Why the responsible entity relationship may need risk considerations

Harvey Kalman explains why the responsible entity relationship may need risk consideration.

The recent attention placed on responsible entities (REs) should perhaps encourage advisers to consider the relationship of the fund manager and RE when assessing risk for clients in the funds they recommend.

There is an argument that, where there is an internal RE in a fund manager operation that has minimum capitalisation, there is an increase in risk for investors.

Supreme Court of Victoria judge Justice Judd said recently that there was irreconcilable conflict between a particular manager’s duty to investors and its self-interest regarding its role as RE.

This was followed by the release of a consultation paper on financial requirements for REs by the Australian Securities and Investments Commission(ASIC). ASIC's move is a positive step, but more needs to be considered to protect investors and remove some of the risk.

The fact is that the collective investments now being developed and offered to investors are often much more complex than when the RE concept was developed and finally introduced.

We have seen increasing mismatches between the complexity and liquidity of managed investments, and the type of investor to whom they are promoted — for example, the open ended, daily priced direct property funds being offered to retail investors.

The RE concept clearly has weaknesses that have been exposed by the financial crisis and which now need to be addressed.

ASIC has identified that increased capital protection is required for investors, whether through capital requirements placed on internal REs or through higher levels of insurance.

Without a doubt, the financial strength of an RE and the people behind the fund is critical to ensuring there is someone left standing, and worth suing, if there is inappropriate behaviour.

However, there are other areas requiring examination that are just as critical.

Indeed, investor protection must start with recognition that many investment schemes are now extremely complex, requiring a greater degree of separation between a fund manager and the RE.

ASIC has also put up a proposal that REs be ‘bankruptcy remote’, which I believe is a worthwhile enhancement and further reinforces the separation of the RE relationship from the fund promoter.

I also believe that greater deterrents in the form of punishment for wrongdoing should be considered.

As said earlier, we need licensing changes that take today’s needs into account to better protect investors.

For example, we could have two levels of licensing recognising that some of the more complex products now being marketed need different levels of control and protection.

The effect and circumstances of some of the recent collective investment collapses and the role of the RE in funds such as the MFS Premium Income Fund and the Astarra Growth Fund, where there is speculation investors are facing losses following apparent improper use of the fund’s capital, need to be considered.

The common denominator in these and other cases is an internal RE which, as Justice Judd has said, can be severely conflicted.

It is usually only during and after severe market downturn that malfeasance, incompetence or conflict of interest is discovered and, when this happens, it nearly always costs investors.

It is therefore timely that all the issues surrounding the role of the RE are looked at before the next boom starts and before current problems are forgotten.

I am not arguing against the RE system. It can work well if there is adequate separation between the RE and the fund manager/promoter to ensure the RE does not fail if the promoter fails and that investors’ savings are protected.

New legislation may not necessarily be required as the clear conflict of interest of fund managers and scheme promoters, and the inadequacies of investor protection that are increasingly apparent, can largely be corrected by strengthening licensing requirements.

In the meantime, these risk factors need to be considered by advisers in order to protect their clients and themselves.

Harvey Kalman is head of funds management at Equity Trustees.