Law of investments and financial markets [2 ed.] 9780455237572, 0455237573

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LAW OF INVESTMENTS AND FINANCIAL MARKETS Second Edition

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LAW OF INVESTMENTS AND FINANCIAL MARKETS Second Edition Melissa NAYLOR LLM (Germany) LLB (Hons)

Compiled by Elizabeth SHI LLM (Monash) LLB (Hons) BSc (Melb) Grad Cert Education (RMIT) Lecturer in Law RMIT University

LAWBOOK CO. 2016

Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668 19 Harris Street, Pyrmont, NSW The Cataloguing-in-Publication entry is available from the National Library of Australia. ISBN: 9780 455 237 572 © 2016 Thomson Reuters (Professional) Australia Limited This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. Product Developer: Vickie Ma Editor: Patrick Wu Printed by Ligare Pty Ltd, Riverwood, NSW This book has been printed on paper certified by the Programme for the Endorsement of Forest Certification (PEFC). PEFC is committed to sustainable forest management through third party forest certification of responsibly managed forests. For more info: http://www.pefc.org.

PREFACE Law of Investments and Financial Markets studies the many and varied areas of law impacting investors and those working in the industries associated with investment products. The focus of the early chapters is on the Corporations Act, outlining in some detail the requirements associated with the provision of financial services and financial product advice, including legal obligations and compliance requirements of licensees and their representatives, disclosure, dispute resolution and investor protection. The latest legislative changes and proposals are discussed, as well as associated regulation and case law. Later chapters concentrate on various forms of investment including managed investments and direct investments into companies. The main sources of law discussed in this book include: • statutes — such as the Corporations Act 2001 (Cth); the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act); the Competition and Consumer Act 2010 (Cth);

• common law — including the tort of negligence, contract law and fiduciary duties; and • regulation — primarily by the Australian Securities and Investments Commission (ASIC) through regulatory guides.

This book attempts to provide most of the answers that a serious investor may require on how the current law impacts upon their particular investments and strategies. The book is also designed to assist the investment adviser to quickly and accurately find the appropriate law that relates to their requirements. Tertiary students of financial planning and finance law, as well as financial planners, accountants and lawyers practising in investment law, should also find the book useful. It has been my pleasure to update this book for a new second edition in 2016, but this edition would not have been possible without the very significant contributions made by Dr John McLaren and Mary Toohey in the previous edition of this book and in prior editions of ‘Law of Investments’, on which this book is based. Thanks must also go to Elizabeth Shi, who has provided helpful guidance on her students’ areas of interest and comments on some chapters. Acknowledgement must also be made of the late John William’s contribution to the very first edition of Law of Investments. On a personal note, I dedicate this book to Laura, Michael, Emma and Andrew. Melissa Naylor Brisbane June 2016

v

TABLE OF CONTENTS Preface................................................................................................................................................. v Table of Cases ................................................................................................................................... ix Table of Statutes ............................................................................................................................... xv

CHAPTER 1 — The Nature of Investing in a Company ............................................. 1 CHAPTER 2 — Members' Rights................................................................................. 17 CHAPTER 3 — Funding Company Operations ........................................................ 35 CHAPTER 4 — Corporate Governance...................................................................... 65 CHAPTER 5 — Corporate Insolvency ....................................................................... 89 CHAPTER 6 — Managed Investment Schemes....................................................... 123 CHAPTER 7 — Introduction to Investments and the Law ................................... 153 CHAPTER 8 — Common Law Framework for Market Participants ................... 169 CHAPTER 9 — Regulation of the Financial Services Industry: Corporations Act, Chapter 7 ............................................................ 181 CHAPTER 10 — Conduct and Disclosure in the Investment Advisory Process ................................................................................................ 213 CHAPTER 11 — Investor Protection and Dispute Resolution............................... 257 CHAPTER 12 — Insider Trading: Using Inside Information ................................. 281 Index ............................................................................................................................................... 301

vii

TABLE OF CASES A A-G’s Reference (No 1) [1973] QB 773 .......................................................................... 12.60 ASIC v Citigroup Global Markets Australia Pty Ltd (No 4) [2007] FCA 963 ................. 8.90 ASIC v Online Investors Advantage Inc [2005] QSC 324 ............................................ 9.375 Adams v Perpetual Trustees Australia Ltd [2006] SADC 62 ........................................ 8.90 Airpeak Pty Ltd v Jetstream Ltd (1997) 73 FCR 161; 15 ACLC 715 ................................. 2.310 Ali v Hartley Poynton Ltd [2002] VSC 113 ............................................................ 8.70, 11.80 Amadio Pty Ltd v Henderson (1998) 81 FCR 149 ......................................................... 6.210 Ampol Petroluem Ltd v RW Miller (Holdings) Ltd [1972] 2 NSWLR 850 ........... 3.80, 3.140 Ampolex Ltd v Perpetual Trustee Trading Co (Canberra) Ltd (1996) 40 NSWLR 12 ............................................................................................................................. 12.150 Astley v Austrust Limited (1999) 197 CLR 1 ................................................................... 8.80 Australian Competition and Consumer Commission v Australian Securities and Investments Commission (2000) 174 ALR 688 ...................................................... 5.720 Australian Securities & Investments Commission v Primelife Corporation Limited [2006] FCA 1072 ........................................................................................... 6.40 Australian Securities & Investments Commission v Takaran Pty Ltd (2002) 43 ACSR 46; [2002] NSWSC 834 ................................................................................... 6.40 Australian Securities Commission v Gallagher (1993) 11 WAR 105; (1993) 10 ASCR 43; (1993) 11 ACLC 286 ................................................................................... 4.310 Australian Securities and Investments Commission v Cash Store Pty Ltd (in liq) [2014] FCA 926 ......................................................................................................... 11.110 Australian Securities and Investments Commission v Hellicar [2012] HCA 17 ............ 4.310 Australian Securities and Investments Commission v Macdonald (No 11) [2009] NSWSC 287 .................................................................................................. 4.310 Australian Securities and Investments Commission v Macdonald (No 12) [2009] NSWSC 714 ................................................................................................... 4.310 Australian Securities and Investments Commission v Maxwell (No 11) [2009] NSWSC 287 .............................................................................................................. 4.310 Australian Securities and Investments Commission v Oxford Investments (Tasmania) Pty Ltd (2008) 169 FCR 522 .................................................................. 9.375 Australian Securities and Investments Commission v Southcorp Ltd (2003) 130 FCR 406 ....................................................................................................... 12.130, 12.180 Australian Securities and Investments Commission v Wellington Capital Limited [2013] FCAFC 52 .......................................................................................... 6.110 Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34 ...................................................................................................................... 1.130, 4.10 Avoca Consultants Pty Ltd v Millennium3 Financial Services Pty Ltd [2009] FCA 883 ................................................................................................................... 11.130

