Review of the Managed Investments Act 1998

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 Submissions - Trustee Corporations Association of Australia



First Submission:
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Trustee Corporations Association of Australia
Submission to the Review of the Managed Investments Act 1998

September 2001

EXECUTIVE SUMMARY

Introduction

The Trustee Corporations Association of Australia (the "Association") represents 18 organisations, comprising all 7 public trust offices and all but one of Australia's 12 statutory trustee companies.

In aggregate, members have capital of about $600 million, and hold assets worth around $300 billion on trust for investors.

The Association welcomes the opportunity to participate in the Government's review of the Managed Investments Act 1998 (MIA).

We believe that the MIA contains major structural flaws that potentially expose investors to substantial loss through maladministration, negligence or fraud on the part of managed fund operators licensed by the Australian Securities and Investments Commission (ASIC) as "responsible entities" (REs).

Moreover, in the event of such a loss, the MIA potentially leaves investors without effective recourse against entities of substance.

The financial sector has experienced a number of serious problems in recent times. These have included the multi-billion dollar HIH insurance debacle, the collapse of licensed superannuation trustees such as Commercial Nominees of Australia (CNA), and the large losses incurred by poorly managed mortgage schemes promoted by solicitors and finance brokers.

The Association submits that those developments have demonstrated that a system of self-regulation, combined with "hindsight" monitoring by the regulator and auditors, is a dangerously weak regime for adequately protecting investors, and one likely to result in pressure for costly Government bail-outs.

Those financial failures have raised questions about the performance, powers, and resources of the regulators.

The dangers inherent in a framework that lacks active and effective compliance supervision apply equally to managed funds as to insurance and superannuation.

The amount of money invested in managed funds is enormous and increasing rapidly. During the past 5 years the sector has grown from about $50 billion to over $165 billion. That figure is expected to quadruple over the next 12 years.

Some 3 million Australians have investments in managed funds. Balances represent a mix of compulsory savings (via superannuation contributions) and discretionary investments. Many of those investors are over 55 years of age and are relying heavily on those investments for their retirement lifestyle.

Investors, large or small, have the reasonable expectation that the law will ensure schemes are managed properly and their money is safe. This requires monies to be invested by competent and honest scheme operators in assets that conform strictly with the scheme's prospectus. Further, assets must be quarantined from loss arising in other areas, and used only for the proper purposes of the scheme.

While investors funds should bear the loss of asset value due to poor investment performance, they reasonably expect to have an unambiguous claim for compensation from an entity of substance in the event of loss caused by negligence or fraud by a scheme operator.

The Association submits that investors in managed funds do not have such protection under Australia's current regulatory regime.

We believe that the Review must carefully consider how the shortcomings in the fundamental structure of the MIA might be strengthened to better protect investors and enhance their rights, and return Australia's investor protection regime to world's best practice as applied in virtually all OECD countries.

Major Weaknesses in the MIA

The Association submits that the MIA compliance framework has serious shortcomings - it lacks adequate independence, appropriate accountability to investors, and sufficient financial underpinning. It has not proven to be effective in promoting an appropriate compliance culture among REs. Nor does it appear to have resulted in cost savings that have delivered promised lower charges to investors.

(a) Lack of genuine independence

The MIA seeks to provide an independent check on the fund manager by mandating that, unless at least half of an RE's board are "external" directors, the RE must establish a Compliance Committee with a majority of "external" members.

However, neither investors nor ASIC are required to approve the appointment or removal of these "external" persons. They are appointed by, paid by, and may be removed by the RE.

Moreover, a person on the board of the RE's owner can qualify as an "external" person, thereby creating potential conflicts of duty.

    Further, the MIA does not require scheme property to be held by an independent custodian. This fails a fundamental requirement for sound investor protection mandated in the vast majority of countries.

(b) Lack of accountability to investors

While the RE's directors have a duty to act honestly and in the best interests of investors, they are not directly accountable to investors.

Even less strict duties and obligations are placed on the Compliance Committee members in that they:

- are not required by law to act in the best interests of investors in fulfilling their duties,

- are not required, if there is a conflict, to give priority to investors' interests,

- are not under a statutory duty to enquire actively into all aspects of compliance by an RE,

- are not required to report all breaches of the compliance plan to ASIC, and

- are not directly liable to investors for performing their statutory duties properly.

Nor do the custody arrangements provide accountability to investors. Under the MIA, custodians are responsible only to the RE. They do not have statutorily-defined duties, and do not owe a duty of care to the investors. Moreover, the RE is permitted self-custody of scheme assets.

(c) The MIA compliance framework lacks effectiveness

"Long-after-the-event" checking by auditors and the regulator is intrinsically less effective than more timely compliance monitoring by an independent specialist entity with a liability to investors to act diligently to protect their assets.

The MIA replaced a competitive private sector compliance industry, which had substantial capital at risk and access to considerable insurance, with a resource-stretched public sector regulator.

ASIC cannot, we submit, closely supervise the day-to-day behaviour of some 450 licensed REs. During 2000/01, for example, ASIC had the resources to conduct inspections of only 19 percent of REs.

Moreover, it is disturbing to note that ASIC found breaches and compliance failures in 83 percent of the REs inspected. For example:

- 4 in 5 had inadequate compliance and operational practices,

- more than 1 in 2 had breached their compliance plan1, and

- 1 in 3 had breached the Corporations Law (the "Act").

Remedial action taken by ASIC in respect of those REs included:

- more than 1 in 4 being required to modify their compliance plans,

- 1 in 6 being required to appoint an independent consultant to undertake compliance monitoring and report regularly to ASIC and the RE, and

- 1 in 20 having their licence revoked.

ASIC also found that 13 percent of compliance plan audits for 1999/2000 were qualified.

(d) Inadequate financial underpinnings

The levels of capital and professional indemnity and fraud insurance underpinning managed investments schemes are totally inadequate. REs with Net Tangible Assets (NTA) of only $5 million (the maximum required) and $5 million of insurance (maximum required) can, and do, hold at risk many billions of dollars of investors' funds.

Under the MIA, schemes no longer have the support of the substantial capital and insurance previously provided by the trustee companies.

Even large financial institutions that operate managed investments do so using a thinly-capitalised subsidiary company whose performance is not, as an almost universal rule, guaranteed by the parent company. Australia's banking regulator specifically disapproves of such guarantees where the parent company is a bank.

Nor should investors in schemes managed by subsidiaries of banks domiciled overseas assume that the shareholders' funds of those banks would be made available to bail out a failed Australian fund manager.

(e) Despite lower protection, fees have not fallen due to the MIA

The MIA arrangements appear not to have resulted in direct cost savings for scheme operators that have been passed on to investors in the form of lower charges, as had been foreshadowed by proponents of the new regulatory framework.

It would seem that in most cases the RE now receives the combined fees of the former trustee and manager.

The CEO of the Investment & Financial Services Association (IFSA) has noted that, while the Management Expense Ratio (MER) for managed funds has fallen slightly over the past 5 years, the introduction of the MIA actually was a factor driving it up.

We believe that compliance costs under the MIA are higher than they were under the previous arrangements, especially for smaller fund managers, yet investor protection is less.

Suggested Improvements to the MIA

The Association submits that, to improve investor protection, the MIA should be amended with a view to:

- reducing the probability of problems arising in the first place - that is, better preventative measures, and

- providing more substantial means of compensating investors in the event of losses caused by maladministration, negligence or fraud - that is, stronger financial underpinning.

1. To improve the preventative element of investor protection, we submit that:

(a) The present compliance arrangements should be strengthened in the areas of independence, clarity of role, and accountability to investors.

- Independence could be improved by replacing the requirement for "external" directors or Compliance Committee members with a genuinely independent corporate compliance entity licensed by ASIC, and to be removed only with ASIC's consent.

Such an entity would bring to a scheme collective expertise beyond that available through individuals, as well as provide access to substantial capital and insurance.

- The role of the compliance entity should be clarified, and set out in the scheme's prospectus and in an annual report to investors. That role should not entail individual transaction checking, which might be seen as relieving the RE of the responsibility of self-compliance. Rather, the duties should encompass:

• monitoring the RE's performance in relation to its obligations under the constitution and the Act, by assessing its compliance with the compliance plan, and

• reporting periodically, say quarterly, to the RE and, as necessary, to ASIC on the RE's compliance procedures and the conduct of the scheme.

On this basis, the compliance entity would eliminate the need for the current compliance plan auditor.

- Greater accountability to investors would be achieved by the compliance entity being required to:

• report to investors at least annually on the RE's compliance with the compliance plan, and

• take action against the RE as the investors' representative should problems occur, including compliance failure.

This improvement in the law would not change the present duties or liabilities of the RE. It would remain liable for breaches on its part that cause loss to investors, but investors would as well have the benefit of a direct right of action against the compliance entity if it failed to carry out its responsibilities diligently.

(b) Schemes should be required to appoint an independent custodian, licensed by ASIC2, with liability to investors limited to its clearly defined responsibilities in relation to holding scheme assets.

The custodian would be required to deal with scheme assets as directed by the RE except where it reasonably believes that the RE's instructions involve self-dealing in contravention of Part 5C-7 of the Act. Such cases would be referred immediately to the compliance entity, which could either report the matter to ASIC or initiate collective action on behalf of investors, by having a right of action to sue the RE on their behalf.

