Significant change to the regulation of collective investment schemes (CIS) may flow from the Securities Law Review. They get their own chapter in the Ministry of Economic Development’s 200 page discussion document and are the subject of 45 questions for consultation.
This Brief Counsel summarises the areas marked for reform and identifies some potential issues. Submissions are due by 20 August 2010.
For our commentaries on the KiwiSaver reforms and on other aspects of the securities law review, refer here and here.
Key reform proposals for collective investment schemes
The key proposals arising out of the discussion document in relation to CIS are:
a broader definition of “collective investment schemes”
application of a standard framework to all schemes falling under this definition regardless of their legal form
independent supervisors to oversee all schemes registration of CIS, managers and trustees, with licensing of trustees and (possibly) custodians and managers
enlarged managers’ duties and responsibilities
prescribed requirements for constitutional documents (more implied provisions)
further regulatory controls surrounding asset valuation and pricing, (including requiring disclosure of how pricing errors will be dealt with and how limit breaks will be rectified), and
powers, additional to those held by the Securities Commission, for the Financial Markets Authority (FMA) to take proceedings against trustees and managers.
The proposals build on, and to some extent revisit, issues in, the Review of Financial Products and Providers.
Proposed definition of CIS
The discussion paper proposes a consistent framework be applied to all CISs, regardless of their legal form. This is to address the potential for regulatory arbitrage arising from the current inconsistent treatment under the Securities Act between unit trusts, superannuation and/or KiwiSaver schemes, group investment funds, investment-linked insurance policies and (potentially) wrap accounts.The proposed definition for a CIS is:
an investment in which a subscriber pays money to another person to invest, but the subscriber does not have day-to-day control over investment decisions or the assets purchased using his or her contributions, provided that the investment:
- is intended to provide members with benefits of investment management and risk diversification, and
- allows investors to withdraw their investment on demand (in a reasonable time), at a price based mainly on the value of the assets owned by the company.
The bullet-pointed provisions are based on UK legislation and are intended to exclude debt and equity securities. Clearly, the definition will need some work as it does not cover superannuation and KiwiSaver schemes, which do not allow withdrawal on demand, nor does it clearly cover investment-linked insurance.
Investment companies could also be CISs, if they meet the criteria. Where a company is a CIS, the board of the company would be deemed to be the manager and the issuer. However, a statutory supervisor would need to be appointed.
The CIS definition is intended to be broad to catch some participatory securities under the existing regime, such as bloodstock interests, property syndicates and forestry partnerships.
MED is seeking comment on whether non-pooled schemes should be included within the scope of CISs – i.e. schemes where investors’ funds are not pooled with other investors or with the promoters of the scheme, but where (for example) an investment management service takes money from an individual investor and invests those assets on behalf of that investor.
Basic CIS framework
All CISs will have to have both a manager and a supervisor (usually the trustee). The manager will be the issuer (except for some superannuation schemes, which will be grand-fathered, and non-retail KiwiSaver schemes). A single responsible entity model (like that adopted in Australia) has been discounted by the MED.
There would be no ability for the manager to remove the supervisor, unless agreed to by a court.
All managers, trustees and custodians will need to register under the new Financial Service Providers (Registration and Dispute Resolution) Act 2008 (FSPA) in order to continue in the business of providing financial services.
All CISs will have to be registered with the proposed Registrar of Securities before offering securities to the public.
To be registered, schemes will need to have:
a registered (and if required) licensed manager
a registered and licensed supervisor, and
constitutive documents that comply with the new statutory requirements for CISs (see below).
This will replace the existing registration regime for unit trusts and superannuation schemes. Where CISs are subject to additional requirements – such as companies under the Companies Act 1993, limited partnerships under the Limited Partnerships Act 2008 and KiwiSaver schemes under the KiwiSaver Act 2006 – these will continue to apply.