B Baker v Palm Bay Island Resort Pty Ltd (No 2) [1970] Qd R 210 ................................. 4.180 Boardman v Phipps [1967] 2 AC 46 .............................................................................. 4.180 Bolkiah v KPMG [1998] UKHL 52 ................................................................................ 12.160 Breen v Williams (1996) 186 CLR 71 ............................................................................... 8.90 Brookfield Multiplex Ltd v International Litigation Funding Partners Pte Ltd (No 3) (2009) FCA 450; 256 ALR 427 ........................................................................ 6.50 Brunninghausen v Glavanics (1999) 46 NSWLR 538 ................................................... 4.140 Burland v Earle [1902] AC 83 ................................................................................ 2.90, 3.80 ix

Law of Investments and Financial Markets

C Capital Finance Australia Limited v Clough [2015] NSWSC 1327 ................................. 3.370 Chan v Zacharia (1984) 154 CLR 178 ............................................................................. 4.180 Chew Investment Pty Ltd v General Corp of Australia Ltd (1998) 6 ACLC 87 ........... 2.300 Chrysler Credit Canada Ltd v MVL Leasing Ltd (1993) 5 PPSAC (2d) 92 ..................... 3.410 Churchill International Inc v BTR Nylex Ltd (1991) 4 ACSR 693 ................................... 2.60 City Equitable Fire Insurance Company Ltd, In Re [1925] Ch 407 .............................. 4.100 Commercial Bank of Australia Ltd v Amadio (1983) 151 CLR 447; 46 ALR 402 ....... 10.200, 11.110 Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115 ............................... 4.100 Cook v Deeks [1916] AC 554 ......................................................................................... 2.250 Cook’s Construction Pty Ltd v Brown (2004) 49 ACSR 62 ......................................... 5.530 Cresvale Far East Ltd (in liq) v Cresvale Securities Ltd [No 2] (2001) 39 ACSR 622 ............................................................................................................................ 5.180 Crocombe v Pine Forests of Australia Pty Ltd [2005] NSWSC 151 ............................... 6.40

D Dalkeith Investments Pty Ltd, Re (1985) 3 ACLC 74 ................................................... 2.250 Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371 ..................................... 8.90, 11.60 Daniels v Anderson (1995) 37 NSWLR 438 ........................................................ 4.110, 4.220 Dawson (deceased), Re [1966] 2 NSWR 211 ................................................................. 4.80 Delmenico v Brannelly [2008] QCA 74 .......................................................................... 8.70 Demondrille Nominees Pty Ltd v Shirlaw (1997) 15 ACLC 1716 .................................. 5.500 Donoghue v Stevenson [1932] AC 562 ................................................................. 8.60, 8.70

E Ebrahimi v Westbourne Galleries [1973] AC 360 ......................................................... 2.280 Elders Forestry Management Ltd, Re (2012) 30 ACLC 12-032 ..................................... 6.130 Eric Preston Pty Ltd v Euroz Securities Limited [2010] FCA 97 .................................... 8.90

F Financial Industry Complaints Service Ltd v Deakin Financial Services Pty Ltd (2006) 157 FCR 229; [2006] FCA 1805 .................................................................... 11.200 Fitzsimmons v The Queen (1997) 23 ACSR 355 ........................................................... 4.180 Forrest v Australian Securities and Investments Commission [2012] HCA 39 ........... 4.315 Foss v Harbottle (1843) 67 ER 189 ............................................................................... 2.320 Francis v United Jersey Bank 432 A 2d 814 (NJ 1981) .................................................. 4.110 Fraser v NRMA Holdings Ltd (1995) 55 FCR 452; 13 ACLC 132 ..................................... 3.180

G G Jeffrey (Mens Store) Pty Ltd (1984) 2 ACLC 421 ...................................................... 2.250 Gambotto v WCP Ltd (1995) 182 CLR 432 .................................................................... 2.230 Gemstone Corp of Aust Ltd v Grasso (1994) 62 SASR 239 ......................................... 4.180 German Date Coffee Company, Re (1882) 20 Ch D 169 .............................................. 2.280 Grand Enterprises Pty Ltd v Aurium Resources Ltd [2009] FCA 513 .......................... 4.230 Green v Bestobell Industries Pty Ltd [1982] WAR 1 .................................................... 4.180 Gunns Finance Limited (in liq) (recs & mgrs apptd) (No 2), Re [2013] VSC 365; (2013) 281 FLR 121 ..................................................................................................... 6.110 Gye v McIntyre (1991) 171 CLR 609 .............................................................................. 5.620 x

Table of Cases

H Harlowe’s Nominees Pty Ltd v Woodside (Lakes Entrance) Oil Co NL (1968) 121 CLR 483 .............................................................................................................. 4.160 Hedley Byrne v Heller & Co Ltd [1964] AC 465 .................................................. 8.70, 11.150 Henderson v Amadio Pty Ltd (No 1) (1995) 62 FCR 1 .................................................. 6.210 Hooker Investments Pty Ltd v Baring Bros Halkerston & Partners Securities Ltd (No 2) (1986) 5 NSWLR 157 .............................................................................. 12.150 Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 ...... 4.180, 8.90 Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 ...................... 3.80, 3.140, 4.160 Humes Ltd v Unity APA Ltd [1987] VR 467 .................................................................. 2.130

I ICAL Ltd v County Natwest Securities Aust Ltd (1988) 39 NSWLR 214 ..................... 12.150 Illingworth v Houldsworth [1904] AC 355 ................................................................... 3.320 Industrial Equity v Blackburn (1977) 137 CLR 567 .......................................................... 2.70 Ingot Capital Investments Pty Ltd v Macquarie Equity Capital Markets Ltd [2008] NSWCA 206 .................................................................................................. 11.80

J JGS Investment Holdings Pty Ltd, Re [2014] NSWSC 1532 ......................................... 2.250 Jenkins v Enterprise Gold Mines NL (1992) 10 ACLC 136 ............................................. 2.250 Johnston v McGrath (2005) 195 FLR 101; [2005] NSWSC 1183 ................................... 5.680 Jtec Pty Ltd v Industrial Development Agency (Ireland) [2003] NSWSC 10 .............. 5.100

