Margin lending and financial advice - a guide to the new legal requirements

Over the last year and a half there has been considerable movement surrounding the governance of the margin lending industry and how financial advice on margin loans will be provided to retail clients. To recap:

• On 3 July 2008, the Federal Government assumed responsibility for the regulation of margin loans from the states.
• On 25 June 2009, the Corporations Legislation Amendment (Financial Services Modernisation) Bill was introduced into Parliament, leading to margin lending facilities being defined as financial products for the purposes of Chapter 7 of the Corporations Act (the Act).
• In November 2009, the Ripoll Inquiry made many adverse comments about the current practices of some members of the banking and finance industry in providing finance for investors through margin loans.
• Between July 2009 and December 2009, various Australian Securities and Investment Commission (ASIC) consultation papers were prepared and released seeking comment on how to accommodate advice in relation to margin loans within the existing regulatory framework.

On 1 January 2010 the new provisions defining margin lending facilities as a financial product became operational. As a result, margin lending facilities are now subject to supervision by ASIC.

Further, the new provisions will have a significant impact upon providers, licensees, and advisers who provide margin lending facility services in that they will have to adhere to a number of additional legislative requirements and obligations.

While there are a number of obligations imposed upon advisers that are still very much relevant to the provision of financial services, such as ‘know your client’ and ‘know your product’, there are nevertheless additional requirements that need to be met in order to avoid non-compliance.

This article discusses what changes have taken place in relation to regulating the margin lending industry; when these changes are due to occur; and what they mean for advisers and licensees.

The broad requirements

To provide a financial service in relation to a margin lending facility (either by way of issuing, or providing advice) an Australian Financial Services Licence (AFSL) is required.

Companies with an existing AFSL will need to apply to ASIC to vary their licence to cover the provision of margin lending services.

As for advisers, they should ensure that their authorised representative status includes the ability to advise and deal in margin lending services.

A licensee’s general obligations under the Act extends to the provision of margin lending facility services in that it must:

• Have appropriate compensation and external dispute resolution arrangements to provide margin lending services;
• Ensure that its advisers are competent and adequately trained to provide advice in relation to these lending facilities; and
• Provide appropriate disclosure documents including a Financial Services Guide (which includes reference to margin lending facility services) and a Product Disclosure Statement with an explanation of what margin lending is, how it works, and the benefits and risks associated with it.

Impact on financial advisers and licensees

In addition to the extension of these existing licensee obligations to margin lending facility services, financial service providers will now be subject to ‘responsible lending’ obligations.

These obligations arise when a margin lending facility is issued to a retail client or when there has been an increase in the limit of a margin lending facility previously issued to a retail client.

Under the Act, a financial services provider must:

• Assess whether the margin lending facility will be unsuitable for the retail client if the facility is issued or the limit is increased; and
• Before making the assessment, make reasonable inquiries about the retail client’s financial situation, and take reasonable steps to verify the retail client’s financial situation.
• In determining whether a margin lending facility is unsuitable, at the time of the assessment, the financial service provider must consider whether the client would:
• Be able to comply with their financial obligations under the terms of the facility, or
• Suffer substantial hardship if a margin call was made.

Distinction of definition

The Act envisages three categories of margin lending facility, namely:

• A standard margin lending facility;
• A non-standard margin lending facility, or
• Any other facility that ASIC declares to be a margin lending facility.

The latter category is designed to capture innovative facilities that may be developed in the future and that may not fall within the first two categories.

A standard margin lending facility is one where credit is provided to a person (investor) who in turn uses the credit to acquire a financial product.

The credit provided must be secured by property that consists wholly or partly of one or more marketable securities.

A non-standard margin lending facility differs from a standard margin lending facility in that ownership of the marketable securities transfers from the investor to the facility provider.

The facility provider in turn gives consideration for the securities back to the investor (which is usually in the form of cash representing the ‘loan’ component of the facility).

The investor then applies the ‘loan’ or consideration, either wholly or in part, to acquire one or more financial products. It should be noted that the investor has the right to be given marketable securities that are equivalent to the transferred securities.

This right is designed to capture arrangements similar to those found at Opes Prime and Tricom Equities.

The distinction between these categories is significant because additional disclosure obligations are imposed upon those who provide non-standard margin lending facilities to retail clients.

ASIC has released a consultation paper and a draft regulatory guide detailing its expectations for improved disclosure to ensure retail clients better understand and assess the risks associated with such facilities.

Expected preparation for financial advisers

ASIC has updated a number of its existing regulatory guides following industry consultation, to accommodate margin lending facility services as a financial product.

One of the updated guides is ‘RG146 Licensing: Training of Financial Product Advisers’ (RG 146), which now requires advisers to be trained in margin lending facilities if they are authorised to provide advice to retail clients in this area.

For the purposes of RG146 margin lending facilities are treated as Tier 1 products. Accordingly, advisers who advise on margin lending facilities will be expected to meet relevant Tier 1 training requirements. This includes specialist knowledge training on:

• The features of margin lending facilities;
• The different categories of margin lending facilities (for instance standard and non standard margin lending facilities);
• The associated risks;
• The product characteristics and the taxation implications;
• The legal environment surrounding disclosure and compliance; and
• Theories of investment, portfolio and risk management (for instance cash flow/risk associated with gearing).

Of course many advisers whose clients currently use margin lending facilities will have already undertaken product specific specialised knowledge in relation to the financial products that may be purchased with the loan.

Transition timeframe

There are several key dates in the transition to the new legislative environment

While the Act commenced on 1 January 2010, applications for an AFSL or variation to an existing licence can be made between 1 February 2010 and 30 June 2010.

Existing margin lenders and advisers on margin loans must apply to ASIC for an AFSL authorisation within this timeframe if they intend to continue to provide a margin lending financial service.

On 1 January 2011 the new licensing, conduct and disclosure requirements for issuers and advisers of margin lending facilities will apply. This also includes the responsible lending obligations as discussed above.

By 1 July 2011 entities and individuals that provide financial product advice on margin lending facilities must comply with the training standards set out in RG146.

Key points

To conclude, the key points associated with the changes to the margin lending industry are:

• Margin loans are now a financial product under the Act;
• Existing licensees will require a variation to their licence to advise retail clients in relation to margin lending facilities;
• Existing disclosure documents will need to be updated to include reference to margin lending services;
• Advisers need to be specifically authorised in and receive specialised training in margin lending products;
• There is a distinction between standard and non-standard margin lending facilities. Appropriate disclosures to retail clients will be determined by the category of the financial product; and
• Advisers have responsible lending obligations that require them to assess whether a margin call can be met or if it will cause substantial hardship.

Mary Ferizis is a solicitor for financial services at Argyle Lawyers.