2011 Funds Planner - Top 10 issues

The Australian funds industry is in for a busy 2011. This includes implementing numerous regulatory changes. This alert aims to assist fund managers to plan for 2011. Our top 10 issues to focus on are:

• Regulatory capital - the amount of regulatory capital held by responsible entities and APRA regulated entities may need to increase;

• Wholesale / retail test - consider whether wholesale funds may need to be converted to retail;

• Remuneration structures - change your fund and platform remuneration structures in anticipation of the legislative changes to conflicted remuneration;

• Take advantage of recent tax changes - ensure you take advantage of recent tax changes;

• Constitutions and deeds - amend fund constitutions for changes to tax legislation and recent tax and other cases;

• Product Disclosure Statements and due diligence - update PDSs and due diligence procedures;

• Other fund documents - review indemnities and guarantees and negotiate changes to agreements for the new Personal Property Securities regime;

• Foreign funds - prepare for more foreign funds being available to Australian investors;

• Offshore strategies - review offshore strategies and the existing foreign investor base; and

• Next steps - participate in the debate of the future reforms.

The level of capital that financial institutions will be required to maintain seems likely to increase in both Australia and elsewhere. The low level of capital held leading up to the GFC has been criticised. For example, the report of the Financial Crisis Inquiry Commission concluded that as at 2007, five major investment banks were operating with “extraordinarily thin capital”.

For responsible entities, the Australian Securities and Investments Commission (“ASIC”) proposes that one of the following two options be adopted as the method for calculating the amount of net tangible assets that a responsible entity is required to hold:

• the greater of $150,000; 0.5% of the average value of scheme property (capped at $5 million); and 10% of its average gross revenue (with no maximum); or

• 10% of its average gross revenue, with a minimum of $500,000 and no maximum.

A new ASIC Regulatory Guide is expected to be released in March 2011 and to have a start date of 1 July 2011 for new responsible entities.

Superannuation trustees and other APRA regulated entities should also expect to have to increase their regulatory capital. In response to the Cooper review, the Government has indicated that it accepts that capital adequacy requirements for superannuation trustees need to change. The Government has indicated that it will consult on the form and calculation of the required capital. In the meantime, trustees that are part of a financial services conglomerate group should take steps to follow the Government's further consultation on capital adequacy requirements for prudentially regulated conglomerate groups.

2. Consider whether wholesale funds need to be converted to retail

Wholesale funds that accept non-institutional investors should be prepared for the possibility of the definition of “wholesale client” being tightened. For more information on the Government’s options paper on the reform of the retail/wholesale client distinction in the Corporations Act, see our previous publication.

A tightening of the wholesale client definition would reduce the universe of investors eligible to invest in wholesale funds and other products. Wholesale fund operators might need to consider converting funds to retail, which would include steps such as registering the fund as a managed investment scheme and preparing a PDS.

3. Change commission structures and platform fees

Managers are already redesigning the commissions provided by funds in anticipation of the 1 July 2012 prospective ban on conflicted remuneration structures. You should:

• review fee and commission structures in light of the Government’s response to the Parliamentary Joint Committee on Corporations and Financial Services’ Inquiry into financial products and services in Australia (see our previous publication); and

• watch UK developments arising from the UK FSA investigation into platform suitability, advice through platforms and disclosure practices.

4. Take advantage of recent tax changes

This year, we are expecting a number of proposed amendments to the tax laws to be enacted, and for further details regarding measures that have been announced to become available. Managers should be aware of these developments so they can identify and utilise opportunities as they arise on a timely basis and to gain competitive advantage.

In particular:

• the new MIT withholding regime — may create opportunities for new collective investment structures that invest in property. Managers should seek to ensure their property investment structures are “MIT compliant”;

• the new MIT attribution regime — managers should review what new opportunities may arise under the new regime; for example, what types of new multi-class structures can be implemented;

• the constituent documents, structure and ownership of any current or intended structures should be reviewed to ensure that they can obtain the benefit of these changes. The administration systems will need to be reviewed to ensure they can support the process required under the new regime;

• the repeal of the foreign investment fund (“FIF”) rules, the new “foreign accumulation fund” rules expected as early as this month and the amendments to the controlled foreign company (“CFC”) rules — managers should identify what types of foreign products that they can now offer to the Australian market;

• proposed new exemptions for foreign managed funds and the investment manager regime (“IMR”) from the 2010 / 2011 income year — managers may wish to examine the appointment of Australian managers to manage portfolios for foreign funds; and

• the proposed new collective investment vehicle regime — may create opportunities for new collective investment structures that may be more palatable to foreign investors and may have less Australian tax risk and exposure.

5. Update product disclosure statements and due diligence procedures

Most funds offered to retail clients will need to replace existing product disclosure statements with short form PDSs from 22 June 2011. Not only will PDSs be significantly different, information to be incorporated by reference will need to be prepared and issuers should update their due diligence and verification procedures accordingly. For further details, see Mallesons’ publication entitled “Final shorter PDS Regulations released” dated June 2010.

Short form PDSs apply only to “simple managed investment schemes”, superannuation products and margin lending facilities. A determination must be made as to whether each fund is simple or not. This is not a straightforward exercise for some funds.