K KGD Investments Pty Ltd v Placard Holdings Pty Ltd [2015] VSC 712 .......................... 2.80 Khadine Pty Ltd v Giant Bicycle Co Pty Ltd (1995) 16 ACSR 421 ................................. 5.100 Kincaid v Capital Markets Equities Ltd (No 2) (1995) 7 NZCLC 260,718 ...................... 12.60 Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722 .................................... 4.150 Kinwat Holdings Pty Ltd v Platform Pty Ltd [1982] Qd R 370 ................................... 12.180

L Lewis v Cook (2000) 18 ACLC 490 ............................................................................... 5.500 Lewis v LG Electronics Australia Pty Ltd [2014] VSC 644 ............................................ 3.370 Lister v Romford Ice and Cold Storage Co Ltd [1957] AC 555 ...................................... 4.90 Lloyds Bank NZA Ltd v National Safety Council of Australia (Vic) (in liq) [1993] 2 VR 506 ................................................................................................................... 5.620 Loch v John Blackwood Ltd [1924] AC 783 ................................................................. 2.280

M MacarthurCook Fund Management Ltd v TFML Ltd (2014) 32 ACLC 14-023 ............. 6.320 Mallesons Stephen Jaques v KPMG Peat Marwick [1990] 4 WAR 357 ..................... 12.160 Mamouney v Soliman (1992) 10 ACLC 1674 ...................................................... 2.250, 2.300 Mann v Sangria Pty Ltd (2001) 19 ACLC 696 ............................................................... 5.530 Market Wizard Systems (UK) Ltd, Re [1998] 2 BCLC 282 ........................................... 9.375 Meinhard v Salmon 249 NY 458 (1928) ....................................................................... 4.140 Mentha v Sydney Airports Corporation (2002) 120 FCR 310; [2002] FCA 530 ........... 5.220 Mercedes Holdings Pty Limited v Waters (No 2) [2010] FCA 472 ............................... 6.185 xi

Law of Investments and Financial Markets

Merrett, Ex parte (1997) 140 FLR 412 .......................................................................... 5.450 Mills v Mills (1938) 60 CLR 150 ........................................................................... 4.150, 4.160

N NRMA v Parker (1986) 6 NSWLR 517 ........................................................................... 2.130 National Australia Bank Ltd v Norman [2009] FCAFC 152 .................................. 6.40, 6.50 Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216 ............ 8.70, 8.100, 9.230, 11.60 Norberg v Wynrib [1992] 2 SCR 226 .............................................................................. 8.90

O One RE Services Ltd v Australian Securities and Investments Commission [2012] AATA 294; (2012) 30 ACLC 12-021 ................................................................... 6.90

P Panasonic Australia Pty Ltd v Wily (1997) 15 ACLC 613 ............................................... 5.530 Percival v Wright [1902] 2 Ch 421 ................................................................................. 4.140 Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187; 14 ACSR 109 ....... 4.90, 4.160 Pilmer v The Duke Group Ltd (in liq) (2001) 207 CLR 165; [2001] HCA 31 .................... 8.90 Promnitz v Australian Securities and Investments Commission (2004) 22 ACLC 108 ............................................................................................................................ 5.720

Q Quitstar Pty Ltd v Cooline Pacific Pty Ltd (2003) 22 ACLC 15 ...................................... 5.100

R R v Chonka [2000] NSWCCA 466 ................................................................................. 12.60 R v Evans [1999] VSC 488 ............................................................................................. 12.40 R v Farris (2015) 107 ASCR 26 ........................................................................................ 12.60 R v Hannes (2000) 158 FLR 359 ....................................................................... 12.160, 12.170 R v Massie [1999] 1 VR 542 ........................................................................................... 12.60 R v Rivkin (2004) 59 NSWLR 284 ................................................................................ 12.170 Rahmat Ali v Hartley Poynton Ltd [2002] VSC 113 ........................................................ 8.80 Rite Flow Pty Ltd v Nahas Constructions (NSW) Pty Limited [2012] NSWSC 553 ...... 5.100 Rivkin Financial Services Ltd v Sofcom Ltd (2005) 23 ACLC 42 ................................. 12.170 Ryan v Triguboff [1976] 1 NSWLR 588 ......................................................................... 12.60

S Saltdean Estate Co Ltd, Re [1968] 1 WLR 1844 ........................................................... 5.330 Sandell v Porter (1966) 115 CLR 666 .............................................................................. 5.50 Sandford v Sandford Courier Service (1987) 5 ACLC 394 ........................................... 2.250 Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324 ....................... 2.250 Selig v Wealthsure Pty Ltd [2013] FCA 348 ...................................... 8.75, 8.80, 8.90, 8.100 Selig v Wealthsure Pty Ltd [2013] FCA 685 ................................................................... 8.75 Selig v Wealthsure Pty Ltd [2014] HCATrans 251 ........................................................... 8.75 Selig v Wealthsure Pty Ltd [2015] FCA 348 ................................................................... 8.75 Selig v Wealthsure Pty Ltd [2015] HCA 18 ..................................................................... 8.75 Selig v Wealthsure Pty Ltd [2015] HCATrans 54 ............................................................ 8.75 xii

Table of Cases

Selim v McGrath (2003) 177 FLR 85 .............................................................................. 5.190 Shafron v Australian Securities and Investments Commission [2012] HCA 18 .......... 4.310 Shirlaw v Graham [2001] NSWSC 612 ............................................................................ 5.110 Sons of Gwalia Ltd v Margaretic (2005) 55 ACSR 365; [2005] FCA 1305 ................... 5.680 Sons of Gwalia Ltd v Margaretic (2007) 81 ALJR 525; [2007] HCA 1 ............... 3.190, 5.680 Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation (2001) 53 NSWLR 213; 19 ACLC 1513 .......................................................................................... 5.50 Spargos Mining NL, Re (1990) 3 WAR 166 ................................................................... 2.250 Sticky Fingers Restaurant Ltd, Re (1992) ACLC 3011 ................................................... 2.280 Stolliar, Re (2003) 21 ACLC 869 ................................................................................... 5.450

T TFML Ltd v MacarthurCook Fund Management Ltd (2013) 31 ACLC 13-046 ............. 6.320 Taxation, Deputy Commissioner of v ABW Design and Construction Pty Ltd [2012] FCA 346 ......................................................................................................... 5.100 Technology Licensing Ltd v Climit Pty Ltd [2002] 1 Qd R 566; (2001) 19 ACLC 808 ............................................................................................................................ 5.90 360 Capital Re Ltd v Watts (2012) 30 ACLC 12-051 ....................................................... 6.130 Trevor v Whitworth (1887) App Cas 409 .................................................................... 5.680

U Unity APA Ltd v Humes Ltd (No 2) [1987] VR 474 ....................................................... 2.190