An independent custodian, we submit, would be better placed to prevent fraud and self-dealing than in the case of self-custody or custody by a party related to the RE. It would also have the benefit of enabling more timely investor repayment should the RE become bankrupt.

The custodian would not be responsible for identifying transactions which appeared to be in breach of the constitution. This would be the role of the compliance entity, which would have a right of action to sue the RE on behalf of investors.

While there might be cost advantages in the same entity carrying out the custody and compliance functions for a scheme, it is suggested that maximum independence, and hence greater investor protection, would be achieved by keeping the roles separate, and clearly defined.

2. In order to strengthen the financial underpinnings of managed investments, we submit that higher capital and insurance requirements should apply to REs, custodians and compliance entities.

    Without substantial capital at risk, we believe that REs and others charged with protecting the interests of investors have less incentive to exercise the necessary degrees of diligence and vigilance assumed but not assured by the MIA regime.

    We submit that REs should be obliged to maintain NTA that, above a specified minimum amount, is in proportion to funds under management (FUM). In addition, REs and their directors should be required to have professional indemnity insurance cover in proportion to FUM.

    We further submit that licensed custodians and compliance entities should themselves have adequate capital and insurance.

    Conclusion

    We believe that the approach outlined above represents a coherent package of measures which collectively would offer a number of benefits:

- it would provide enhanced investor protection through more robust custody and compliance arrangements, and stronger financial underpinning of schemes,

- Australia's regulatory framework would again measure up to international best practice,

- there would be enhanced investor rights, with the independent compliance entity, serving as the "investors' champion", improving the ability of investors to enforce those rights,

- the arrangements would cater for diversity, by enabling lesser known scheme operators to generate investor confidence through the use of trusted custody and compliance entities,

- competition among private sector custodians and compliance entities with access to economies of scale, together with an expected reduction in related-party outsourcing by REs, should put downward pressure on costs,

- costs should also fall with use of specialist compliance entities removing the need for external directors or Compliance Committee members, and compliance plan auditors,

- reduced costs should result in lower charges for investors,

- there would be less pressure on limited regulator resources, and

- the need for costly Government bail-outs of failed managed investments schemes should be reduced.

The Association acknowledges that other approaches could be considered to address the shortcomings in the present arrangements.

For example, the independence and effectiveness of the compliance regime might be improved by strengthening the tenure of external Compliance Committee members, perhaps by mandating that they could only be removed with ASIC's consent.

Alternatively, appropriately qualified corporates might be permitted to act as external members of Compliance Committees.

Another approach would be to mandate an independent custodian and independent compliance entity only for "smaller" schemes, defined in terms of a certain level of capital, given that these operations may be more likely to have relatively weaker internal control systems.

Or, the MIA could be amended to remove the present prohibition on REs offering investors the choice of a structure with genuinely independent custodial and compliance functions. However, it would seem likely that many of the schemes opting to stay with the current model may well be those which most warrant a stronger investor protection structure.

We would, of course, be happy to explore further with the Review these options.

However, the Association believes that it would be unfortunate if a "piecemeal" approach were to be taken to improving the investor protection regime for managed investments, such that the full benefits of the package of refinements recommended above were not realised.

*****

Introduction

The Trustee Corporations Association of Australia (the "Association") represents 18 organisation, comprising all 7 public trust offices and 11 of Australia's 12 statutory trustee companies.

Trustee companies have been protecting the wealth of Australians for over 100 years.

Association members, in aggregate, have capital of about $600 million and hold assets worth around $300 billions on trust for investors. They have a fiduciary responsibility to ensure that those investments are sound, and that associated fees are appropriate.

The Association welcomes the opportunity to participate in the Government's review of the Managed Investments Act 1998 (MIA).

The MIA was introduced 3 years ago after a lengthy period of debate. Amid considerable controversy, the Government accepted the view that the "two-party" structure which previously applied, comprising a fund manager and an independent trustee, had led to confusion about responsibility for protecting the interests of investors.

The Government was also persuaded that the proposed new regime would result in lower costs, which in turn would translate into lower fees for investors.

At that time, the Association (and other commentators) argued that the MIA regulatory regime - involving a single responsible entity (RE), supposedly robust compliance arrangements, and a greater role for the regulator - contained fundamental flaws that would weaken investor protection.

The Association acknowledged that the former dual-party system did not prevent all problems. Indeed, no system can. However, we submitted that critics of the previous approach had put too much weight on the failures of the Estate Mortgages and the Aust-Wide schemes, without regard to the fact that those failures, while significant, were isolated incidents over a period of several decades. Further, investors received a large part of their money back because of the presence of the trustee and its capital and insurance resources - the failed fund managers, on the other hand, contributed nothing towards the losses.

The Importance of the Managed Investments Industry

Managed funds have become a major investment vehicle for some 3 million Australians. This partly reflects the increasing compulsory superannuation contributions required to be made by employers under the Government's retirement income policy.

Over $165 billion was held in managed funds at the end of March 2001 compared with about $50 billion only 5 years ago.

About $95 billion of the money in managed funds represents investments by superannuation funds of part of the $500 billion that is currently held in member accounts.

The managed investments sector is expected to continue to grow strongly. The Commonwealth Bank, for example, has estimated that, by the year 2012, Australia's ageing population could lead to a quadrupling of the amount of money invested in superannuation assets and managed funds.

Investors in managed funds represent a cross-section of the community. They range from "mums and dads" to more sophisticated investors. Many of those investors are over 55 years of age and are depending heavily on that money for their retirement lifestyle.

All of those investors, however, have one thing in common - a reasonable expectation that the law will ensure schemes are managed properly and that their hard-earned money is safe.

Risk

The nature of financial regulation should reflect the type of risk being incurred and the type of promise being made by providers of a particular product.

In the case of managed investments, the promise by the operator is to invest the funds to achieve the best returns within the promised mandate. The return to the investor is based on the (fluctuating) value of the underlying scheme assets. It is appropriate that the investor bear the investment (or market) risk - that is, accepting the possibility of capital gain or loss, provided only authorised investments are made.

However, because of the trust extended to the fund manager by the investor, it is essential the regulatory framework ensure that:

- investors receive all the information necessary to make informed decisions between alternative investment products (adequate disclosure),

- scheme assets are protected from the possible failure of the scheme operator (institution risk),

- there is proper protection against the risk that the operator may not comply with the scheme's constitution and disclosure documents, or might act negligently or fraudulently (compliance risk), and

- adequate investor compensation is available in the event of compliance or institution risk failure (financial underpinning).

While it is expected that the great majority of financial institutions will be managed in a prudent and honest manner, history repeatedly has shown that there will always be some entities, large and small, which will not. It is inevitable that there will be failures. As the CEO of the Australian Prudential Regulation Authority (APRA) recently noted:

"...no system of prudential regulation ever has, or can, provide an absolute guarantee against financial failures."

Nonetheless, the regulatory framework should constrain (or preferably eliminate) investor loss through negligence, fraud or other illegal activity.

Recent Financial Sector Developments

While it is true that there has not been a major failure of a managed investments scheme since the introduction of the MIA, a number of recent well-publicised problems in other sectors of the Australian financial system have rightly focused attention on the general question of the effectiveness of the present framework of prudential supervision.

The most notable and damaging financial failure in recent times has, of course, been the multi-billion dollar HIH insurance debacle. The impact of the collapse of HIH was felt not only in the insurance industry but across the economy more generally. The failure seriously affected public confidence in the financial system and is the subject of a Royal Commission.

Other financial sector problems have included:

- Employees Productivity Award Superannuation fund (EPAS), where some 26,000 members lost about $10 million, or half of their savings, through imprudent investment practices by the fund's APRA-approved trustee,

- the collapse of Commercial Nominees of Australia Ltd (CNA), another APRA-approved trustee, which resulted in estimated losses of some $25 million for the 25,000 beneficiaries of about 500 small superannuation funds - some of those losses arose from investments in unregulated managed investments schemes that failed, and

- the losses, estimated to total hundreds of millions of dollars, experienced by thousands of investors in poorly managed mortgage schemes promoted by solicitors and finance brokers, some of which were managed investments schemes under the MIA regime. (A Royal Commission on this matter is underway in Western Australia.)

Those incidents have highlighted the shortcomings of industry self-regulation, combined with "hindsight" monitoring of a financial institution's activities by auditors and regulators, notwithstanding the existence of a licensing regime and various prudential entry criteria.

Those events revealed gaps in the regulatory regime, with "finger pointing" between APRA and ASIC as regards demarcation between their respective roles.

In its recent reports on those financial failures, described as "severe wake-up calls" for the regulators, the Senate Select Committee on Superannuation and Financial Services was very critical of the effectiveness of the present prudential supervision framework. It recommended, among other things, that APRA should:

"...review its approach to risk management to ensure its procedures detect early warning signs of impending financial problems..." and "...work more quickly when matters come to its attention..."

Noting the significant amounts of money lost by many investors through no fault of their own, the Committee pointed out that:

"If APRA had acted more pro-actively,.... the problems may have been detected sooner and the losses may have been contained."

Apart from the serious financial hardship and emotional stress suffered by those policyholders or investors directly affected, such supervisory lapses can put the taxpayer at risk when the Government feels obliged to bail out a failed institution.

The HIH episode has demonstrated this quite dramatically, with the Federal and State Governments putting together a $1.5 billion package to assist policyholders suffering hardship as a result of the insurer's failure. It has been suggested that this amount will need to be increased.