Managers’ and supervisors’ functions and duties
It is proposed that all supervisors of CISs will have the same functions, duties, powers and rights, regardless of the scheme’s legal form. Both managers and supervisors will have clear and direct duties to investors to act in their best interests.
These functions and duties will be prescribed in legislation. Many of the proposed functions would commonly appear in trust deeds now.
We support this move as it will ensure greater accountability and transparency of roles and duties to investors without imposing large additional costs. Most scheme managers doubtless already act in the best interests of investors so the proposal should simply formalise existing practice, provided the obligation is limited to only taking all reasonable actions.
Managers’ functions and duties
Managers are to be legally responsible for all administration and management functions of the scheme, even where these functions are delegated, and are to have duties and liabilities similar to those of a manager under the Unit Trusts Act 1960. This would include adherence to the terms of the constitutive document, reporting to the supervisor and investors and publication of quarterly information. It is also proposed that they adhere to the duties of a fiduciary.
Consequences of a breach of the proposed duties include:
removal by investors
a direction from investors that the scheme supervisor take action in court to seek compensation for loss caused by the breach
prosecution on behalf of investors by the FMA, and
liability for criminal penalties where there is a high level of culpability.
Supervisors’ functions and duties
The role of the supervisor will extend beyond mere supervision.
Proposals are that supervisors also:
perform functions, duties and liabilities similar to those of a trustee under the Unit Trusts Act 1960 (including negotiating the terms of the constitutive document and securities offers with the manager)monitor the scheme’s adherence to the constitutive
document, any management agreement and offer terms and take relevant enforcement action against the manager where duties to investors are breached
disclose to investors the duties the supervisor owes the investor as well as any restrictions on those duties and submit an annual declaration to the FMA that these duties have not been breached, and
comply with reporting requirements to the regulator and investors, and maintain appropriate custodial arrangements and take responsibility for scheme property. (Even where an external custodian is appointed, supervisors would retain liability for the performance of the duties and obligations relating to the custody of the scheme’s assets).
The supervisor of a CIS will have to be licensed under the proposed new Securities Trustees and Statutory Supervisors Bill. Input is sought on whether managers and custodians should also be licensed.
The rationale behind licensing custodians is that it is important for assets to be held in an appropriate manner, and that custodians in overseas jurisdictions are subject to a more rigorous regime than currently proposed under the FSPA.
Regulation of asset valuation and unit pricing errors
MED wants the asset valuation and pricing methodologies to be prescribed in the constitutive document for the scheme, including a mechanism for changing the methodology should the need arise.
Managers will have the freedom to set their own process, including timing of valuation, but this will have to comply with enforceable guidance notes issued by the FMA. Responsibility for ensuring that the valuation policies are consistent with the FMA guidelines will lie with the scheme supervisor.
To prevent schemes “hiding” fees, the constitutive document will specify that – where expenses are included in the unit valuation – they must be identified and their purpose given (e.g. supervisor fees or brokerage).
Because the treatment of unit pricing errors can have a significant impact on investor returns, the MED proposes that scheme managers be required to develop policies to deal with pricing errors and breaches of investment limits and to set these out in the constitutive document.
Managers will be required to report to the supervisor if a pricing error or limit break occurs, explaining why it occurred and what actions will be taken to avoid a recurrence. Supervisors will be required to report to the FMA on breaches above a threshold.
Additional provisions required in constitutive documents
Additional provisions identified for mandatory inclusion in constitutive documents include:
the CIS’s investment policies, how any minimum contribution levels and rates will be established and revised, entry and exit rules, returns, pricing, fees, the circumstances which will trigger a wind-up, how it will be conducted, and the distribution of assets
any limits on the investments of the scheme, and (possibly) a methodology for how the investment strategy can be developed, amended and measured (existing investors would need to be advised of any changes in authorised investments and given the opportunity to exit the scheme at no penalty if not satisfied with the changes), and
the types of fees that are, or could be, deducted and how they would be calculated (with investors able to exit without penalty upon notice of a fee increase).