Even for non-simple schemes, PDSs should be reviewed to take into account:

• changes to commission structures (see 3 above);
• constitutional amendments (see 6 below);
• recent tax changes, including the new managed investment trust (MIT) rules (see Mallesons’ alert entitled “New MIT tax rules” dated 18 October 2010);
• unfair contracts legislation (see Mallesons’ publication “Reshaping the Australian funds industry” dated April 2010);
• proposed privacy changes - the Government has announced that changes will be made to the Privacy Act in response to the review undertaken by the Australian Law Reform Commission in 2008. While we anticipate that PDSs and due diligence procedures won’t necessarily need to be changed to deal with the proposed privacy changes (which are a little unclear at this stage), amendments may be required to respond to any changes to the Fund entity’s anti-money laundering controls (designed to take advantage of better electronic verification options following changes to the AML laws that are expected to become effective this year); and
• for capital protected products and retail structured or derivative products, ASIC’s expectations as set in ASIC Report 201.

6. Amend fund constitutions and trust deeds

Fund constitutions and trust deeds should be reviewed as soon as possible and amended where appropriate to take into account:

• the Federal Court's decision in Colonial on the tax treatment of the unit trust in terms of allocation of income (see our previous publication);
• if not already addressed, ensure they adequately cover the timing of issue and redemption of units. Constitutions of existing funds may need to be adjusted in light of the guidance in the Basis Capital decision to be sure they have the intended effect and operate consistently with existing systems offer documents (see Mallesons’ publications entitled "Warning: Period for holding application money" and "Issue and redemption of units in managed funds" dated); and
• the new managed investment trust regime - for example, whether a trustee has the power to make the “election for capital treatment” and whether the trustee has the requisite powers to determine and allocate taxable income under the proposed managed investment trust attribution regime.

Where constitutions are to be amended, the possible requirement for a meeting and resettlement risks should be considered.

7. Update other fund related documents

In addition to the regulatory capital issue raised in 1 above, ASIC Consultation Paper 140 also indicates that ASIC is considering prohibiting responsible entities from providing certain guarantees and indemnities (such as guarantees in their capacity as responsible entity of a scheme). Responsible entities will need to review guarantees and indemnities once ASIC releases the new Regulatory Guide (which is anticipated to occur in March 2011).

Expect counterparties to amend documents under which the fund trustee or responsible entity gives a security interest that will be subject to the Personal Property Securities (“PPS”) reform. The PPS Act and PPS Register are now anticipated to come into effect in October 2011. In addition to charges and mortgages, other agreements may include prime brokerage agreements, custody agreements, nominee agreements, and sponsorship agreements.

At this stage, we consider that it will not be necessary to amend other fund documents during the course of 2011 to deal with the proposed privacy changes (although we anticipate that this is likely to be a project for 2012).

8. Prepare for more offshore funds being offered to Australian investors

We expect to see more foreign funds offered to Australian residents by mid 2011 for two reasons:

• the previous Australian tax obstacles to offering foreign funds to Australian investors may no longer exist due to the repeal of the current FIF regime and reforms to the CFC rules (see Mallesons’ publication “Reshaping the Australian funds industry” dated April 2010). It will, however, be important to monitor these developments. In particular, the application of the future “foreign accumulation fund” rules;
• as more US managers register as investment advisers with the SEC, more US managers will be able to manage Australian capital via the passport relief structure (see our previous publication).

If you have access to foreign funds that are not currently offered in Australia, you might wish to re-consider offering them in Australia.

9. Comply with stricter regulation of offshore capital raisings

Managers should review their offshore strategies and their existing foreign investor base.

It will be more difficult to raise capital in some offshore countries.

• US - It is more likely that Australian managers wanting to access US capital will need to register as investment advisers with the SEC (see Mallesons’ publications “What’s over the horizon for Fund managers” and “Dodd-Frank on funds - negatives and positives for Australian and other managers”). The effective date of adviser registration and the associated additional reporting, record-keeping and other requirements is 21 July 2011;
• European Union (“EU”) - The Alternative Investment Fund Managers (“AIFM”) Directive is expected to enter into force in early 2011. The Directive aims to establish a comprehensive and effective regulatory and supervisory framework for AIFMs in the EU. EU Member States will then have two years to transpose the Directive into their national laws. A key aspect of the Directive is its treatment of non-EU AIFMs in relation to products and distribution within the EU (i.e. what they can sell and who they can sell it to). There is a temporary reprieve for non-EU AIFMs using existing private placement rules until the EU ‘passport regime’ comes into force (see our previous publication).

Fundraising might also be easier and more attractive in some other countries. For example, since January 2011 foreign private equity investors are able to form limited partnership Renminbi funds, and qualified foreign limited partners are able to invest with RMB converted from foreign currency. For further details see our previous publication.

10. Be part of the debate of future changes

“You deserve the government you get” - this quote has been attributed to various people, including Joseph de Maistre and Thomas Jefferson.

We encourage you to participate in the debate regarding further reforms that could reshape your industry. Future reforms that are currently in the ‘consultation / debate’ stage, and that have the potential to significantly affect the funds industry, are set out below:

The authors wish to acknowledge the contributions made to this alert by John Malon, Andrew Clements, Michael Mathieson, James Moore, Hal Bolitho, Glenda Hanson, Will McCosker and John Sullivan.