The Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 ushers in a new regime for margin lending products, as part of the Australian Labor government’s plan to regulate consumer credit nationally.
The effect of the legislation is to treat margin-lending facilities as a form of financial product under the Corporations Act, meaning that providers and advisers of such facilities are subject to licensing, disclosure and responsible lending requirements.
Existing issuers and advisers on margin lending facilities who have not applied to the Australian Securities and Investments Commission (ASIC) for a variation of their licences before 30 June 2010 must now cease to advise on, and deal in such products until they are licensed or authorised to do so. The balance of the requirements such as disclosure, suitability assessment and responsible lending obligations will commence on 1 January 2011.
Financial planners who advise on, and deal in, margin lending facilities must:
- Be aware of the requirements and make adequate preparations.
- Review the internal guidelines to ensure full compliance.
- Undertake the necessary training.
Features of a Margin Lending Facility
Generally speaking, a margin lending facility allows an investor to borrow to invest in financial products against the security of any equity contribution, usually in the form of financial products. It is common for advisers to recommend margin lending facilities to their clients as part of the financial planning process (wealth creation strategy), and they are generally offered to investors who wish to increase the size of their investment portfolios, boost investment returns and accelerate wealth creation in a tax effective manner.
The Act classifies margin-lending facility into standard and non-standard facilities.
A standard facility is one where:
- Credit is provided to a natural person, and the credit is applied wholly or partly to acquire a financial product.
- The credit provided is, or must be, secured by property which consists, wholly or partly of one or more marketable securities.
- The client becomes required to, or the provider or another person becomes entitled to, take action in accordance with the terms of the facility where the current loan to valuation ratio (LVR) of the facility exceeds a ratio, percentage, proportion or level determined under the terms of the facility.
A non-standard facility is a facility under the terms of which:
- A natural person transfers one or more marketable securities to the provider of the facility.
- The provider transfers property to the client which is, or must be applied wholly or partly to acquire one or more financial products; and the client has a right, in the circumstances determined under the terms of the facility, to be given marketable securities equivalent to the transferred property given to the provider.
- The client becomes required to, or the provider or another person becomes entitled to take action in accordance with the terms of the facility where the current LVR of the facility exceeds a ratio, percentage, proportion or level determined under the terms of the facility.
Under the ASIC definition, a non-standard margin lending facility is “intended to target those arrangements that are not based on a loan agreement, but instead use a type of securities lending agreement (with variations) to achieve a similar economic outcome as would a standard margin lending facility.”1
This type of structure was used by lenders such as Opes Prime Stockbroking and Tricom Equities up until 2008.
One important point to remember is that the margin loan regulatory regime will only apply to loans:
- Made to a natural person.
- That are used partly or wholly for the purchase of financial products – meaning that the use of the loan for such purpose must form part of the margin lending facility.
The new regime will not apply to general business lending; nor will it capture loans used solely for personal, domestic or household use.
The standard margin lending facility is by far the more common form of facility. Typically, the margin lending facility provider would prescribe a certain level of LVR, and the level of LVR will vary with the particular marketable securities which will be determined by the lender from a risk and liquidity perspective. Where the value of the underlying securities decreases to the level below the agreed contract (margin), margin call will occur when the client will have to either ‘top up’ the margin loan account, provide the lender with additional securities, or liquidate the position. Margin lenders usually have the right to liquidate the client’s position if certain action is not taken by the client.
Reasonable Inquiries and Suitability Assessment
One of the fundamental requirements in relation to the issuing of a margin lending facility or the increase of limit is the requirement to undertake an assessment of the suitability of the facility for the retail client (the suitability assessment). The provider must, within 90 days before issuing (or increasing the limit of) the facility, assess whether it will be unsuitable for the client. In order to undertake the suitability assessment, the provider must make reasonable inquiries about, and take reasonable steps to verify, the client’s financial situation.
In the explanatory memorandum to the Bill, it states: “The purpose for undertaking reasonable inquiries about the client’s financial situation is to obtain an understanding of the client’s ability to meet all the repayments, fees, charges and transaction costs of complying with a possible margin call. The general position is that clients should be able to meet their contractual obligations from income and available liquid assets, rather than from long term savings or from equity in a fixed asset such as a residential home. The returns that are potentially available from the portfolio financed by the loan may be taken into account in a reasonable manner, but should not constitute the sole or main source of funds available to meet a margin call and service the margin loan.”2
The Corporations Amendment Regulations 2010 (No4), which will come into effect on 1 January 2011, set out the type of information a licensee and authorised representative must inquire of its clients.
