in contravention of section 1041B(1)(a) of the Corporations Act.

The AAT held that he had not done so. This was because the section required that the appearance must be of active trading in financial products on a financial market. This could not be the case with special crossings because special crossings are transacted off-market and it therefore follows that a person reading the IRESS Depth Replay screen should be immediately aware that a special crossing trade does not, of itself, involve active trading on the market.

Did the special crossings amount to a breach of 1041B(1)(b) of the Corporations Act? - No

The second question to be considered by the AAT was whether the managing director committed an act that had or was likely to have the effect of creating or causing the creation of a false or misleading appearance with respect to the market for or the price for trading in financial products on a financial market operated in Australia in contravention of section 1041B(1)(b) of the Corporations Act.

While the tribunal held that the managing director might possibly have been in breach of the market rules by reason of the fact that the AFSL holder was not an independent purchaser of the securities which were the subject of the special crossings, nevertheless he was not in breach of section 1041B(1)(b) of the Corporations Act.

The AAT held following an earlier High Court decision in relation to a forerunner to this section, that this section was dealing with market manipulation i.e. the provision was designed to protect the market from such manipulation in order to ensure that market transactions reflected genuine supply and demand.

However in this case, the AAT noted that special crossings:

  • are not usual market trades  
  • are not the product of normal trading on the market  
  • are by their nature “special”, and  
  • are permissible under the market rules at any time at an agreed price.  

The AAT also noted that although not specifically stated in the market rules, it was clear that the agreed price for the special crossings need bear no relation to the market price of the securities.  

Therefore in these circumstances the special crossings did not involve any market manipulation in breach of the section.

Did the special crossings amount to a breach of 1041H(1)) of the Corporations Act? - No

The third question was whether by placing the buy and sell instructions for the 12 special crossings the managing director had engaged in conduct in relation to a financial product or a financial services that was misleading or deceptive or was likely to mislead or deceive in contravention of section 1041H(1) of the Corporations Act?

The AAT held that the managing director had not engaged in conduct that was misleading or deceptive in terms of its inducing or being capable of inducing error in relation to dealings in the securities that were the subject of the special crossings. The information reported to the ASX about the special crossings and available to IRESS subscribers was neither false nor misleading for the reasons stated in relation to the alleged breaches of section 1041B of the Corporations Act.

The ASIC decision was therefore set aside.

The AAT also held that even if there had been a breach of the Corporations Act, in this case the tribunal considered the banning order imposed by ASIC was disproportionate to the alleged contraventions of the Act.

Promissory Notes not a Managed Investment Scheme

In a recent NSW Supreme Court case, it was held that a scheme involving loans by a property developer to investors on promissory notes was not a managed investment scheme. This was contrary to an earlier WA Supreme Court decision that held promissory notes on the facts of that particular case were a managed investment scheme.

The earlier decision was referred to by the judge. However he said that the distinction in the present case from the earlier case was, according to the judge, that in the present case there was no evidence that representations were made to any of the persons to whom promissory notes were issued that the payment of principal or interest due under the notes would be derived from any particular source and therefore the holder of a promissory note did not acquire a right, even an unenforceable right, to have any particular assets deployed in order for the borrower to meet its obligations under the note.

The judge held that in order to satisfy the first limb of the definition of managed investment scheme the question must be answered as to what was the consideration for the contribution of money or money’s worth. Unless the consideration was the right (even if unenforceable) to acquire benefits produced by the scheme, then the first limb of the definition is not satisfied. In this case it was neither a term of a promissory note, nor was there any evidence of a representation being made to a holder of a promissory note, that the holder had a right, even an unenforceable right, to acquire benefits produced by the borrower’s business of raising money from lenders and developing and selling properties. The holders had the right to interest and repayment of principal. Although the parties might have expected these payments to be made from the revenue of the business nevertheless the holders had no right to obtain payment from that source. In other words there was a simple loan arrangement with an obligation on the borrower to pay the interest and repay the principal irrespective of success of any underlying business.

The judge also held that the second limb of the definition was not satisfied. Following earlier authority he stated that in order for this second limb to be satisfied, there must be an intention, objectively ascertained, that the members’ contributions are to be pooled, or used in a common enterprise, to produce financial benefits or rights or interests in property for the members. In this case there was no evidence that any one holder of a promissory note intended that his or her or its contribution in money or money’s worth should be pooled with a contribution of any other holder of a promissory note, as distinct from being applied by the company. Further there was no evidence that holders of promissory notes had a purpose that their contributions (whether contributions made through payment of money or forbearance from calling up an existing debt) were to be pooled or used in a common enterprise with the contributions of other holders, to produce financial benefits for the holders. At most the only evidence was that each holder of a promissory note had the purpose of being paid in accordance with the terms of the note.

However there were some other interesting issues of note.

In the Multiplex decision (litigation funding case), the majority of the Full Bench of the Federal Court held that just because the structure of a scheme does not comply with the requirements of Ch 5C does not mean it is not a managed investment scheme. If it is such a scheme then it must be constituted so it can be registered. This principle means that if a scheme is a managed investment scheme then it must be structured in a way that it can be registered. Simply because the scheme does not easily fit within such a structure does not cause it not to be a managed investment scheme.