V Vehicle Wash Systems Pty Ltd v Mark VII Equipment Inc (1997) 80 FCR 571; 16 ACLC 223 .................................................................................................................. 5.100 Vincent, White & Associates Pty Ltd v Vouris (1998) 16 ACLC 974 ............................. 5.190

W Walker v Nicolay (1991) 4 ACSR 309 ............................................................................ 4.180 Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326 ..... 2.70, 2.80, 2.250 Wayde v New South Wales Rugby League Ltd (1985) 180 CLR 459 .......................... 2.250 Wealthsure Pty Ltd v Selig [2013] FCA 628 ................................................................... 8.75 Wealthsure Pty Ltd v Selig [2014] 221 FCR 1 .................................................................. 8.75 Wealthsure Pty Ltd v Selig [2014] FCAFC 76 ................................................................. 8.75 Wealthsure Pty Ltd v Selig (No 2) [2013] FCA 770 ........................................................ 8.75 Webb v Earle (1875) 20 Eq 556 ..................................................................................... 1.200 Wellington Capital Ltd v Australian Securities and Investments Commission [2014] HCA 43 ........................................................................................................... 6.110 Westgold Resources NL v St George Bank Ltd (1998) 29 ACSR 396 ......................... 12.120 Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285 ............................................ 4.160 Will v United Lankat Plantations [1994] AC 11 ............................................................. 1.200 Willmott Forests Ltd (in liq) v Primary Securities Ltd (2013) 31 ACLC 13-068 ............. 6.110 Wondoflex Textiles Pty Ltd, Re [1951] VLR 458 .......................................................... 2.250

xiii

TABLE OF STATUTES COMMONWEALTH Anti-Money Laundering and Counter-Terrorism Financing Act 2006: 7.200 s 6: 7.200 s 81: 7.200

Australian Securities Commission Act 1998: 7.130

Australian Securities and Investments Commission Act 2001: 7.105, 7.170, 7.180, 11.20, 11.80 s 1(1)(a): 7.180 s 1(1)(d): 7.180 s 1(2): 7.180, 7.190 s 12A: 7.130 ss 12BB to 12DE: 11.130 s 12BC: 11.140, 11.145 s 12BF: 11.145 s 12BG: 11.145 s 12BK: 11.145 s 12CA: 11.110, 11.150 s 12CB: 11.110, 11.150 s 12CC: 11.110, 11.150 s 12DA: 5.680, 8.70, 8.75, 11.80, 11.120, 11.150, 11.220 s 12DB: 11.120, 11.220 s 12EB: 11.80, 11.140, 11.150 s 12EC: 11.150 s 12ED: 11.140, 11.150 s 12ED(2): 11.140 s 12ED(3): 11.140 s 12GF: 8.75, 11.110 s 12GI: 11.220 s 12BAA: 9.250 s 12BAB: 9.360 s 50: 11.230 Pt 2, Div 2: 11.100, 11.150 Pt 2, Div 2, subdiv C: 11.110 Pt 10: 7.180 Banking Act 1959: 1.250

Bankruptcy Act 1966: 9.60

Competition and Consumer Act 2010: 11.80, 11.110 s 60: 11.140 Sch 2, s 18: 11.120

Corporations Act 2001: 1.50, 1.60, 1.110, 1.130, 1.140, 1.160, 1.180, 1.190, 1.230, 2.10, 2.20, 2.120, 2.140, 2.160, 2.170, 2.230, 2.310, 3.140,

3.230, 3.240, 3.280, 3.330, 3.340, 4.10, 4.20, 4.80, 4.180, 4.190, 5.100, 5.360, 6.90, 6.100, 6.140, 6.160, 6.170, 6.185, 6.320, 6.350, 7.105, 7.180, 7.190, 8.70, 8.90, 9.70, 9.78, 9.375, 9.380, 9.490, 10.190, 10.200, 10.350, 10.530, 11.90, 11.220, 12.40, 12.110 s 9: 1.60, 2.120, 3.230, 4.190, 5.490, 6.10, 6.40, 6.50, 6.110, 9.270, 12.160, 12.200, 12.220 s 92: 3.270 s 95A: 3.80 s 95A(1): 5.50 s 95A(2): 5.50 s 112(2): 1.70 s 113: 1.60, 3.160 s 113(3): 3.140 s 114: 1.60 s 117: 1.50 s 117(2)(k): 1.140 s 119: 1.80 s 124: 1.80, 1.160, 3.10, 3.110, 3.230, 6.110 s 136: 1.140, 2.120, 2.170, 2.270, 3.130, 3.135 s 140: 2.10, 2.180, 3.130 s 141: 1.60, 1.140 s 162: 2.120 s 169: 1.180 s 171: 3.290 s 175: 2.200 s 180(1): 4.190, 4.220, 4.310 s 180(1)(a): 4.310 s 180(1)(b): 4.310 s 180(2): 4.120, 4.220 s 180(3): 4.220 s 181: 2.80, 4.190, 4.310 s 181(1): 4.200, 4.310 s 181(1)(b): 3.140 ss 181 to 183: 4.190 s 182: 4.190, 4.310 s 182(1): 4.210 s 183: 4.190 s 183(1): 4.210 s 184: 4.190, 4.300 s 185: 4.190 s 187: 4.150 s 189: 4.290 s 190(1): 4.290 s 190(2): 4.290 s 191: 4.250, 4.270, 4.280 s 191(1): 4.230 s 191(2)(a): 4.240 s 191(2)(b): 4.240 s 191(2)(c): 4.240 xv

Law of Investments and Financial Markets

Corporations Act 2001 — cont s 191(2)(d): 4.240 s 191(5): 4.230 ss 191 to 195: 4.190 s 192: 4.240, 4.250 s 192(1): 4.250 s 192(2): 4.250 s 192(3): 4.250 s 192(4): 4.250 s 192(6): 4.250 s 193: 4.250 s 194: 4.280 s 195(1): 4.270 s 195(1A)(b): 4.270 s 195(2): 4.270 s 198A: 1.120, 4.10 s 198D: 4.170 s 198D(2): 4.170 s 198D(3): 4.170 s 201A: 1.60 s 201G: 2.120 s 201H: 2.120 s 201M: 5.340 s 202A: 2.120 s 203C: 2.120 s 203D: 2.120 s 204A: 1.60 s 206C: 4.300, 5.550 s 231: 1.60, 1.140, 1.180, 3.10 s 232: 2.80, 2.90, 2.250, 3.140 s 233: 2.250, 2.260, 2.280 s 236(3): 2.320 ss 236 to 239: 4.320 s 237(2): 2.320 s 240: 2.320 s 242: 2.320 s 246B: 2.120 s 246B(1): 2.270 s 246B(2): 2.270, 3.140 s 246C: 2.120, 3.140 s 246C(6): 3.140 s 246D: 2.270 s 246F(3): 2.270 s 247A: 2.190 s 247E: 3.190 s 249D: 2.130 s 249E: 2.130 s 249F: 2.130 s 249G: 2.280 s 249H: 2.140, 2.300 s 249L: 2.300 s 249N: 2.130 s 249HA: 2.140 s 250E: 2.160 s 250J: 2.160 s 250L: 2.160, 2.300 s 251A: 4.170 s 251B: 2.190 xvi

