Who does this affect?

Responsible entities, trustees and other fund administrators

What do you need to do?

Review constitutions and offer documents, and procedures for dealing with application money and assessing liquidity, in light of the decision in Basis Capital

Authors
Barry McWilliams  
Partner

Glenda Hanson  
Special Counsel

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Barry McWilliams  
Partner
T +61 2 9296 2252

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Jim Boynton  
Partner
T +61 2 9296 2086

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Melbourne
John Malon  

Canberra
Stephen Jaggers  

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The decision in Basis Capital Funds Management Ltd v BT Portfolio Services Ltd [2008] NSWSC 766 has provided the first judicial guidance on several aspects of the operation of managed funds. The judgment highlights the importance of having clear constitutional provisions as to when units are issued and redeemed. This timing is critical in determining the status of investors and the duties of the responsible entity.

While managed investment scheme constitutions commonly deal in detail with the time for calculation of unit prices they may not adequately cover the timing of issue and redemption of units. This may increase the risk of breach of application money rules and other duties.

What were the key points arising from the Basis Capital case?

• Application money must be returned if the interests in the fund as described in the product disclosure statement (PDS) are not issued within a month, and there can be no general extension. This was noted in our earlier alert.
• Units are not normally “issued” automatically - the responsible entity (RE) must do something to effect the issue.
• Where there is a right to redeem, redemption can occur when the holder has done everything necessary on their part to exercise the right.
• Assets are “liquid” for Corporations Act purposes when they are “marketable securities” (as defined) which can be realised at any price within the redemption period, not just at their normal market value.
• The drafting in the scheme’s constitution to deal with these issues is crucial, and the product disclosure statement also influences the outcome.

What should responsible entities do?

Review constitutions and product disclosure statements

Constitutions for existing funds may need to be adjusted in light of the guidance in the Basis Capital decision to ensure they have the intended effect, and operate consistently with the RE’s existing systems and product disclosure statements. The possible need for investor meetings and resettlement concerns should be considered in deciding whether or how to make changes.

Responsible entities should ensure that their documentation is clear about the time when units are issued and a person becomes a member of the scheme, and the time when they are redeemed and the person ceases to be a member. The reasons why this matters include the following:

• For applications, if the constitution provides that units are issued at the time of entry in the register, the applicant becomes a “member” of the scheme and their application money (less any up front fees) becomes an asset of the trust established under the constitution only at that time.
• It is important to know when the application money becomes property of the trust, because it can then be invested for the purposes of the scheme. At this point the money normally moves from the applications account to an operations account in the name of the custodian (or the RE if there is no custodian). The time when the money becomes trust property is relevant to the application of GST to fees.
• A lack of clarity about when units are issued could lead to breaches of the application money rules in section 1017E of the Corporations Act:

• At the time units are redeemed, the former holder ceases to be a member of the scheme and becomes a creditor of the scheme for the redemption price.

The Basis Capital decision indicates that the terms of the constitution and what the RE does in response to the application or redemption request can vary the timing of issue and redemption. For funds that price frequently, a form of constitution which allows for the issue of units to occur at a time before entry in the register may be helpful. For hedge funds and other issuers who experience delays in receiving valuation information, the issue of an “interim” financial product should be considered.

Austin J referred extensively to the Basis product disclosure statements to interpret the constitution and define investors’ entitlements, so the PDS and constitution should be considered together.

Review application money procedures

Where a one month period for an offer of financial products is insufficient, issuers should consider other strategies, such as issuing in tranches through the offer period or making greater use of broker firm or similar arrangements.

Review procedures to assess liquidity and suspension powers

Responsible entities should have and monitor procedures for determining when their funds are “liquid”. It is important to remember that inflows for new investments which are sufficient to fund redemptions do not necessarily mean the fund is liquid. The test is whether at least 80% of the fund’s assets are liquid assets, and market conditions for realisation of assets are critical in classifying the assets as liquid or not. The drafting of constitution powers concerning suspension of redemptions or deferral of payment should also be reviewed in light of the way the Court interpreted the relevant provisions in the Basis Capital case.

What about wholesale and superannuation funds?

While some of the lessons from Basis Capital apply only to registered managed investment schemes, the principles relating to applications and redemptions set out in Austin J’s judgment are applicable to unit trusts generally, including wholesale and superannuation funds. The application money rules are relevant to all financial products (except securities) even if the offer is only made to wholesale clients.