Major Weaknesses in the MIA

The Association submits that the MIA compliance framework has serious shortcomings - it lacks adequate independence and appropriate accountability to investors. It does not have sufficient financial underpinning. It has not proven to be effective in promoting an appropriate compliance culture among scheme operators. Nor can it be demonstrated that there have been any cost savings directly attributable to the MIA that have been passed on to investors in the form of lower fees.

(a) Lack of genuine independence

The present arrangements seek to provide an independent check on the fund manager by mandating that, unless at least half of the board of an RE are "external" directors, the RE must establish a Compliance Committee with a majority of "external" members.

However, the MIA does not require either investors or ASIC to approve the appointment or removal of these "external" persons. They are appointed by, paid by, and may be removed by the RE. Indeed, investors need not even be notified of a change.

Moreover, a person on the board of the RE's owner can qualify as an "external" person, thereby creating potential conflicts of duty.

Also, the MIA does not require scheme property to be held by an independent custodian. This fails a fundamental requirement for sound investor protection mandated in the vast majority of countries.

Under the former collective investments regime, the trustee corporation also acted as an independent custodian, holding scheme assets on behalf of investors. This achieved segregation of the assets in the event of insolvency of the manager, and helped generate investor confidence.

Under the MIA, the RE itself or its agent holds scheme property on trust for investors. In terms of ASIC's Policy Statement 133 (PS 133), the RE or its agent must meet standards on:

- organisational structure,

    - staffing capabilities, and

    - ability and resources to perform core administrative activities.

Further, in terms of PS 131, if an RE has Net Tangible Assets (NTA) of less than $5 million it must use a "third party" custodian which, apart from meeting the above standards, has NTA of at least $5 million.

However, an RE may appoint a third party custodian which is legally or commercially related to it. Such arrangements entail an inherent conflict of interest that is banned elsewhere in the world.

The Association submits that legal and functional independence is essential in order to avoid the controllers of an RE inappropriately influencing the decision-making of the custodian.

(b) Lack of accountability to investors

While the RE's directors are under a duty to act honestly and in the best interests of investors, they are not made directly accountable to investors.

Even less strict duties and obligations are placed on the Compliance Committee members in that they:

- are not required by law to act in the best interests of investors in fulfilling their duties,

- are not required, if there is a conflict, to give priority to investors' interests,

- are not under a statutory duty to enquire actively into all aspects of compliance by an RE,

- are not required to report all breaches of the compliance plan to ASIC, and

- are not directly liable to investors for performing their statutory duties properly.

Under the previous arrangements, investor rights were championed by the independent trustee company, which acted as the investors' representative and had a duty to take legal action, funded from scheme assets, to protect and enforce investor rights, and could itself be sued if it proved negligent in this role.

However, under the MIA, investors face the "collective action" problem. To enforce their rights against the RE for breaches of the law, individual or groups of investors face onerous costs and processes that often outweigh the expected benefits to the individual(s).

The alternative is for ASIC to expend taxpayers' money on enforcement action and seek civil penalties on behalf of investors.

ASIC, however, cannot realistically take such action until it has carefully collected and verified the necessary evidence. Investors have no recourse against ASIC if it acts too late, and scheme assets are gone.

The MIA has further weakened investors' rights in that:

- because investors can only sue the RE, they must rely on the RE itself or ASIC to bring action against the people actually running a scheme,

- the RE can change a scheme's constitution if the RE "reasonably considers the change will not adversely affect members rights",

- the RE can unilaterally suspend investors' rights to exit the fund via buy-backs, and

- it is now almost impossible for investors to sack the RE; this would require individual investors to overcome the complex logistics of calling a meeting of members to achieve a vote of 50 percent of all members to remove the incumbent RE and to select a new one.

Nor do the present custody arrangements provide accountability to investors. Custodians are responsible only to the RE. They do not have statutorily-defined duties under the MIA, and do not owe a duty of care to the investors whose assets they hold. Moreover, self-custody by the RE is permitted.

(c) Lack of effectiveness

Experience has demonstrated that "long-after-the-event" checking by auditors and the regulator is intrinsically less effective than more timely compliance monitoring by an independent specialist entity with liability to investors to act diligently to protect their assets.


The MIA replaced a competitive private sector compliance industry, which had substantial capital at risk, with a resource-stretched public sector regulator.

We believe that the present regulatory framework places excessive reliance on ASIC to monitor and enforce compliance by REs with their performance obligations.

ASIC cannot, we submit, closely supervise the day-to-day behaviour of some 450 licensed REs, a number likely to increase as Australia's pool of superannuation and non-superannuation savings grow. The infrequency of ASIC's surveillance activities on individual REs is a good example of this problem. During 2000/01, ASIC had the resources to conduct inspections of only 19 percent of REs.


Moreover, it is disturbing to note that ASIC found breaches and compliance failures in 83 percent of the REs inspected. For example:

- 4 in 5 of those REs were seen as having inadequate compliance and operational practices,

- more than 1 in 2 had breached the compliance plan, including:

_ over 1 in 4 not undertaking adequate monitoring of service providers, and

_ 1 in 10 failing to properly assess the independence of Compliance Committee members,

- more than 1 in 3 had breached the Act, including non-lodgement or late lodgement of statutory documentation by 1 in 4 REs, and

- 1 in 4 had breached licence conditions, including 1 in 6 having failed to correctly calculate their NTA.

ASIC's report on its surveillance activities noted:

      "Our findings demonstrated a lack of active implementation of compliance arrangements and a lack of strong management commitment to implementing them in some organisations."

Remedial action taken by ASIC in response to its findings during those inspections included:

- more than 1 in 4 being required to modify their compliance plan,

- 1 in 6 being required to appoint an independent consultant to undertake compliance monitoring and report regularly to ASIC and the RE, and

- 1 in 20 of those REs having their licence revoked.

As part of its surveillance activities during 2000/01, ASIC also carried out a review of compliance by REs with their compliance plan audit obligations. The regulator found that 13 percent of the more than 1,700 compliance plan audit reports prepared by 65 audit firms for the previous year were qualified.

We submit that the results of ASIC's surveillance activities clearly have demonstrated that, after 3 years, the MIA has been quite unsuccessful in strengthening compliance awareness and procedures among scheme operators.

(d) Inadequate financial underpinning

It is important for investor confidence and protection that there be an adequate pool of capital and insurance supporting a managed investments scheme. This might be provided directly by the scheme operator or indirectly through another party.

The former trustee corporation underpinned its fiduciary monitoring and custodial functions by holding high levels of capital and insurance.

In contrast, the capital and professional indemnity and fraud insurance required under the MIA are totally inadequate:

- as a pre-condition to issuing a licence, ASIC must be satisfied that an RE will maintain minimum NTA (capital) of only $50,000 or, where the value of scheme property is more than $10 million, an amount equal to 0.5% of those assets. The maximum NTA requirement is only $5 million, and

- in terms of PS 131, an RE must maintain appropriate professional indemnity insurance and insurance against fraud by its officers. This should cover claims up to, and in aggregate, $5 million, or the value of scheme assets, whichever is less.

This means that REs with only $5 million of capital (the maximum required) and $5 million of insurance (maximum required) can, and do, hold at risk many billions of dollars of investors' funds.

Even large financial institutions that operate managed investments do so using a thinly-capitalised subsidiary company whose performance is not, as an almost universal rule, guaranteed by the parent company. Australia's banking regulator specifically disapproves of such guarantees where the parent company is a bank.

Nor should investors in schemes managed by subsidiaries of banks domiciled overseas assume that the shareholders' funds of those banks would be made available to bail out a failed Australian fund manager.

It is interesting to note that fund manager groups tend not to disclose in the prospectus the minimal level of capital held by REs.

We believe that the Review needs to consider very closely the adequacy of the financial support currently underpinning managed investments.

(e) Despite lower protection, fees have not fallen due to the MIA

An important aim of public policy is to ensure that the required level of investor protection is provided at the minimum cost possible.

Under the former collective investments regime, trustee company fees represented only a small fraction of the overall cost of the running a scheme. Typically, these ranged between 5 and 10 basis points per annum (or 0.05-0.10%). That translated to $10-20 pa for an average investment of $20,000.

The trustee's fee covered custody, settlement, banking and "on-the-spot" monitoring of the fund manager's compliance with the trust deed, the prospectus and the Act. It also secured access to substantial professional indemnity insurance.

Those fees were modest relative to the fees typically charged by the fund manager of between 100 and 250 basis points (1.0-2.5%), or $200-500 pa for an average investment of $20,000.

Proponents of the MIA claimed that the new RE regime would result in greater cost efficiency and, through the forces of competition, lower charges for investors.

The Association argued that this seemed unlikely. Leaving aside the substantial transitional costs that would be involved, the move to the new RE arrangements was seen as resulting in higher on-going costs due to:

- increased external audit work,

- added fees for "external" directors or compliance committee members,

- additional directors' and officers' insurance,

- added costs of dedicated compliance staff, and

- separate custodian fees in many cases.

There do not appear to have been cost savings for scheme operators directly attributable to the introduction of the MIA that have been passed on to investors in the form of lower charges.

Under the RE structure, most activities of a scheme are sub-contracted to related entities at prices that are higher than would apply through arm's length negotiations, and certainly higher than would be permitted if an independent entity acted as the investors' representative.