s 254A: 3.110, 3.140 s 254A(2): 1.200, 2.270 s 254A(3): 1.200 s 254B: 1.160 s 254D: 3.130 s 254K: 1.200 s 254M: 1.70 s 254Q: 1.70, 5.470 s 254T: 1.210, 2.80, 3.80 s 254U: 2.70, 3.80 s 254V(1): 2.70 s 254V(2): 2.70 s 254W(2): 2.70 s 256: 2.310 s 256C: 2.120 s 257A: 2.310 s 257B: 2.120 s 260A: 2.310 s 260B: 2.120 s 262: 3.330 s 262(11): 3.330 s 264: 3.330 s 266: 3.330 s 267: 3.480 s 279(2): 3.340 s 279(3): 3.340 s 280: 3.340 s 283AA: 3.280 s 283AA(1)(a): 3.280 s 283AB: 3.280 s 283AC: 3.280 s 283BB: 3.280 s 283BE: 3.280 s 283BF: 3.280 s 283BH: 3.230 s 283DA: 3.280 s 283BCA: 3.280 s 286: 5.60 s 313: 3.280 s 318: 3.280 s 325: 2.120 s 325A: 2.120 s 327B: 2.120 s 327F: 2.120 s 329: 2.120 s 413(1)(d): 5.710 s 433: 3.340 s 436A: 5.110 s 436B(2): 5.110 s 436C: 5.110 s 436E(1): 5.210 s 436E(3): 5.210 s 436F(1): 5.210 s 436F(2): 5.210 s 436F(3): 5.210 s 436G: 5.210 s 437A: 5.180 s 437A(1): 5.180

Table of Statutes

Corporations Act 2001 — cont s 437B: 5.180 s 437C(1): 5.180 s 437D: 5.180 s 437F: 5.160 s 438A: 5.190 s 438B(1): 5.190 s 438B(2): 5.190 s 438B(3): 5.190 s 438B(4): 5.190 s 438B(6): 5.190 s 438C: 5.180 s 438D(1): 5.190 s 439A(1): 5.220 s 439A(2): 5.220 s 439A(3)(a): 5.220 s 439A(3)(b): 5.220 s 439A(4): 5.220 s 439A(6): 5.220 s 439B(1): 5.220 s 439B(2): 5.220 s 439C: 5.220 s 440A: 5.170 s 440A(3): 5.170 ss 440A to 440J: 5.170 s 440B: 5.170 s 440C: 5.170 s 440C(1): 5.170 s 440F: 5.170 s 440G(2): 5.170 s 440J: 5.170 s 440JA: 5.170 s 441A: 5.170 s 441B(1): 5.170 s 441C: 5.170 s 442A: 5.180 s 442C(1): 5.180 s 442C(2): 5.180 s 442C(3): 5.180 ss 443(2) to (4): 5.200 s 443A(1): 5.200 s 443A(2): 5.200 s 443B(2): 5.200 s 443B(3): 5.200 s 443B(4): 5.200 s 443B(7): 5.200 s 443E(1)(a): 5.180, 5.200 s 443E(1)(b): 5.200 s 443BA: 5.190 s 443BA(1): 5.190 s 444A: 5.230 s 444A(4): 5.230 s 444B: 5.230 s 444B(2): 5.240 s 444C: 5.230 s 444D: 5.230 s 444E(2): 5.230 s 444E(3): 5.230

s 444F(3): 5.230 s 444G: 5.230 s 444H: 5.230 s 445B(1): 5.230 s 445B(2): 5.230 s 445D: 5.290 s 445E: 5.230 s 445F: 5.230 s 445F(2): 5.230 s 445F(5): 5.230 s 445G(3): 5.260 s 445H: 5.230 s 446: 5.170 s 446(3): 5.240 s 446(5): 5.240 s 446A: 5.240 s 447A(1): 5.270 s 447A(3): 5.270 s 447A(4): 5.270 s 447C(1): 5.280 s 447C(2): 5.270 s 447D(2): 5.270 s 449E: 5.180 s 459A: 5.300 s 459B: 5.300 s 459C: 5.60 s 459C(3): 5.60 s 459D(1): 5.50 s 459E: 5.80 s 459E(2)(c): 5.90 s 459E(2)(d): 5.90 s 459E(2)(e): 5.90 s 459E(3): 5.90 s 459E(4): 5.80 s 459F: 5.60 s 459G(1): 5.100 s 459H: 5.100 s 459J(1): 5.100 s 459J(2): 5.100 s 459N: 5.100 s 459P: 5.310 s 459P(2): 5.310 s 459P(3): 5.310 s 459S: 5.100 s 461: 2.280, 5.300 s 465A(a): 5.320 s 465A(b): 5.320 s 465A(c): 5.320 s 465B(1): 5.320 s 465C: 5.320 s 466: 5.320 s 467(1): 5.330 s 467(2): 5.330 s 467(4): 2.280, 5.330 s 467(5): 5.330 s 467A: 5.330 s 468: 5.440 s 468(1): 5.440 xvii