The reasonable inquiry must relate to:
- Whether the client has taken out a loan to fund the secured property, or transferred securities contributed by the client for establishing the facility (i.e. double gearing).
- If the loan has been taken out – whether the security for the loan includes the primary residential property of the client.
- Whether there is a guarantor for the facility and, if so, whether the guarantor has been appropriately informed of, and warned about, the risks and possible consequences of providing the guarantee.
- The amount of any other debt incurred by the client.
The above information must also be included in the statement of advice (SoA) presented to clients.
Such inquiries would encompass an examination of the client’s asset and liability position, reliability of income, investment objectives, risk tolerance, lifestyle, availability of liquid assets and other financial commitments. The legislative requirements mean that advisers will be required to delve further into a client’s financial situation when margin lending is involved.
The rationale for this requirement is clear: to prevent the situation where clients risk losing their homes if they could not service their loans following a margin call.
Verification of the client’s financial situation is not required to be undertaken if a licensee that is authorised to provide financial product advice has prepared an SoA no more than 90 days before the date the facility is issued or limit of which is increased, the SoA contains specific recommendation in respect of that facility, and the limit specified in the facility is not greater than the limit detailed in the SoA. The rationale behind this is to reduce the regulatory burden on the lender where the same information has already been provided to an adviser. In practical terms, it is envisaged that margin lenders will enter into some kind of arrangement with the adviser whereby: “information relevant to a margin loan [is able] to be excerpted from an SoA and presented to them in a particular format. Lenders will have to obtain appropriate confirmation that any information excerpted in this way forms part of an SoA, including the date of the SOA.” 3
Facility Assessed as Unsuitable
Under the Act, the margin lending facility must be deemed to be unsuitable if, at the time of assessment, it is likely that the client:
- Would be unable to comply with the financial obligations under the terms of the facility.
- Could only comply with substantial hardship, if the facility were to go into margin call.
- Is, on an ongoing basis, unable to be contacted by any of the usual means of communication and has not appointed an agent to act on his/her behalf.
The first and third elements are straightforward. The question is: what constitutes ‘substantial hardship’? The concept is not defined in the legislation. However, in the superannuation context, one of the tests for whether a person is in ‘severe financial hardship’ is that: “the person is unable to meet reasonable and immediate family living expenses.”4
It would appear that, if this definition is adopted, then the following factors would need to be considered:
The amount of money the client is likely to have remaining after living expenses have been deducted from his/her after-tax income.
- Consistency and reliability of the income and the size of loan relative to income level.
- The client’s other debt repayment obligations and similar commitments.
- The amount of buffer between the client’s disposable income and meeting the margin loan obligations.
- Whether the client is likely to have to sell his/her assets to meet the margin loan obligations.
In paragraph 1.97 of the explanatory memorandum, it states: “The assessment conducted by the lender must specifically address the ability of the client to cope with the potential consequences of a margin call, in particular the possibility of having to deal with negative equity situations. An important factor in the assessment is the time allowed to the client to meet the margin call. Where clients are allowed only a short period within which the margin call must be met, the importance of the client having sufficient liquid assets to cope with such situations is enhanced. It is not intended that the potential sell down of part or all of the portfolio to adjust the LVR to the required level should imply substantial hardship.”
Where it is determined that the facility would be unsuitable for the retail client, the provider must not issue, or increase the limit of, the margin lending facility. Failure to comply constitutes a criminal offence and also attracts a civil penalty of 100 penalty units, two years imprisonment, or both.
Notification of a Margin Call
Under the Act, a client may enter into arrangements with the provider of a margin lending facility and a financial adviser, whereby it is the adviser who will receive the notification of a margin call. If this arrangement is entered into, the lender must take reasonable steps to notify the adviser (instead of the client) of the margin call, and the adviser must take reasonable steps to notify the client. The notice must be given as soon as practicable, and be provided in a form that is agreed between the parties. If there is no such agreement, and in the absence of ASIC’s determination, notices must be given in a reasonable manner. Paragraph 1.115 of the explanatory memorandum states:
‘Reasonable manner’ is considered to include electronic means such as the telephone, facsimile, SMS and email. Notification through a client’s individual account which is accessed by means of the client logging on through the lender’s website alone is generally not considered to be a ‘reasonable manner’, unless the client is simultaneously alerted through other means that an important notice has been placed in their account.’