It seems that, in most cases, the RE now receives the combined fees of the former trustee and manager.

Indeed, the CEO of the Investment & Financial Services Association (IFSA) has noted that, while a variety of drivers, such as competition, may have contributed to a lower average Management Expense Ration (MER) for managed funds over the past 5 years, the introduction of the MIA
"... drove it back up."

We believe that compliance costs under the MIA are higher than they were under the previous arrangements, especially for smaller fund managers. At the same time, investors have less protection.

The Australian Consumers' Association (ACA) was a supporter of the MIA on the (false) assumptions that investors' funds would be at least as safe as under the former scheme, and that expected cost savings would be passed on to consumers. However, the ACA recently expressed concern about the high level of fees - around 2 percent in Australia compared with 1 percent in the US and 1 .45 percent in Europe. 

It should also be noted that, in addition to the direct charges borne by investors in managed funds, the MIA regime has required a significant increase in ASIC's resources funded by taxpayers. However, as noted above, the regulator still does not appear to have adequate resources to handle its expanded responsibilities.

International Best Practice

Australia, by removing the requirement for an independent trustee or custodian to protect investors in managed funds, is out of step with virtually every other country.

A 1995 survey of 43 countries by KPMG revealed that only the British Virgin Islands and Netherland Antilles did not mandate a trustee or functional equivalent for collective investment schemes. The British Virgin Islands subsequently moved in the opposite direction to the MIA and now requires an independent custodian.

Respected international ratings agency Standard & Poor's, when commenting on Australia's MIA legislation, noted:

"The failure to mandate that fund assets must be held in safekeeping by an independent custodian is of concern and is in contrast to all other major financial centres of the world, where an independent custodian is a minimum standard."

A number of overseas scandals have highlighted the importance of having effective compliance monitoring by a well-capitalised and independent party. For example:

- the plundering of the Maxwell Communications pension fund in the UK was facilitated by the presence of a "bare" custodian which was obliged to act on the fund manager's instructions and did not block improper use of scheme assets.

In Australia, the custodian role is one of "bare" custodian, with no accountability to investors for the proper application of scheme assets.

- when Barings Bank plc collapsed as a result of reckless actions by a trader/manager, some STG 35 billion of funds under management were not affected because they were held by the Royal Bank of Scotland's trustee company, an independent and reputable custodian.

Such an outcome is not assured under the MIA.

- when a fund manager with Morgan Grenfell Asset Management in the UK lost over $A500 million through unauthorised investments, investors were compensated only because Morgan Grenfell's parent, Deutsche Bank, went beyond its legal liability and came to their aid.

This type of action would be unlikely to occur in Australia. Under the Banking Act, APRA is charged with protecting the interests of banks' depositors. For this reason it explicitly prohibits a bank from providing general guarantees to repay liabilities issued by its associates and must ensure that associates do not give any impression that the bank's resources stand behind, or could be called upon to stand behind, its operations.

In the case of associated funds management operations, a bank must hold the necessary capital against any formal commitments to the fund. Where appropriate disclosure, separation and arm's length criteria specified by APRA are not met, a bank may be required to hold capital against the full value of the associated managed funds assets.

US Arrangements

Supporters of the MIA claimed that the RE arrangements are similar to the investor protection regime for mutual funds in the US. In reality, there are fundamental differences between the RE regime and the US mutual fund structure:

- under the US Investment Company Act 1940, the equivalent of the RE is an investment company or trust. However, it is not owned by the fund manager, as is typically the case with REs in Australia - it is owned solely by the investors,

- moreover, directors of the US board/trust are elected directly by shareholders (that is, investors) - not appointed by the fund manager as is the case with REs in Australia;

- US directors have full fiduciary responsibilities to act only in the interest of the fund and its investors - they have no responsibility to the fund manager,

- at least 40% of US directors (and the US Securities and Exchange Commission actively encourages a substantial majority) must be completely independent of any "affiliated" or "interested" person, including the fund manager, underwriter, or anyone that has a business relationship with the fund - this genuine independence provides far more investor protection than the "external" requirement of the MIA , and

- a fund's assets must be held by a custodian independent of the fund manager. Normally, the assets must be held in the name of the investors. While in limited cases the assets may be held in the name of the fund itself (but never the fund manager, as may occur in Australia), SEC rules then require the custodian to be a bank, independent of the fund manager, with the assets verified by independent auditors at least 3 times each financial year, twice without notice.

UK Arrangements

A few years ago in the UK, the Treasury initially proposed a new style investment structure called an "Open-Ended Investment Company" (essentially a unit trust in corporate form) that need not have a trustee.

The funds management industry, however, firmly rejected the proposal for an investment fund with, in effect, a single responsible entity, and insisted that assets be held by an independent third party - called a "depositary" - with responsibilities similar to those of the independent custodian / trustee of a unit trust. That stance reflected:

- belief that even independent directors could not provide the effective day-to-day compliance monitoring essential to investor protection,

- a desire to meet the investor protection standards that apply throughout Europe (the UCITS code), and

- concern that investors would have less confidence if their assets were not separately held and independently safeguarded.

Global Standards

It should be noted that the minimum standards agreed by the International Organisation of Securities Commissions (IOSCO), of which ASIC is a member, also mandate similar investor protection principles, that is:

- separation of scheme assets from the funds manager and related entities,

- appropriate qualifying requirements on custodians in relation to their financial and other resources, and

- the custodian should be functionally independent of the fund manager and must always act in the best interests of investors.

The MIA seeks to meet IOSCO principles in ways that the rest of the world has rejected as providing inadequate investor protection.

Supervision of Superannuation

Following the Wallis Report, the MIA regime was supposed to provide harmony with the regulatory arrangements for superannuation embodied in the Superannuation Industry (Supervision) Act 1993 (SIS).

Wallis recommended that there would be benefits if the regulation of public offer superannuation funds and managed investments schemes were harmonised, by introducing an RE structure for managed funds, "subject to appropriate safeguards considered necessary for the holding of assets and ensuring scheme compliance."

The Association submits that this demonstrably is not the case:

- the RE of a managed investments scheme is not subject to prudential supervision - superannuation funds are regulated by APRA,

- a managed investment scheme is not required to have an independent custodian - SIS requires an independent custodian for certain public offer superannuation funds,

- under the MIA, the directors of REs do not owe duties directly to investors - under SIS, directors of trustees do, and

- REs do not have a fidelity fund to levy the managed investments industry to compensate investors for fraud - superannuation funds do.

Thus, not only did the MIA weaken investor protection, it introduced a scheme that in no way represented a functional equivalent to superannuation funds.

Even with the stricter regime that applies to superannuation compared to managed investments, APRA acknowledged in June that risk management shortcomings remain a problem in superannuation, particularly in respect of the 3,000 or so corporate and industry funds that are permitted to operate without an APRA-approved trustee company.

The Association submits that there clearly is scope to strengthen - and harmonise as necessary - the supervisory frameworks that apply to managed investments and superannuation.

Suggested Improvements in the MIA

The Association submits that it is vital, especially given recent financial sector problems, that more effective investor protection measures be put in place. To this end, we believe that the legislation should be amended with a view to:

- reducing the probability of problems arising in the running of managed funds in the first place - that is, better preventative measures, and

- providing more substantial means of compensating investors in the event of losses caused by maladministration, negligence or fraud - that is, stronger financial underpinning of schemes.

1. To strengthen the preventative element of investor protection, we submit that:

(a) The present compliance arrangements should be improved in the areas of independence, clarity of role, and accountability to investors:

- Independence could be improved by replacing the "external" directors or Compliance Committee members with a genuinely independent corporate compliance entity licensed by ASIC. Such an entity would bring expertise beyond that available through individuals, as well as provide access to substantial capital resources and insurance.

    This independence could be reinforced by introducing arrangements similar to those applying to the compliance plan auditors - that is, the compliance entity would be appointed by the RE but could only be removed with ASIC's consent.

- The role of the compliance entity should be clarified and set out in the prospectus and an annual report to investors. This role should not entail individual transaction checking, which might be seen as relieving the RE of the responsibility of self-compliance. Rather, it should encompass:

    • monitoring the RE's performance in relation to its obligations under the constitution and the Law, and

    • reporting periodically, say quarterly, to the RE and, as necessary, to ASIC on the RE's compliance procedures and the conduct of the scheme.

      On this basis, the compliance entity would eliminate the need for the current compliance plan auditor.

    - Greater accountability to investors would be achieved by the compliance entity being required to:

    • report to investors at least annually on the RE's performance, and

    • take action against the RE as the investors' representative should problems occur, including compliance failure.

    This improvement in the law would not change the duties or liabilities of the RE as defined in the MIA. The RE would be liable for breaches on its part that cause loss to investors, but investors would as well have the benefit of a direct right of action against the compliance entity if it failed to carry out its responsibilities diligently.

(b) We suggest that schemes should be required to appoint an independent custodian with clearly defined responsibilities in relation to holding scheme assets. Those custodians should be licensed by ASIC, having met appropriate minimum criteria as regards having the necessary expertise and resources to properly carry out that role.

The custodian would be required to deal with scheme assets as directed by the RE except where it reasonably believes that the RE's instructions involved self-dealing in contravention of Par 5C-7 of the Act. Such cases would be referred immediately to the compliance entity, which could either report the matter to ASIC or initiate collective action on behalf of investors, by having a right of action to sue the RE on their behalf.