Law of Investments and Financial Markets

Corporations Act 2001 — cont s 468(3): 5.440 s 468(4): 5.440 s 471: 5.330 s 471A: 5.410 s 471A(4): 5.410 s 471B: 5.420 s 471C: 5.420 s 472(1): 5.340 s 472(2): 5.320 s 472(4): 5.320 s 472(6): 5.320 s 473(1): 5.340 s 473(2): 5.320 s 473(3): 5.320 s 473(4A): 5.320 s 473(7): 5.340 s 473(9): 5.340 s 475: 5.360 s 476: 5.370 s 477: 5.360 s 477(2A): 5.360 s 477(3): 5.360 s 478: 5.430 s 479(1): 5.370 s 479(2): 5.360, 5.370 s 479(3): 5.380 s 479(4): 5.380 s 480: 5.700 s 481(2): 5.700 s 481(5)(b): 5.710 s 483: 5.430 s 486A: 5.460 s 486A(1): 5.460 s 486B: 5.460 s 487: 5.460 s 488(2): 5.360 s 491: 5.240 s 494: 5.240 s 497: 5.240 s 509: 5.710 s 509(6): 5.710 s 513A: 5.330 s 515: 5.470 s 516: 5.470 s 517: 5.470 s 518: 5.470 s 520: 5.470 s 521: 5.470 s 530A: 5.360 s 530A(2): 5.360 s 530B: 5.360 s 530C: 5.380 s 530C(3): 5.380 s 531: 5.370 s 532: 5.340 s 532(1): 5.340 s 532(7): 5.340 xviii

s 532(8): 5.340 s 532(9): 5.340 s 533: 5.370 s 536: 5.380 s 536(1): 5.380 s 538: 5.430 s 539(1): 5.430 s 539(1A): 5.430 s 539(2): 5.430 s 541(1): 5.400 s 542(1): 5.370 s 542(2): 5.370 s 542(3): 5.370 s 542(4): 5.370 s 543(1): 5.430 s 543(2): 5.430 s 545(1): 5.340 s 545(2): 5.340 s 553(1): 5.600 s 553A: 5.610 s 553B: 5.610 s 553C(1): 5.620 s 553C(2): 5.620 s 553D: 5.600 s 553E: 5.600 s 553AA: 5.610 s 554: 5.620 s 554A: 5.620 s 554B: 5.620 s 554C: 5.620 s 554E: 5.630 s 554F: 5.630 s 554G: 5.630 s 554H: 5.630 s 555: 5.650 s 556: 3.80, 5.200 s 558(1): 5.670 s 559: 5.650 s 561: 3.340, 5.660, 5.670 ss 561 to 564: 5.660 s 563A: 3.190, 5.680 s 563B(1): 5.620 s 588E: 5.60 s 588E(3): 5.60 s 588E(4): 5.60 s 588E(8): 5.60 s 588E(9): 5.60 s 588G: 1.90, 2.80, 4.190, 5.140, 5.560, 5.570 s 588G(1A): 2.80 s 588G(1): 5.550 s 588G(2): 5.550 s 588G(3): 5.550 s 588H: 2.80 s 588H(2): 5.560 s 588H(3): 5.560 s 588H(4): 5.560 s 588H(5): 5.560

Table of Statutes

Corporations Act 2001 — cont s 588J(1): 5.550 s 588M: 5.550 s 588V: 1.90, 5.570 s 588W: 5.570 s 588X: 5.570 s 588X(3): 5.570 s 588X(4): 5.570 s 588X(5): 5.570 s 588FA: 5.490, 5.500 s 588FB: 5.490, 5.500 s 588FC: 5.490, 5.500 s 588FD: 5.490, 5.520 s 588FE: 5.480, 5.490 s 588FF: 5.530 s 588FF(1): 5.480 s 588FF(3): 5.480 s 588FG(1)(a): 5.530 s 588FG(1)(b): 5.530 s 588FG(2): 5.530 s 588FDA: 5.490, 5.510 s 596A: 5.450, 5.670 s 596B: 5.450 s 596D: 5.450 s 597(4): 5.450 s 597(11): 5.450 s 597(12): 5.450 s 597(12A): 5.450 s 601AC(1): 5.710 s 601AH(1): 5.720 s 601AH(2): 5.720 s 601AH(5): 5.720 s 601EA: 6.80 s 601EA(4): 6.80, 6.120 s 601EB: 6.10, 6.70 s 601EB(1): 6.80 s 601EB(2): 6.80 s 601EB(3): 6.80 s 601ED(1): 6.70 s 601ED(3): 6.70 s 601ED(5): 6.70, 6.210 s 601EE: 6.70 s 601FA: 6.80, 6.90 s 601FB: 6.90 s 601FB(2): 6.90 s 601FB(4): 6.90 s 601FC: 6.100 s 601FC(1): 6.100 s 601FC(1)(g): 6.140 s 601FC(1)(h): 6.140 s 601FC(1)(i): 6.150 s 601FC(2): 6.110 s 601FC(4): 6.110 s 601FC(5): 6.100 s 601FC(6): 6.100 s 601FD: 6.100, 6.185 s 601FD(1): 6.100 s 601FE: 6.100

s 601FF: 6.170 s 601FF(2): 6.170 s 601FS(1): 6.110 s 601GA: 6.80, 6.100, 6.170 s 601GA(1): 6.130 s 601GA(2): 6.90, 6.130 s 601GA(3): 6.130 s 601GA(4): 6.310, 6.320 s 601GB: 6.80, 6.100, 6.120 s 601GC(1): 6.130 s 601GC(1)(b): 6.130 s 601HA: 6.80, 6.100, 6.140, 6.150 s 601HA(1): 6.140, 6.150 s 601HC: 6.80 s 601HE: 6.150 s 601HG: 6.80, 6.150 s 601HG(1): 6.160 s 601HG(3): 6.160 s 601HG(4): 6.160 s 601JA(1): 6.170 s 601JB(1): 6.170 s 601JC(1): 6.170 s 601JC(2): 6.170 s 601JD(1): 6.170 s 601JD(2): 6.170 s 601JD(3): 6.170 s 601JD(4): 6.170 s 601KA: 6.310 s 601KA(3)(b): 6.320 s 601KA(4): 6.320 s 601KA(5): 6.310 s 601KA(6): 6.310 s 601KB(1): 6.320 s 601KB(2): 6.320 s 601KB(3): 6.320 s 601KB(5): 6.320 ss 601KB to 601KE: 6.320 s 601KC: 6.320 s 601KD: 6.320 s 601KE: 6.320 s 601KE(2): 6.320 s 601KE(3): 6.320 s 601MA: 6.185 s 601MA(3): 6.185 s 601MB: 6.70, 6.185, 6.210 s 601MB(2): 6.185 s 601NA: 6.330 ss 601NA to 601ND: 6.330 s 601NB: 6.330 s 601NC: 6.330 s 601ND: 6.330 s 601PA: 6.330 s 601RAB(2A): 9.50 s 601RAC: 9.50 s 601RAC(1)(b): 9.50 s 601RAC(1)(c): 9.50 s 606: 6.320 s 670A: 10.510 xix