Much of what is proposed is already standard practice in the industry, and for that reason, we welcome these changes in principle, provided that they are not made too prescriptive. There might be arguments for prescribing investment objectives, asset class preferences and categories of excluded assets within a scheme’s constitutive document. But it would seem more flexible (without loss of transparency) to require disclosure of the permitted ranges of asset allocation through a statement of investment policy and objectives which are described in the offering documents as these can be more easily changed if required.
To better enable scheme members to call meetings to exercise control over the fund manager and supervisor, MED proposes that investors have access to the contact details of other investors so they can seek support to reach the relevant thresholds to call a meeting. Members of some CISs can get this information now via the Securities Act in some cases, although there are some exemptions from this general disclosure requirement.
This right is not available to KiwiSaver or superannuation scheme members and, on balance, we do not think it appropriate in other CIS contexts given that public disclosure of individuals’ personal information has significant privacy implications. Also, to date these powers have been more often used by competitors, seeking to identify target clients to promote their own products or, more rarely by low price offerors seeking names of the unwary to make unauthorised offers.
MED is looking for submissions on whether voting threshold requirements should be changed, for example to a simple majority rather than extraordinary resolution (75 percent majority) to more closely align CIS with companies. Such a change, together with proposals to relax requirements to requisition meetings and for reduced quorums, would make it easier for investors to remove the manager of a CIS.
MED is seeking feedback on whether CISs should be required to have an external administrator to carry out duties relating to valuing assets and setting unit prices.
The rationale for the move is that it would serve as a check on the valuation processes of the fund manager. We consider, however, that the benefits would not justify the costs, especially as those benefits can be delivered in large part by the oversight of the supervisor.
The discussion paper asks whether a whistle-blowing regime similar to that contained in section 18A of the Superannuation Schemes Act 1989 should apply to all CISs. This would require the administration manager, investment manager, actuary or auditors to disclose information to the FMA if they consider that there is a serious problem with a scheme and would provide protection against any liability for such disclosure where it was made in good faith.
We are unconvinced that this is necessary, given the oversight of the FMA and the statutory obligations proposed for scheme managers and supervisors. Also the anecdotal evidence to date regarding the effectiveness of the provisions in relation to the regulation of superannuation schemes is not compelling, particularly given that the last formal notice received by the Government Actuary under section 18A was in 1997.
Wrap accounts: Wrap accounts (where a provider holds securities on behalf of an individual investor) are separately regulated in Australia, and MED is considering whether the same should apply here.
Group Investment Funds: It is proposed that group investment funds no longer be exempt from the relevant requirements in the Securities Act when the current exemption for externally managed GIFs expires. As the main reason for the exemptions was to ensure that these products were treated in the same manner as unit trusts, it may be that they will be made redundant by the proposed reforms. As the original applicants for the exemptions, we will monitor their continued need.
Mutual recognition offerings: Australian securities offered into New Zealand by way of the Mutual Recognition Regulations should continue to be subject to only minimal requirements under the New Zealand securities framework.
Investment-linked insurance policies: It is proposed that any new insurance policies that have an investment component would be regulated as if they were two separate contracts – one of insurance and one for investment. The policies would still be able to be bundled and sold together as a single product offering. The insurance part of the contract would be covered by the insurance prudential supervision framework and the investment part of the contract would be regulated as a CIS. Existing investment-linked policies are regulated entirely under the Securities Act and the relevant provisions in the Life Insurance Act 1908.
New Zealand as a financial hub – a possible dual regime? To support the Government’s aim of establishing New Zealand as a financial hub, a dual regime is proposed under which schemes that are offered domestically would be subject to lesser regulation than those being offered internationally. Requirements which would at least match and (possibly) better the European Union’s Undertakings for Collective Investment in Transferable Securities (UCITS) would be necessary for international offerings if New Zealand is to be competitive.
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