An independent custodian, we submit, would be better placed to prevent fraud and self-dealing than in the case of self-custody or custody by a party related to the RE. It would also have the benefit of enabling more timely investor repayment should the RE become bankrupt.

We suggest that the custodian should not be given responsibility for identifying transactions which appeared to be in breach of the constitution. Rather, it would be more appropriate for this role to be assigned to the compliance entity, which would have a right of action to sue the RE on behalf of investors in the event of non-compliance.

It may well be more cost-effective for the one entity, meeting the appropriate criteria, to serve both as a scheme's custodian and as its compliance monitor. However, maximum independence and, hence greater investor protection, would be achieved by keeping those roles separate, and clearly defined.

2. In order to strengthen the financial underpinnings of managed investments, we submit that the Act should impose higher capital and insurance requirements on REs, custodians and compliance entities.

    We believe that, without substantial capital at risk, REs and others charged with protecting the interests of investors have less incentive to exercise the necessary degrees of diligence and vigilance that are assumed but not assured by the MIA regime.

    We see the present cap on the NTA requirements for REs as a weakness in the regulatory framework and suggest that fund operators should be obliged to maintain a level of capital resources that, above a specified minimum amount, is in proportion to funds under management (FUM).

    In addition, REs and their directors should be required to have professional indemnity and fraud insurance cover in proportion to the size of their FUM.

    We further submit that licensed custodians and compliance entities involved in managed funds should themselves be required to hold adequate amounts of capital and insurance. Lowly-capitalised custodians may not have the resources to properly protect scheme assets against complex risks, including computer fraud.

Conclusion

The Association submits that the approach suggested above represents a coherent package of measures which, taken together, would offer a number of benefits:

- such a regulatory regime would provide enhanced investor protection through more robust custody and compliance arrangements, as well as stronger financial underpinning of schemes,

- Australia's regulatory framework would again be seen as measuring up to international best practice as mandated in almost all countries,

- the amendments would result in enhanced investor rights, with the independent compliance entity, serving as the "investors' champion", improving the ability of investors to enforce their rights in the event of scheme failures,

- the arrangements would cater for diversity, enabling lesser known scheme operators to generate investor confidence through the use of trusted custody and compliance entities,

- competition among private sector custodians and compliance entities with access to economies of scale, together with an expected reduction in related-party outsourcing by scheme operators, should put downward pressure on costs,

- costs should also fall with use of a specialist compliance entity removing the need for external directors / Compliance Committee members, as well as compliance plan auditors,

- reduced costs should, in turn, result in lower charges for investors,

- there would be less pressure on limited regulator resources, and

- an improved regulatory framework should lessen the likelihood of fund failures and, hence, the need for Government bail-outs at great cost to the public purse.

The Association acknowledges that there would be a variety of other approaches that could be considered to address the shortcomings that are evident in the present regulatory arrangements for managed investments.

For example, consideration might be given to improving the independence and effectiveness of the compliance regime by strengthening the tenure of external Compliance Committee members, perhaps by mandating that those persons could only be removed with ASIC's consent.

Alternatively, the compliance function might be improved by allowing appropriately qualified corporates to act as external members of Compliance Committees.

Another approach would be to mandate an independent custodian and independent compliance entity only for "smaller" schemes, defined in terms of a certain level of capital maintained by the RE. This would reflect the premise that these operations may be more likely to have relatively weaker internal control systems.

Or, the MIA could be amended to remove the present prohibition on REs offering investors the choice of a structure with genuinely independent custodial and compliance functions. However, it would seem likely that many of the schemes opting to stay with the current model may well be those which most warrant a stronger investor protection structure.

We would, of course, be happy to explore further with the Review these options.

However, the Association believes that it would be unfortunate if a "piecemeal" approach were to be taken to improving the investor protection regime for managed investments, such that the full benefits of the package of refinements recommended above were not realised.

*****

1 The compliance plan sets out the measures the RE is to apply to ensure compliance with the Corporations Law (the "Act") and the scheme's constitution.

2 We note that under recent changes to the Financial Services Reform Bill there will no longer be a need for a custodian of a managed investments scheme to hold an Australian Financial Services Licence. This, in our view, is a weakening of investor protection, and may need to be reviewed if an independent custodian is mandated.


Second Submission:
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Trustee Corporations Association of Australia
Second Submission to the Review of the Managed Investments Act 1998

October 2001


SECOND SUBMISSION TO THE MIA REVIEW

This supplementary submission sets out the Association's views on questions raised by the Review in relation to our initial submission.

1. Liability for loss caused by fraud, negligence or maladministration

The Association agrees that the liability of the RE (or manager) under the MIA is legally unambiguous. This was the fundamental purpose of the MIA and full liability should remain with the RE.

Nonetheless, a damaged investor also would, reasonably, expect to be able to claim against others who may have contributed to, or failed to protect them from, any mischief - such as RE directors, Compliance Committee members, auditors, custodians or other agents appointed by the RE. However, the MIA regime does not appear to facilitate such accountability:

- firstly, as the MIA does not make those entities directly answerable to investors, the investors' claim is limited to the inadequate assets of the thinly-capitalised RE, plus the RE's modest insurance cover,

- secondly, even if those other parties could be successfully sued1, the RE, or its liquidator, may lack the means to pursue claims against other parties. Similarly, investors are also likely to lack the capacity to pursue these parties, and

- further, we suggest many investors feel that any claim would actually be against the owners of the RE, and not limited to the RE's maximum required capital of $5m and maximum required insurance of $5m. The very limited extent of the financial capacity of REs themselves is certainly not explicitly stated in prospectuses.

In the case of a bank-associated managed fund, it is important to note that APRA requires the parent bank to state in the prospectus that neither the bank nor members of the bank group stand behind the fund. We doubt that the implications of that position are absorbed by most investors (even those few that read the prospectus).

This has potential systemic implications:

- if APRA were to permit payment, concerns may arise about other banks with large funds management arms,

- if APRA did not permit payment, then concerns about inadequate investor protection under the MIA could be heightened.

To avoid this situation, we submit it is important that the investor protection regime for managed funds be strengthened considerably. Investors should not rely on the assumption of support from parties that explicitly state in the prospectus that they do not stand behind the fund.

2. Substance of scheme operators

The Association submits that there is a serious danger of unscrupulous or incompetent individuals establishing a managed investment scheme.

Previously, this risk was minimised, because a scheme operator had to find a trustee willing to put its assets and reputation on the line. Statutory trustee companies frequently declined to offer their services to operators that did not meet their standards. Investors relied on the reputation and financial substance of the trustee standing behind a scheme in which they invested. The absence of a well-known and well-regarded corporate trustee reduced the appeal of a scheme.

Under the MIA, provided the proposed RE meets the criteria set down, ASIC is obliged to allow it to operate. Thus, investors no longer have the protection of the trustee's commercial judgement, reputation, prior vetting, ongoing monitoring, capital, or insurance.

The Association submits that investor protection requires that REs should have greater substance than at present, and certainly a level of substance that will better ensure that REs take their responsibilities seriously and reinforce the incentive to undertake their duty of compliance with diligence and vigilance.

What constitutes "sufficiency" is, of course, a matter of judgement.

However, we don't think it makes sense to cap the insurance and capital requirements of an RE, particularly at a level as low as $5 million. Rather, financial underpinning for a scheme should increase in line with funds under management.

The current rule for RE capital of 0.5% of funds under management (capped at $5 million) is, in our opinion, too low, and should be increased to perhaps 1% (uncapped). This level would be broadly consistent with the level of capitalisation that was maintained by trustee companies under the pre-MIA arrangements.

Capital is not "dead" money, and a fund manager is able to earn a reasonable rate of return on it in various liquid investments.

We recognise that raising the capital requirement for an RE to even 1% (uncapped) of funds under management would not provide much protection against serious losses. It is thus most important to also strengthen preventative measures.

Similarly, compliance entities and custodians should be required to hold minimum levels of capital (perhaps $5 million) and adequate insurance (perhaps 1% of FUM/custody).

3. Should capitalisation of REs differentiate as between different asset classes under management?

The Association does not believe that the capital requirements imposed on REs need differentiate as between different classes of assets under management.

A risk-weighted approach to assessing capital adequacy is relevant for financial institutions such as banks. Banks essentially enter into contracts with the public whereby they promise to repay a specified nominal sum of money (ie principal plus interest) at some future date. If those institutions cannot meet their nominal commitments they become insolvent and fail. Hence, an appropriate capital "cushion" is critical to their ongoing viability.

Unlike a managed fund, a bank cannot justify a lower return than was promised on a deposit, or less than full repayment of principal, on the grounds that market conditions proved unfavourable.

Managed investment products, on the other hand, offer returns based on the actual earnings of a specified pool of assets. Those assets are managed on a "best endeavours" basis, and a fund may produce a negative return without failing.

In a managed funds regime with adequate investor protection, there should be little investor concern with the solvency of the fund manager, because scheme assets should be held separately on trust by an independent custodian. (In this way, the Barings collapse left investors in the group's managed funds unharmed because the assets were held separately on trust by the Royal Bank of Scotland.)

We submit that the protection investors need is against the fund manager's negligence, fraud or maladministration. This is linked more clearly to the size of funds under management than to the type of scheme.