However in the present case, the judge distinguished this statement preferring the statement in another Federal Court Full Bench decision that there is a requirement that the scheme has to be of a kind which can in fact be registered. The judge said that it would be incongruous that a scheme should need to be registered when it does not have the features that would pertain to the scheme once it was registered.

The second issue was that if the scheme was a managed investment scheme, should it be wound up. The judge acknowledged that prima facie an unregistered managed investment scheme that is required to be registered should be wound up. However in this case there were difficulties of identifying any scheme property at all. In line with an earlier Qld Court of Appeal decision, the judge held that the winding up power does not authorise the appointment of receivers to property which is not property of a scheme. In this case there was no scheme property to which a receiver could be appointed. Further in line with earlier authority the judge held that the winding up power did not permit the court to impose new duties or obligations on any person or to alter substantive rights. Therefore the judge held that if there had been a managed investment scheme, it would not have been appropriate to wind it up.

Litigation Funding Arrangement not a Financial Product – No requirement to be licensed

In a recent NSW Supreme Court case, the issue of whether or not a litigation funding arrangement was a financial product and therefore requiring the funder to hold an AFSL had to be considered. In this case the claimant sought to avoid having to pay the funder an early termination fee payable on a change of control of the claimant on the basis that the funder was unlicensed and therefore the agreement was unenforceable. This depended upon the claimant being able to establish that the arrangement was a financial product. If the argument was successful, the claimant would obtain the benefit of the funds advanced to the claimant by the funder in addition to any early termination fee payable.

The first argument of the claimant was that the funding agreement was a financial product because it was a facility through which it made a financial investment or managed financial risk and was a specifically named financial product being a derivative.

Firstly the judge rejected the argument that the finding agreement was a derivative.

The judge noted that the definition of “derivative” requires the amount of the consideration or the value of the arrangement ultimately to be determined, derived from or vary by reference to (wholly or in part) the value of something else. The judge held that the word “ultimately” plainly qualifies the words “determined, derived from or varies by reference to”, His Honour noting that there was no comma before the words which follow the words in parentheses. This was because it is in the nature of a derivative that the value of the arrangement will (as the word “ultimately” connotes) in every case be affected by (and hence derived from) the value of something else. In this case the judge held that the funding agreement did not have this operation. In this particular case the amount of the early termination fee on change of control was not determined or derived from, nor did it vary by reference to the value of, something else.

Secondly the judge noted that there was a fundamental problem with the claimant’s argument that the funding agreement was a facility through which it made a financial investment or managed financial risk. This was because the claimant was relying upon it being the “client” which meant that it had to be the person making the financial investment or managing financial risk. In this case, if anyone was making a financial investment, it was the funder and not the claimant because the funder was paying the legal costs in return for which it might receive a possible enhanced return.

Thirdly the funding agreement did not involve the claimant managing financial risk. The judge held that the funding agreement did not the characteristics of a financial risk management instrument in that:

  • the object of the funding agreement was to facilitate the claimant succeeding in its claim against the alleged wrong doer and not to manage the risk of possible failure in that endeavour  
  • under the terms of the funding agreement the claimant undertook the risk of payment of an early termination on change of control unrelated to the success of the claim.  

Therefore the funding agreement was not a financial product and the funder did not require an AFSL.  

The judge also held the funding agreement was not a “credit facility” as defined even though a funding agreement is an “in substance” limited recourse loan i.e. the amount advanced by the funder for legal costs is repayable in the event of success in the action. If it was a credit facility then it is excluded by definition from being a financial product without even having to consider whether or not it was a derivative or a financial product within the general definition.

The reason the funding agreement was said not to be a credit facility was according to the judge because:

  • the agreement did not operate so as to defer payment of any debt owed by the claimant to the funder or result in the claimant incurring a deferred debt to the funder  
  • the claimant did not incur a debt to the funder as a result of the funder paying the legal costs and it did not incur any personal obligation to repay the amount funded, and  
  • the payment by the funder of the legal costs was not an advance and the agreement did not contain provisions under which the claimant incurred a personal obligation to repay.  

While this was true if the claim was unsuccessful, that was not the case if the claim was successful. In the light of this decision one has to question whether any form of limited recourse financing is not a credit facility and might well be caught as a financial product if it is not carefully drafted.  

MIS Protection Funds Not Available to Investors – Property of old Responsible Entity  

Often forestry schemes have been promoted on the basis that all of the fees required to maintain the plantation are paid by the investor up front or a paid as deferred management fees out of future harvests. However in order to protect investors, some responsible entities have established separate “forestry protection funds” into which the responsible entity pays a proportion of its receipts to cover future maintenance and management costs of the plantation. These sorts of funds were promoted as a protection to the investors that there would be funds always available to cover the future costs of maintenance of their investment.  

However such funds do not have the protection for investors that might have been thought to apply. In a recent case the Federal Court held that such funds belonged to the original responsible entity that had gone into liquidation. Therefore those funds were not available to the new responsible entity to maintain the investors’ plantation but were available to the creditors of the old responsible entity.

The effect of this case and an earlier decision shows that there is a defect in the current legislation that is need of urgent reform.