Law of Investments and Financial Markets

Corporations Act 2001 — cont s 674: 5.680, 10.200, 10.430 ss 674 to 675: 12.300 s 675: 10.200, 10.430 s 706: 3.170 s 707: 3.160 s 708: 3.170, 3.280 s 708(14): 3.280 s 708A: 3.160, 3.170 s 709(2): 3.160 s 709(4): 3.160 s 710: 3.180, 10.200 s 711: 3.180 s 712(1): 3.160 s 715: 3.160 s 718: 3.170 s 719: 3.180 s 721: 3.180 s 727: 3.270 s 728: 3.200, 10.490, 10.510 s 728(1): 3.200 s 728(2): 3.180, 3.200 s 729: 3.190, 3.200, 10.490 s 731: 3.200 ss 731 to 733: 3.200 s 732: 3.200 s 733: 3.200 s 739: 3.180 s 761A: 9.320, 12.40, 12.200 s 761D: 9.330, 12.40 s 761D(1): 9.330, 12.210 s 761D(2): 9.330 s 761D(3): 9.330, 12.210 s 761D(3)(c): 9.330 s 761D(3)(d): 9.320 s 761D(4): 9.330, 12.210 s 761E: 12.300 s 761G(5): 9.440, 9.470 s 761G(6): 9.450, 9.470 s 761G(7): 9.460, 9.470 s 761G(8): 9.480 s 761G(9): 9.480 s 761G(11): 9.470 s 761G(12): 9.440 s 761EA: 7.105, 9.310 s 761GA: 9.480, 10.460 s 762B: 9.260 s 762C: 9.260, 9.375 s 763A: 7.50, 9.250, 9.340 s 763A(1): 9.250, 9.260 s 763A(1)(b): 9.375 s 763B: 6.114, 7.50, 9.270 s 763C: 9.280, 9.375 s 763D(1): 9.290 s 763D(2): 9.290 s 763E(1): 9.300 s 764(1)(b): 12.40 s 764A: 9.250, 9.340 xx

s 764A(1): 9.310 s 764A(1)(a): 9.320 s 764A(1)(g): 12.40, 12.230 s 764A(l): 9.310 s 765(2): 9.340 s 765A: 9.250, 9.340 s 765A(1)(h): 9.290 s 766A(1): 9.360 s 766A(3): 9.360 s 766A(4): 9.360 s 766B: 9.370 s 766B(1): 9.370 s 766B(3): 9.380 s 766B(4): 9.380 s 766B(5): 9.380 s 766B(9): 9.370 s 766C(1): 9.390 s 766C(2): 9.390 s 766C(3): 9.390 s 766C(4): 9.390 s 766C(5): 9.390 s 766D: 9.400 s 766D(2): 9.400 s 767A(1): 9.410 s 767A(2)(a): 9.400 s 768A: 9.420 s 768A(1): 9.420 s 791A(1): 9.410 s 792A: 7.150 s 819: 8.70 s 911A: 9.50 s 911A(2): 9.60 s 911A(2)(a): 9.60 s 911A(2)(b): 9.60 s 911A(2)(c): 9.60 s 911A(2)(d): 9.60 s 911A(2)(f): 9.60 s 911A(2)(g): 9.60 s 911A(2)(h): 9.60 s 911A(2)(i): 9.60 s 911A(2)(j): 9.60 s 911A(2)(k): 9.60 s 911A(2)(l): 9.60 s 911A(2)(ba): 9.60 s 911A(2)(ea): 9.60 s 911A(2)(eb): 9.60 s 911A(2)(ec): 9.60 s 911A(2)(ee): 9.60 s 911A(6): 9.60 s 911B: 9.60, 9.210 s 911B(1): 9.210 s 912A: 6.90, 9.75, 10.530, 11.10, 11.90, 11.280 s 912A(1): 9.70, 9.240, 10.40 s 912A(1)(a): 10.530, 11.60 s 912A(1)(d): 6.90 s 912A(1)(e): 9.80 s 912A(1)(f): 9.230

Table of Statutes

Corporations Act 2001 — cont s 912A(1)(g): 9.70, 11.170, 11.180 s 912A(1)(aa): 9.70, 11.250 s 912A(1)(ca): 9.230 s 912(A)(2): 9.70 s 912A(2): 11.170 s 912A(aa): 10.530 s 912B(1): 9.190 s 912B(2): 9.190 s 912B(3): 9.190 s 912C: 10.520 s 912F: 10.350 s 913A: 9.100 s 913B: 9.100 s 914A: 10.520 s 915B: 9.120, 10.520 s 915B(1): 9.110 s 915C: 9.110, 10.520 s 915C(2): 9.110 s 915C(4): 9.110, 9.120 s 916A: 9.200 s 916A(1): 8.100, 9.200 s 916A(2): 9.200 s 916A(3): 9.200 s 916A(4): 9.200 s 916F: 9.200 ss 917A to 917E: 11.90 s 917E: 9.230 s 917F(1): 9.230 s 920A: 9.120, 10.520 s 920A(1): 9.120, 10.520 s 920A(2): 9.120 s 920A(3): 9.120 s 920B: 10.520 s 920B(1): 9.120 s 920B(2): 9.120 s 920C(1): 9.120 s 921A(1): 9.130 s 921A(2): 9.130 s 921A(4): 9.130 s 923A: 9.140 s 923B: 9.150 s 925A: 9.170, 9.180 s 925A(1): 9.170 s 925A(2): 9.170 s 925A(3): 9.170 s 925A(4): 9.170 s 925A(5): 9.170 s 925B: 9.170, 9.180 s 925C: 9.170 s 925D(1): 9.180 s 925D(2): 9.180 s 925E: 9.180 s 925F: 9.180 s 925H: 9.180 s 925H(1): 9.180 s 925H(2): 9.180 s 925I: 9.180

s 941(3): 10.250 s 941A: 10.230 s 941B: 10.230 s 941C: 10.240 s 941D: 10.240, 10.250 s 941D(2): 10.250 s 941D(3): 10.250 s 941D(4): 10.250 s 942A: 10.260 s 942B: 10.260, 10.490 s 942B(6A): 10.230 s 942B(2)(e): 10.180 s 942B(2)(f): 10.180 s 942B(3): 10.230, 10.260 s 942C: 10.260, 10.270, 10.490 s 942C(6A): 10.230 s 942C(2)(f): 10.180 s 942C(2)(g): 10.180 s 942C(3): 10.230, 10.260 s 943A: 10.270 s 944AA: 9.380 s 945A: 8.75, 11.90, 11.230 s 945B: 8.75, 11.150 s 946A: 10.300 s 946B: 10.330 s 946B(3A): 9.370 s 946C(1): 10.340 s 946C(3): 10.340 s 946AA: 10.320 s 946AA(4): 10.320 s 946AA(5): 10.320 s 947A: 10.300, 10.350 s 947B: 10.350, 10.490, 10.530 s 947B(2)(a): 10.350 s 947B(2)(b): 10.350 s 947B(2)(c): 10.350 s 947B(2)(d): 10.180, 10.340, 10.350 s 947B(2)(e): 10.180, 10.340, 10.350 s 947B(2)(f): 10.110, 10.340, 10.350 s 947B(3): 10.280, 10.300, 10.350 s 947B(5): 10.350 s 947B(6): 10.280, 10.350 s 947C: 10.350, 10.490 s 947C(2)(a): 10.350 s 947C(2)(b): 10.350 s 947C(2)(c): 10.350 s 947C(2)(d): 10.350 s 947C(2)(e): 10.180, 10.340, 10.350 s 947C(2)(f): 10.180, 10.350 s 947C(2)(g): 10.110, 10.350 s 947C(3): 10.280, 10.300, 10.350 s 947C(5): 10.350 s 947C(6): 10.280, 10.350 s 947D: 10.340, 10.350, 10.490 s 947D(2): 10.350 s 949A: 10.170, 10.180 s 949A(1): 10.170 s 949A(2): 10.170 xxi

