A guide to the managed investment scheme disclosure changes

Following the Government's prescription for better managed investment schemes disclosure, Brendan Ivers explains how these changes have affected the industry.

Late last year the Federal Government issued draft regulations for comment that will usher in a new era of disclosure for managed investment schemes (MISs) and superannuation products.

The new disclosure regime is one of the key elements of the government’s ambitious reform agenda for the financial services industry.

The Ripoll Inquiry and the Cooper Review have been the focus of talk about future changes to the financial services industry, but the new disclosure regime represents a significant regulatory change that fund managers and advisers need to be aware of.

While the Federal Government has issued draft regulations for comment for both MISs and superannuation products, this article will focus on the changes for MISs.

The need for change

The great hope of the Financial Services Reform Act (FSRA) was that a single, unified regulatory regime built on licensing and disclosure would produce outcomes to protect investors and provide sufficient flexibility for the industry to innovate and grow. But the reality has been quite different.

The many flaws in the licensing regime and the Australian Securities and Investments Commission’s (ASIC’s) oversight of it have been highlighted by the various collapses of financial services providers, as well as the Storm Financial saga.

Similarly, the idea of a principles-based disclosure regime for financial products has proven to be less than effective.

The idea behind a principles-based disclosure regime is that providing investors with all the relevant information, to allow them to make an informed investment decision, is the most flexible and effective means of regulating financial markets.

The idea is not new. It formed the basis of the Securities Acts in the United States in the early 1930s, and formed the basis of the disclosure regime for securities (eg, shares issued under a prospectus) in Australia.

The problem with the implementation of the principles-based idea in the FSRA reforms was that:

• The legislation was overly complex
• ASIC provided little (if any) real guidance on complying with the disclosure requirements; and
• The liability regime was too strict.

The Corporations Act imposes an obligation on the issuer of a financial product to include all “information that might reasonably be expected to have a material influence on the decision, of a reasonable person, as a retail client, whether to acquire the product”.

While the act provides some guidance about the extent to which information is required to be included in a disclosure document, catch-all sections such as these leave it up to product issuers to determine the level of disclosure required to be included.

However, with only limited guidance from ASIC (and with this guidance often consisting of broad principles-based statements lacking any real substance), directors of product issuers have had to look to their lawyers to provide sign-offs on disclosure documents to provide reassurances about omissions and legal liabilities. The result?

Overly complicated and lengthy disclosure documents that investors don’t read.

The Government’s own research has indicated that many investors don’t read disclosure documents, and that a significant proportion of those who do read them still don’t feel very confident about their investment decisions.

The Investment and Financial Services Association has also conducted its own qualitative research in the context of superannuation product disclosure statements (PDSs) on this issue, which revealed that most participants considered PDSs dull and uninviting. This meant PDSs were usually not read in great detail.

With the current regime producing such lacklustre outcomes, the need for a change is broadly recognised by both the Government and the industry.

The Financial Services Working Group

In early 2008, the government established the Financial Services Working Group to look at a raft of issues in the financial services industry.

The working group consists of senior officials from Treasury, ASIC and the Department of Finance and Deregulation.

The working group also receives input from the Consumer Advisory Panel, which consists of industry and consumer representatives.

Since its establishment, the working group has implemented a number of the government’s financial services initiatives, such as disclosure regimes for the First Home Saver Account, margin lending products and the changes to intra-fund superannuation advice.

The working group has also developed the new disclosure regime for superannuation products and MISs.

The proposed regulations — a prescriptive approach

The proposed new disclosure regime will be implemented via the introduction of new regulations to the Corporations Act (Regulations).

The regulations represent a stark departure from the principles-based approach of the current regime. For example, the Regulations prescribe that PDSs must be no longer than six A4 pages — a significant shift from the current regime, which does not prescribe any PDS length.

In addition to prescribing PDS length, the Regulations mandate the content to be included in the PDS. This is achieved by prescribing eight sections for the PDS as well as their content.

The proposed regulations — incorporation by reference

Incorporation by reference is an essential component of the disclosure regime. The regulations introduce a new ‘incorporation by reference’ regime, which will only apply to PDSs caught by the regulations.

The current incorporation by reference regime is cumbersome and uncertain in its practical operation, so the move away from it is a positive step.