A lender must not require the entering into of an arrangement for notification through third parties as a condition of issuing a margin lending facility. Advisers must ensure that, if a third party communication arrangement is entered into, they will have sufficient resources and supervisory arrangement to pass on the notices to the clients as soon as possible.
Australian Financial Services Licence Requirements
Existing issuers and advisers on margin lending facilities should have applied to ASIC for licence authorisation to advise on, and deal in, margin lending facilities by now. Those who fail to do so and wish to commence such activities must not do so until the authorisation is granted by ASIC.
Apart from applying for authorisation to provide financial product advice on margin lending products, advisers must also consider whether, during the course of advising clients, they will also be engaging in dealing activities. Although advisers do not deal by issuing margin lending products to clients, their conduct in assisting clients via the explanation of the terms of issue, completing application forms, lodging the forms on their behalf and actively facilitating the transaction between the parties, could potentially constitute ‘dealing’ in such facilities, which requires express authorisation. Applying for the correct authorisations is critical, as a licence with inadequate or deficient authorisations will lead to regulatory enforcement action and interruption to your business.
When applying for an Australian Financial Services (AFS) licence, or a variation to an existing AFS licence, the organisational competency is of paramount importance. That is, the nominated responsible managers (RMs) must meet the qualifications and experience requirements of ASIC Regulatory Guide 105. This generally requires the completion of a diploma or higher qualification in a financial services-related course, and three years of relevant experience in the past five years. In some circumstances, an applicant may be able to demonstrate competency by making a submission to ASIC of their RMs’ experience.
Applicants are, therefore, strongly advised to review the qualifications and experience of their existing staff and senior management to ensure that ASIC requirements are able to be met, and undertake recruitment if necessary. This is an important point because ASIC needs to be satisfied that the RMs, being the people who have primary responsibility of the organisation’s financial services business, are competent to provide, or supervise the provision of, the financial services efficiently, honestly and fairly. Applicants must specifically outline the relevant expertise and experience of the nominated RMs as it relates to margin lending, including details of any qualifications or courses which cover margin lending (or the underlying marketable securities over which margin loans have been issued), that the nominated RMs have completed.
When preparing the application, it is important to decide the type of authorisation required and whether the financial services will cover both standard and non-standard margin lending facilities. It is also important to document any relevant processes or measures the applicant has implemented or developed specifically for the provision of margin lending facilities, which include:
- Assessment of a client’s personal circumstances.
- Selection of margin lending products.
- Gearing policy, including LVRs.
- Risk mitigation.
- Client contact procedures where acting as an agent.
- Procedures for any deviation from the processes or measures.
Applicants must also ensure that the terms of their professional indemnity cover do not exclude margin lending products.
Finally, those who provide financial product advice in respect of margin loans must take note of the training requirements set out in Regulatory Guide 146. Those who provide advice on margin lending facilities must meet these requirements on and from 1 July 2011.
Advisers must complete the modules on generic knowledge, specialist knowledge and a skills component (where personal advice is given). Specialist knowledge on margin lending facilities must be completed, in addition to the specialist knowledge in respect of products acquired through the margin lending facilities. Licensees must, therefore, put in place a training regime now to ensure timely compliance.
The new margin lending regulatory regime includes a range of licensing, disclosure, assessment and responsible lending obligations which can be difficult to navigate and handle. Issuers and advisers on margin loans must undertake a detailed assessment of their financial services businesses, review the compliance structure, and take appropriate steps to usher in the new legislative requirements.
1ASIC, Consultation Paper 129, Non-standard Margin Lending Facilities: Improving Disclosure for Retail Clients, paragraph 6, pg7, December 2009, accessed 17 August 2010.
2The Parliament of the Commonwealth of Australia, Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009, Explanatory Memorandum, paragraph 1.80, pg30, accessed 17 August 2010.
3Ibid, paragraph 1.92, p32.
4APRA, Superannuation Industry Supervision (Regulation) 6.01(5), Retirement Savings Accounts Regulation 4.01(5), Guidelines For Trustees Early Release of Superannuation Benefits, July 1999, p2, accessed 17 August 2010.
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