4. Role of the trustee pre-MIA

Prior to the MIA, where loss was caused by the fund manager's fraud, negligence or making investments in breach of trust deeds, investors had claims against both:

    - the manager; and

- the trustee, where it was negligent or failed to carry out its surveillance role with the requisite level of diligence and vigilance.

Investors had two pools of capital and insurance from which to gain compensation. They are less well placed under the MIA.

The clear evidence that the trustees had liability is that, in cases such as Estate Mortgage, Aust-Wide and Rural Property Trust, the very substantial amounts recovered by investors (between 60 - 80%) came mostly from the trustees and their insurers.

It is also clear that fund managers were liable in those cases, but few had assets to meet compensation claims by investors. In those circumstances, it provided little comfort to investors that some fund managers were jailed, while some went bankrupt.

Further, it should be noted that where scheme failure occurred, aggrieved parties had no difficulty pursuing multiple defendants (managers, directors, auditors, trustees, valuers, advisors and anyone else possibly liable). The fact that the Australian legal process takes time does not of itself reflect ambiguity as to liability for fraud or negligence.

If the trustee role were restored, negligence or fraud by a scheme operator would indeed lead to a clear claim against the trustee where lack of diligence and vigilance was established. In this situation, the trustee would again be the "entity of substance".

However, our submission does not argue for restoration of the pre-MIA regulatory framework, although we believe it had many advantages over the MIA regime in terms of investor protection. Rather, our proposal seeks to improve upon the MIA.

5. Clarity of roles and liabilities

Under the Association's proposed amendments to the MIA, the respective roles and liabilities of the various parties involved in the operation and oversight of schemes would be made clear:

(a) The RE would remain liable for all its misdemeanors, and those of its agents. It would be solely responsible for the prudence of investments.

(b) The independent custodian would have clear responsibilities to:

      - identify and hold scheme assets separately,

- reject instructions from the RE if it has knowledge of fraud, and

- identify and refer to the compliance entity cases of suspected self-dealing by the RE.

    The custodian itself would need to determine how it would check for self-dealing, depending on the particular nature of the scheme and the RE. One option might be to refer to a list of related parties provided by the RE to the custodian and to the compliance entity. It might also assist the fund manager to focus on its obligations if it were required to supplement each custody instruction with an explicit statement that the transaction does not involve self-dealing.

      We propose that the custodian would be liable if it failed to exercise reasonable diligence in performing those duties. The absence of a statutory liability under the MIA contributes to the inadequacy of the present investor protection regime.

      Thus, we are not suggesting a "bare" custodian. Rather, we are proposing codification of existing common law that deems any custodian to be a trustee, with trustee responsibilities and duties beyond the mere holding of assets and the blind following of instructions.

      The independence of the custodian would also have the benefit of providing bankuptcy remoteness in the situation where the RE collapsed.

(c) The proposed role for the independent compliance entity, to be licensed by ASIC, is not to take on the responsibilities of the RE, but to:

- monitor the adequacy of the compliance plan,

- monitor the RE's performance in relation to its obligations under the Constitution and the Act by assessing its compliance with the compliance plan,

- report periodically, say quarterly, to the RE, and as necessary, but at least annually, to ASIC and investors on the RE's compliance procedures and the conduct of the scheme, and

- act as the investors' representative in pursuing remedies against the RE, its directors and agents should it become aware of fraud, negligence or maladministration on their part.

      The compliance entity would need to determine the frequency and type of compliance checking appropriate for the particular fund and the particular RE, in light of all relevant circumstances.

      Again, the compliance entity would be liable if it failed to carry out its assigned duties diligently.

      We submit that these arrangements would eliminate the need for "external" directors or a Compliance Committee, and a compliance plan auditor.

      These proposed arrangements differ from those under the previous regime in several ways:

    - formerly, the trustee acted as custodian,

    - under the old regime, the trustee was obliged to undertake transaction-by-transaction vetting of fund manager investment decisions for compliance with the prospectus and the trust deed,

    - the pre-MIA regime also placed on the trustee responsibility to prevent imprudent investment decisions by the fund manager. Because imprudence is a matter for judgement, this on occasion led to disputes which needed to be adjudicated by the Court , and

    - formerly, statutory trustee corporations were responsible for compliance and custody functions for the great majority of funds invested. Under our proposal, we believe that far more parties would be involved in a very substantial way, including accounting firms, custodians, and the compliance and custody arms of major fund managers.

We submit that it would be viable for the same appropriately qualified entity to undertake both the custody and compliance roles for a scheme. However, this would not provide as much independence as having two separate parties, independent of the RE, responsible for those functions.

6. Prudential supervision and the MIA

We are not suggesting that the MIA regime should be one of prudential regulation.

Under the Wallis framework, APRA is the financial system's prudential regulator. Its role is to protect the interests of depositors, policyholders and investors with certain groups of financial institutions. It does this by promoting prudent risk management by those supervised entities in order to minimise the possibility that they will become insolvent. Managed investment schemes do not fall within APRA's area of responsibility.

Our proposal is not designed to protect investors in managed funds against disappointing returns, or possible falls in absolute value, due to market developments. Nor is it designed to prevent the RE collapsing because of poor business decisions.

Rather, the amended framework we have suggested, which would continue to be administered by ASIC in terms of the role assigned to it under the Wallis model, aims to better protect scheme assets from the consequence of fraud, negligence and maladministration.  

7. Relevance of the HIH collapse and superannuation fund losses

The Association submits that the HIH failure and the observed problems in the supervision of the superannuation industry demonstrate weaknesses in the regulatory framework that apply to the managed investments area just as much as to the insurance and superannuation industries.

These weaknesses include:

    - the difficulty of predicting failures,

- the fact that size and purportedly excellent systems provide no guarantee against failure (the NAB HomeSide debacle is another example of these points),

- a board of senior experts provides no guarantee that a business will be properly and honestly run (the OneTel debacle is another recent example of this),

- it is dangerous to rely on self-monitoring by an industry, coupled with well-after-the-event monitoring by regulators, and

- regulators have some inherent weaknesses and constraints in that they:

• are inadequately resourced, and cannot quickly obtain additional resources in response to market need,

        • generally lack commercial experience,

• have restricted delegations of authority, which limit areas that they can cover,

    For example, in the case of Commercial Nominees, neither APRA nor ASIC had formal responsibility for the "excluded offer" investments that were misleading to investors, with disastrous consequences. A corporate compliance entity with its own capital and commercial reputation at risk would not have felt constrained from acting to prevent investment of superannuants' funds in a "cash management" trust whose main assets were mushroom farms, and

• have due process constraints, that limit the speed with which they can act,

    For example, market participants were selecting higher-cost alternatives to HIH well before APRA indicated concern, and APRA was criticised by the Senate Select Committee on Superannuation and Financial Services for moving too slowly to prevent, or at least minimise, the losses suffered by EPAS and Commercial Nominees.

Experience demonstrates that the failure of supervised entities results in calls on the Government for compensation.

It should also be noted that the MIA was intended to bring the regulatory structure for managed funds into harmony with that for superannuation. In fact, the regulatory regime for superannuation under SIS is considerably stronger than for managed funds (see initial submission), yet this has not prevented failure.

Further, APRA has noted that the greatest risk of loss in the superannuation area lies in those 3,000 or so employer-sponsored funds that are allowed to operate without an approved corporate trustee. Those funds are generally managed by individual employee/employer representatives.

Under the MIA, the compliance committee can only be composed of individuals. The Association submits that individuals cannot bring to bear the skills or independence of a specialist corporate compliance entity, nor the capital and insurance in the event of a problem.

8. Examples of financial loss incurred by REs

The association can provide details of many, many examples of fraud, negligence and maladministration by fund managers that trustees picked up under the former regime. Without the trustee, these incidents would have resulted in losses to investors, of which they might have been unaware - indeed, in most cases they were unaware of the rectification forced on the fund manager by the trustee.

There seems to be no reason to expect that the introduction of the MIA would have eliminated the potential for such inappropriate activity by fund managers. Indeed, ASIC's surveillance reports reveal an appalling degree of compliance failure, even though ASIC would not have had the resources to undertake the thorough compliance checking that was previously done by the trustee.

We acknowledged in our initial submission that, to date, there have not been enormous RE losses of the scale of, for example, HIH. However, we submit that this is not a reason to be relaxed - there were no large-scale insurance losses before HIH - as the fundamental structural flaws remain.

It is also important to remember that the recent long-running boom would have tended to mitigate against losses, which generally become more prevalent during downturns.

Nevertheless, we understand that many thousands of investors have lost tens of millions of dollars in managed funds such as the Cardinal and the Triscott schemes, and that some of the problem mortgage investment schemes (involving losses in aggregate of hundreds of millions of dollars) were operated by REs under the MIA.

ASIC, of course, will have a much greater knowledge of those failures than the Association.

9. Investor rights versus shareholder rights

The Association does not believe that seeking to align the rights of investors in a managed investment scheme with those of shareholders in a company would address the concerns we have with the MIA.

As regards the possible merits of managed investment schemes being required to hold Annual General Meetings, we note that, as a general rule, managed fund investors do not feel as "proprietorial" as do shareholders in companies.

Where an RE is properly managing a scheme, we believe that an AGM would seem an unnecessary expense.