The three most significant differences between the incorporation by reference regime introduced by the Regulations and the existing regime are as follows:

• Only matters that are expressly provided for in the Regulations can be incorporated by reference into the new regime, whereas under the current regime any matter can be incorporated by reference into the PDS.
• The Regulations, generally speaking, provide a more workable mechanism for incorporating information by reference.
• Information that is incorporated by reference is deemed to be provided to a retail client when they are given the PDS. This differs from the current regime, which only deems that information incorporated by reference “is taken to be included” in the PDS. The new regime places the onus on the investor to seek out the information that is incorporated by reference, which should help to resolve some of the legal uncertainty that exists for information incorporated by reference under the current regime.

The proposed regulations — other information

Another feature of the new regime is the ability for product issuers to refer to “other information”. Other information is information that is referred to in the PDS, but set out in another document and not incorporated by reference.

The information referred to will not form part of the PDS and therefore not be subject to the PDS liability and enforcement provisions.

However, the information will still be subject to the general liability and enforcement provisions in the act and the ASIC Act, such as the misleading and deceptive conduct provisions.

The proposed regulations — a brief summary

Comparison of the existing regime and the proposed regulations

The differences between the existing regime and the Regulations can best be illustrated by comparing how each regime deals with different disclosure issues. Table 2 sets out a very brief comparison of some key disclosure issues.

The proposed regulations — application

The Regulations do not apply to all MISs. The working group has indicated that the Regulations are only intended to apply to straightforward MISs. Consequently, the Regulations only apply to MISs that invest at least 80 per cent of their assets in “financial assets”.

The term “financial assets” is not defined in the Corporations Act; however, “financial asset” is defined as part of ASIC’s standard licensing conditions.

If a similar definition is used, then the kinds of MISs that will be caught by the Regulations are equities funds, fixed interest funds, property securities funds and most managed funds.

At this stage, the Regulations will not apply to many of the alternative asset funds, such as property funds and agribusiness schemes.

The working group has indicated that it will clarify whether certain types of investments, such as stapled securities, are included or excluded from the requirements of the new regime through the consultation process.

A two-tiered disclosure regime

For MISs not caught by the Regulations, the existing disclosure regime will continue to apply. This will result in a two-tiered disclosure regime: PDSs caught by the Regulations (which can be no more than six A4 pages in length) and PDSs that are not (which can run for up to 100 pages).

While this is probably the right outcome, given the differing complexities of the different MISs, it does raise the potential of creating an uneven playing field.

If a prospective investor is faced with the choice of reading a six-page document or one that is 50-100 pages, they might sway towards the product with the shorter PDS.

Given the government’s desire to reduce the length of disclosure documents, it seems likely that it will continue to investigate ways to improve disclosure to retail investors in all MISs, so the MISs excluded from the Regulation will most likely be targeted in the future.

What will the changes mean for product issuers?

Product issuers who have to comply with the new Regulations will find themselves operating in a far more prescriptive and regulated environment.

However, it should be easier for them to comply with legal obligations when preparing a PDS.

The most significant initial change will be the need to prepare new PDSs for each MIS that is caught by the Regulations.

The working group has indicated that it will prepare application and transitional arrangements at a later date.

It has also indicated that those arrangements will take into account the need to give product issuers sufficient time to comply with the new regime.

Compliance officers for product issuers will need to undergo further training to understand the new regime, and to produce disclosure documents that comply with it.

Additionally, more sophisticated computer systems may need to be developed so that product issuers can use their websites to incorporate information into their PDSs

Currently, PDSs are often seen as the primary documents used to summarise MISs, educate investors and sell MISs.

However, the Working Group has indicated that it believes PDSs only exist to summarise products, and that the Regulations tend to reflect this idea.

Consequently, there may also be a shift in the way product issuers caught by the Regulations market their products.

What will the changes mean for financial advisers?

Advisers who use PDSs as their primary source of information about MISs may find they need to refer to additional sources (such as the product issuer’s website) to obtain all the information about the MISs they require.

However, advisers could still request copies of all the information incorporated by reference into a PDS from the product issuer.

PDSs should become more user friendly, so that it will become easier to utilise PDSs as tools for explaining the key terms of MISs to clients.

Finally, and most importantly, clients may actually read PDSs produced under the new regime. As a result, there will be less chance of calls from angry clients complaining that they were not told about some facet of an MIS.

The next steps

The consultation period closes on February 26, 2010. While it’s not clear when the Regulations will take effect, given that this is an election year and this is one of the government’s key financial services reforms, it’s likely that the Regulations will take effect in the first half of this year.

Brendan Ivers is a solicitor at McMahon Clarke Legal.