Where an RE is not properly managing a scheme, we do not see an AGM as overcoming the practical obstacles that the MIA places in the way of investors exercising their rights:

      - investors might not be aware of the mismanagement,

- even if an individual investor (or group of investors) becomes aware of mismanagement, it would have to use its own resources to advise other members of the situation, and

- investors could not effect a change of RE at a meeting without more than 50% of the votes of all members, a very difficult threshold for a single investor or a group of investors to arrange.

We believe an independent compliance entity that monitored the operation of each scheme would be a more effective way of improving investor rights. It would:

- increase the likelihood of mismanagement being detected,

- increase the likelihood of the RE rectifying mismanagement rather than letting it stand,

- enable investor rights to be pursued from scheme funds, and

- allow for professional coordination of any action required against the RE.

*****

1 We note that the Law Council's submission suggests that other parties may be pursued under Section 1325 of the Corporations Law. We believe this should be clarified. Regardless, we believe that investor rights would be greatly strengthened with an independent compliance entity acting as investor champion.


Third Submission:
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Trustee Corporations Association of Australia
Third Submission to the Review of the Managed Investments Act 1998

October 2001

THIRD SUBMISSION TO THE MIA REVIEW

Association Responses to Comments Made in Other Submissions

This third submission to the Review of the Managed Investments Act 1998 (MIA) offers responses to various statements in other submissions which the Trustee Corporations Association of Australia (the "Association") believes are ambiguous or potentially misleading, or otherwise warrant comment.

The Association sees it as very important that these matters be clarified. We believe that one of the reasons Australia has a managed investments regime that has been rejected everywhere else in the world as providing inadequate investor protection, is that misleading information was presented by supporters of the Managed Investments Bill when it was being debated.

For example, supporters of the MIA falsely claimed that the proposed new regulatory regime would have the desirable qualities of:

- adequate investor protection,

- consistency with international best practice,

- similarity to the US system,

- support from the Wallis Report,

- harmonisation with the superannuation regime, which (supposedly) had proven to be robust, and

    - reduced costs, and lower charges to investors.

We submit that all of these attractive-sounding claims are demonstrably false.

The Association's responses to a number of statements in other submissions to the current Review are set out below. They are grouped according to the Review's Terms of Reference.

1. Whether the arrangements have delivered benefits in terms of:

(a) ....better protection of investors' interests

IFSA:

"Notwithstanding claims that trustee companies, as external compliance entities, undertook active and `real time' monitoring of managers, most IFSA member companies have always maintained, and now re-confirm, that little meaningful compliance monitoring occurred under the dual entity regime."

"Individual trustee companies often `administered' many hundreds of trust deeds and could not, realistically, be expected to provide genuine `day-to-day' supervision."

"As external compliance entities, removed from the business and its operational imperatives, trustees did not have the capability to assess the merits of asset allocation or transaction decisions taken by increasingly well-resourced, sophisticated and fast growing fund managers."

Response:

Those charged with honestly investing billions of dollars of other people's money claim that they should be allowed to monitor themselves, because of the inability of an independent, external monitor to provide `genuine day-to-day supervision.' We submit that the facts show otherwise.

The Association can provide details of many, many instances of `meaningful compliance monitoring' by trustees under the pre-MIA regime that picked up fraud and negligence by fund managers, large and small, thereby resulting in direct savings for investors.

Some examples include:

- a manager bought a property, then floated a unit trust in order to sell the property into it, and submitted claims for $7 million for work done in the short period that it had owned the property. The trustee found that over $750,000 constituted illegitimate claims, including accounts for work done on other properties and penalties for late payment of payroll tax.

- a manager sought to purchase for a trust a block of land adjacent to an existing trust-owned property. The trustee rejected the proposal after discovering that the manager had previously declined an offer to buy the property, but was now proposing to buy it, at a price some 30% higher, from one of the manager's executives who had recently exchanged contracts on the property.

- a fund manager proposed acquiring shares in a company which had recently made an unsuccessful share issue. Because the manager was also an underwriter of the stock issue, the trustee declined to authorise the purchase of the shares until the full impact of the underwriting shortfall had been absorbed by the market. As a result, the fund bought the shares later at a much lower price.

- a trustee, on discovering faulty methodology for unit pricing, commissioned a review by auditors and then required the manager to make good any losses to investors after fixing the pricing system.

- a manager submitted expense claims which, on review, were found to include golf club memberships, airfares for executives' wives to attend weekend conferences, and flowers for the chairman's wife. The trustee rejected those claims.

- a trustee company blocked a proposal by the manager to amend the trust deed in a way which exempted the manager from liability for losses caused "through its own negligence".

The Association understands that this type of "intervention" by trustees, which represented very valuable compliance monitoring that protected the interests of investors, would be galling to the fund managers.

As regards IFSA's comments on the matter of asset allocation, the trustees argued during the Managed Investments Bill debate that they were never responsible for this area of a scheme's operation. However, in the face of large losses caused by fund managers with negligible financial underpinning, the Courts ruled that trustees should accept liability for such losses, even if the investments were completely within the prospectus guidelines.

The refinements to the MIA proposed by the Association seek to ensure that the RE alone is clearly responsible, and accountable to investors, for the prudence of particular investments or investment strategies within the parameters of the scheme's constitution.

Australian Consumers' Association:

"From our perspective, the trustee structure generally appeared to offer little additional benefit to consumers. ...... ACA was not convinced that the dual responsibility provided additional security for investors."

Response:

It is true that trustees did not previously publicise the many instances of fraud, negligence and maladministration that they identified and caused to be rectified. This is similar to auditors not publicising errors that they have found and had corrected.

Thus, even though the ACA may not have been aware of the protection provided by trustees, it was real.

Commonwealth Bank:

"Having a single responsible entity has provided certainty for investors. This certainty provides a clear benefit to investors over the previous dual manager-trustee structure."

Response:

The Association submits that certainty as to the liability of scheme operators provides a benefit that is illusory and trivial. The MIA in no way provides greater protection for investors:

- the absence of an independent compliance monitor increases the probability of loss caused by fraud, negligence or maladministration,

- the responsible entity lacks substance in terms of having adequate capital and insurance to compensate investors in the event of losses, and

- the substantial resources of the trustee are no longer available.

CBA:

"ASIC has significant powers under the MIA to, among other things, revoke licences, enter into enforceable undertakings, modify compliance plans and issue stop orders in relation to prospectuses. This has enhanced the protection of investors and has allowed ASIC to move quickly to address areas where investors' interests may be compromised."

Response:

The Association submits that experience has demonstrated that
"well-after-the-event" checking and enforcement actions by the regulator do not provide greater protection to investors than more timely monitoring by an independent, specialist corporate compliance entity. Examples include HIH, Commercial Nominees, EPAS etc.

CBA:

"ASIC's requirement for minimum net tangible assets has resulted in substantial responsible entities and custodians."

Response:

The Association suggests that the NTA requirements under the MIA (maximum required $5 million, even for schemes where many billions of dollars of other people's money is at risk) do not equate with "substantial" REs and custodians.

Australian Securities and Investments Commission:

"The systems of data collection available to ASIC .........do not enable meaningful comparisons of the relative effectiveness of the old and new law. However, analysis suggests that features of the new law and its administration, including:

    - more rigorous licensing criteria

    - more rigorous licence assessment

    - broader compliance obligations, and

    - increased surveillance

may assist the early identification and rectification of problems, and may be more effective in the protection of investors' investments." (Emphasis added.)

Response:

The Association acknowledges the more rigorous licensing arrangements, and broader compliance obligations, for managed funds under the MIA, compared with the previous regime.

However, we submit that "well-after-the-event" surveillance by a resource-stretched regulator, which is a demonstrated feature of the new system, is less likely to result in early identification and resolution of problems than more timely monitoring by a specialist compliance entity with its own capital and reputation at risk.

At a minimum, adding an independent compliance monitor to plug the current investor protection gap, can only be of benefit.

ASIC:

"Neither the old law nor the new law puts in place any statutory safety net for guaranteeing or protecting investments whether lost through investment risk or compliance and institutional risk. In two respects, however, the new law does put in place mechanisms that were not required under the old law.

Firstly, as a condition of obtaining a licence ASIC requires responsible entities to maintain appropriate indemnity insurance and insurance against fraud of officers and agents."

Response:

The Association submits that this statement is misleading. It is relevant to note that, apart from being obliged to meet minimum capital requirements under the relevant State legislation, statutory trustee companies have traditionally maintained very high levels of insurance.

The practical benefit of this was demonstrated in the Estate Mortgage and Aust-Wide cases where investor compensation was provided solely through the trustees' insurance - the fund managers provided nothing.

The insurance requirements under the MIA (maximum cover required $5 million) are, by comparison, clearly inadequate.

ASIC:

The new law also imposes a simplified mechanism for ensuring that if an operator fails the scheme can be transferred to a new operator."

Response:

The Association agrees that the process for transferring a scheme to a new operator has been simplified. However, we see this change as offering only a minor benefit, and submit that it will provide cold comfort to investors damaged by a bankrupt operator to find that the process for the operator's removal has been streamlined.

More importantly, in situations where the operator has not yet actually failed, the absence of an independent compliance entity means that it is less likely that investors will receive early alert of potential problems.

Further, even if investors do become aware of an RE's incompetence or negligence, it is still very difficult for them to remove the RE.

(b) ....greater certainty as to the responsibilities, obligations and liability of scheme operators

KPMG:

"We believe that the great majority of Boards of responsible entities are certain of their responsibilities, obligations etc under the legislation. The format of licensing procedures that require financial and operational capabilities to be demonstrated to the regulator's satisfaction has been a key factor in this area."

Response:

The Association submits that ASIC's surveillance activities suggest the opposite - 83% of schemes examined during 2000/01 exhibited compliance breaches.

Moreover, even if awareness of responsibilities is there, this does not necessarily mean that these arrangements are effective in practice and that investors are adequately protected. The conflicts of interest and opportunities for self-dealing are readily apparent.

(c) ....rights of investors in managed investment schemes

Ernst & Young:

"It appears that investors perceive little impact on their rights in relation to unitholdings in managed investment schemes. For most investors the level of awareness of the changes is considered minimal even though the rights of investors have improved under the Managed Investments Act."

ASIC:

"To the extent that investors can obtain remedies through either ASIC action or complaints resolution systems then it would appear, from the investors' perspective, that that is a better outcome than attempting to directly enforce rights provided under the law.

Given the limited use of members' right provisions, it is difficult to come to a view as to whether the MIA has delivered benefits in terms of the rights of investors. However, nothing has come to ASIC's attention which indicates that there is a diminution in the rights of investors under the new law."

Response:

The Association submits that, while the average investor may have perceived little change in their rights following the introduction of the MIA, it is untrue to claim, as E&Y does, that those rights have improved.

Indeed, ASIC's comment that investors attempting to directly enforce their rights under the law is not the best outcome, can be seen as highlighting a structural flaw in the present arrangements - ie the absence of an investors' champion to overcome the "collective action" problem inherent under the MIA.

We suggest that relying on the regulator to address this problem does not adequately protect the interests of investors. This is because:

    - ASIC's surveillance is largely "well-after-the-event",

- the regulator faces due process constraints that limit the speed with which it can act,

- ASIC's ability to take action depends very much on its own funding position, which it admits is stretched,

- the regulator's own litigation priorities may not be the same as those of the investors, and they may change over time, including due to the influence of political considerations, and

- investors have no right of recourse against ASIC if it acts too late and scheme assets are gone.

Law Council:

    The Council recommends that section 601MA of the MIA be repealed on the basis that "it appears to be completely subsumed by section 1325." The Council notes that 601MA "does not provide a single gateway for claims for breach of Chapter 5" and that "it appears section 1325 creates rights in the members of a registered scheme to bring action for breach of Chapter5C by persons other than the RE itself (including directors, compliance committee members and others)."

Response:

    The Association agrees that this issue needs to be clarified. An alternative view is that action against the RE under section 601MA is necessary before the apparently wider reach of section1325 is able to be activated against others who were involved in the contravention by the RE. It is arguable that section 1325 could not be used to initiate an action against the RE for breach of Chapter 5 but is only available for "accessory" actions.

In any case, we submit that the legal right to pursue those responsible for losses needs to supplemented by a practical way for investors to do so. We believe that this is best achieved by an independent compliance entity acting as the representative of investors and being capable of pursuing all available courses of action.

(d) ....reducing the costs of investing in managed investment schemes

IFSA:

"The emphasis that was placed on costs during the period prior to introduction and passage of MIA was quite inappropriate, deliberately diverting attention from far more important issues. Estimates publicised at that time were unverifiable and speculative."

Response:

It is interesting that IFSA did not attach such a qualification to its 1998 submission, which included estimated industry cost savings of $30 million per annum based on a survey of fund managers conducted by Price Waterhouse and funded by IFSA.

IFSA:

"MIA has also resulted in cost savings to consumers. Since introduction of MIA on 1 July 1998, there has been an overall decline in the total weighted MER [Management Expense Ratio] of 2% (or 3 basis points). This ......... translates to an annualised cost saving of approximately $26.8 million."

Response:

This statement is misleading. IFSA's assertion is based on a survey undertaken by KPMG covering the 5 year period from 1996 to 2000. It is relevant to note that, of the 350 or so prescribed interest management companies that were registered in February 1998, about half did not switch over to the new MIA regime until the last 6 months of the transition period (ie during Jan-June 2000).

Further, the statement contradicts comments on the survey results by IFSA's CEO, who acknowledged that:

"We tried to get some attribution, with the MER, but it is virtually impossible. There were a variety of drivers that would have driven MERs down such as competition, however, the introduction of GST and the Managed Investments Act drove it back up." (Emphasis added.)

Comments by E&Y support our view that IFSA's submission is misleading, ie:

"While some MERs have decreased, this appears to be due to the creation of economies of scale rather than the reduction in costs of managing the investment schemes."

2. Whether the arrangements have strengthened compliance practices, procedures and awareness amongst responsible entities and others involved in the managed investments industry

IFSA:

"MIA's principal success has been in the way it has encouraged and driven compliance best practice at all levels of management in mainstream managed investment scheme operations."

Paul Dortkamp (Independent Compliance Committee Members Forum):

"It is my belief that MIA has been the catalyst for a huge lift in the standards of compliance related activities in fund managers."

Response:

The Association agrees that awareness of compliance issues has increased in recent years. However, as ASIC's surveillance report clearly demonstrated, awareness does not necessarily translate into generally strengthened compliance practices that will protect investors against fraud, negligence and maladministration by fund operators.

3. Whether the arrangements cater for the diversity of managed investments, including consideration of the way in which the legislation is administered by ASIC

The Association agrees with comments in other submissions that the MIA caters for a diversity of schemes.

However, we believe that our proposed refinements, in terms of introducing independent, well-capitalised and well-insured custodians and compliance entities, would better cater for smaller, lesser-known fund managers by generating greater investor confidence in those operators.

4. What refinements might be made to the MIA?

IFSA:

    "It should be made absolutely clear that the custodian is not liable to investors when acting on instructions from the RE" and "is not bound to inform itself of the terms of the scheme constitution, compliance plan or offer documents."

    Response:

    Our view is that this would further weaken already-inadequate investor protection, and drive Australia's managed investments framework even further from world best practice.

    The Association's proposal is to enhance investor protection by requiring the custodian to deal with scheme assets as directed by the RE, except where it reasonably believes that the RE's instructions involve self-dealing in contravention of Part 5C-7 of the Act, or it has knowledge of fraud.

    We agree that the custodian should not be bound to inform itself of the terms of the constitution, compliance plan or offer documents. The compliance entity under the Association's proposal would, of course, need to do so.

IFSA:

    The MIA should be amended "to modify the liability of the RE for losses caused to the scheme by the default of an agent where the RE can show that it has taken reasonable care and diligence in selecting the agent and monitoring it in the performance of its duties.

Response:

    This approach would also further weaken investor protection. In addition, it would introduce confusion as to the extent and scope of liabilities, and effectively replace the Single Responsible Entity concept with a "Reasonable-Care-but-Limited-Responsibility Entity" regime.

    One might ask why IFSA or any self-respecting RE would advocate reduced liability for the RE - is this indirect acknowledgement of the likelihood of problems down the track for managed funds? This "limited responsibility" stance is consistent with the present thin capitalisation and insurance requirements for REs.

    Our view is that investor protection warrants retaining the provision that the RE is liable for the actions (and inactions) of its agents, although it may seek to be indemnified by an agent.

    IFSA:

    Compliance plan provisions should be modified to require "regular checking only in those areas where consumers are at significant risk eg fees, unit price calculations, custody, compliance with investment mandates."

Response:

    The Association submits that this proposal should not be endorsed by the Review as it would have the potential to further weaken investor protection. We believe that the compliance plan should encompass all aspects of the Law.

    Our view appears to be supported by the Senate Select Committee on Superannuation and Financial Services, which has recommended that superannuation fund auditors be required to report to APRA, as well as to the fund's trustee, any breach of compliance with SIS or suspicion of a fund's unsatisfactory financial position.

IFSA:

    "Section 601FC(1) could be amended to allow for the RE to be changed to another company in the same group without member consent (section 601FK already provides that a company cannot be the SRE unless it complies with section 601FA ie it is a public company and holds a licence to operate a registered scheme). A change of RE operating a fund need not be any different to a change in key personnel within the same RE operating the fund, or the sale of the shareholding in the RE itself. The critical issue is investment style and a different company operating the scheme might acquire the investment personnel from the former RE and even if it does not, the new RE might nevertheless continue the same investment style."

Response:

    This suggestion highlights the lack of power that investors have over the way their funds are managed. An independent compliance entity would ensure that any change in the RE maintained the level of management expertise that investors were entitled to expect.

IFSA:

    Section 601JB(2) should be modified so that a person only fails to qualify as an external compliance committee member if they have had substantial business dealings with the RE or a related body corporate "...which a reasonable person would expect to influence the member in the performance of their duties."

Response:

    The Association believes that such an amendment would further weaken the already-inadequate independence of "external" Compliance Committee members. The Act now requires a judgement as to what constitutes "substantial" business dealings.

    IFSA's proposed amendment would involve a further difficult judgement about a prospective committee member - namely, would a reasonable person expect that particular individual to be influenced by his or her dealings with the RE or a related entity. Rejecting a prospective member on the basis that they would not be impartial could be construed as casting aspersions on their character.

    Such an amendment would therefore run the risk of opening compliance committee membership to all comers.

    We believe that true independence should be introduced by replacing external directors/Compliance Committee members with a genuinely independent, unrelated corporate compliance entity.

*****

 

 

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