Law of Investments and Financial Markets

Corporations Act 2001 — cont s 949A(3): 10.170 s 949A(4): 10.170 s 949A(5): 10.170 s 951A: 10.180, 11.150 s 951A(1): 11.150 s 951A(2): 11.150 s 952B: 10.490 s 952C: 10.480 s 952D: 10.490 ss 952D to 952M: 10.480 s 952E: 10.490 s 953B: 8.75, 10.490, 10.500 s 953B(6): 10.500 s 961(1): 10.60 s 961(2): 10.60 s 961(3): 10.60 s 961(4): 10.60 s 961(5): 10.60 s 961(6): 10.60 s 961B: 10.80, 10.95, 10.100, 10.130, 10.140, 10.500 s 961B(1): 10.80 s 961B(2): 10.80 s 961B(2)(c): 10.80 s 961B(2)(d): 10.80 s 961B(2)(e)(i): 10.80 s 961C: 10.80 s 961D: 10.80 s 961E: 10.80 s 961G: 10.100, 10.130, 10.140, 10.500 s 961H: 10.130, 10.140, 10.350, 10.500 s 961H(1): 10.110 s 961H(2): 10.110 s 961H(3): 10.110 s 961H(4): 10.110 s 961J: 10.120, 10.130, 10.140, 10.500 s 961K: 10.130 s 961L: 10.130 s 961M: 10.130, 10.500 s 961Q: 10.140 s 963A: 11.270 s 963C(c): 11.270 s 963C(d): 11.270 s 963E: 11.260 s 963F: 11.260 s 963G: 11.260 s 963H: 11.260 s 963J: 11.260 s 963K: 11.260 s 963L: 11.260 s 964A: 11.260 s 964D: 11.260 s 964E: 11.260 s 974C: 10.530 ss 985E to 985J: 9.310 s 985K: 9.310 ss 985EA to 985K: 9.310 xxii

s 991A: 10.200 s 1010A: 10.360 s 1010B: 10.360, 10.460 s 1012A: 10.380 ss 1012A to 1012C: 10.370 s 1012B: 10.380 s 1012C: 10.380 s 1012D(9A): 10.460 s 1012D(1): 10.460 s 1012D(2): 10.460 s 1012D(3): 10.460 s 1012D(5): 10.460 s 1012D(6): 10.460 s 1012D(7): 10.460 s 1012D(8): 10.460 s 1012D(9): 10.460 s 1012E: 10.460 s 1012J: 6.10, 10.420 s 1013A: 10.420 s 1013B: 10.420 s 1013C: 10.490 s 1013C(1)(a)(i): 10.420 s 1013C(3): 10.360 ss 1013C to 1013F: 10.420 s 1013D: 10.390, 10.420, 10.430 s 1013D(1): 10.430 s 1013E: 10.420, 10.430 s 1013F(2): 10.430 s 1013G: 10.420 s 1016A: 10.360 s 1016F: 10.500 s 1018A: 9.370, 10.440 s 1019A: 10.450 s 1019B: 10.450 s 1019B(3): 10.450 s 1020D: 10.180, 11.150 s 1021B: 6.10, 10.490 s 1021C: 10.480 s 1021D: 10.490 s 1021E: 10.490 s 1022B: 10.490, 10.500 s 1022B(7): 10.500 s 1041H: 5.680, 8.75, 10.510, 11.220 s 1041H(3): 10.510 s 1041I: 8.75, 11.220 s 1042A: 12.40, 12.150, 12.300 s 1042B: 12.40 s 1042C: 12.180, 12.300 s 1042C(1)(a): 12.300 s 1042C(1)(b): 12.180, 12.300 s 1042D: 12.170 s 1042F(1): 12.60 s 1042G(1)(a): 12.160 s 1042H(1): 12.160 s 1043(1): 12.300 s 1043(2): 12.300 s 1043A: 12.120, 12.130, 12.300 s 1043A(1): 12.60

Table of Statutes

Corporations Act 2001 — cont s 1043A(1)(c): 12.60, 12.300 s 1043B: 12.300 s 1043C: 12.300 s 1043C(1)(b): 12.250 s 1043E: 12.130 s 1043F: 12.160 s 1043G: 12.160 s 1043H: 12.150 s 1043I: 12.150 s 1043J: 12.150 s 1043L(2): 12.260 s 1043M: 12.250 s 1043M(2)(b): 12.250 s 1043M(3)(b): 12.250 s 1043N: 12.260 s 1071F: 2.200 s 1282(3): 5.340 s 1282(4): 5.340 s 1282(5): 5.340 s 1286: 5.340 ss 1290 to 1298: 5.340 s 1311(1): 10.170 s 1312: 12.250 s 1317E(1): 4.300 s 1317E(1)(jf): 12.260 s 1317E(1)(jg): 12.260 ss 1317E to 1317J: 4.190 s 1317F: 4.300 s 1317G: 4.300, 5.550, 12.260 s 1317H: 4.300 s 1317J: 4.300 s 1317DA: 12.260 s 1317HA(1): 12.260 s 1317HA(2): 12.260 s 1318: 4.180, 4.300 s 1324: 2.310, 4.300 s 1324(1A): 2.310 s 1324(1B): 2.310 s 1325: 6.185, 8.75 s 1325(2): 6.185 reg 7.7.11: 10.350 reg 7.7.11A: 10.350 reg 7.7.12: 10.350 Ch 1: 11.80 Ch 2E: 4.270 Ch 2J: 5.680 Ch 2L: 3.280 Ch 5C: 6.10, 6.90, 6.110, 6.185, 6.310, 6.380, 7.180, 7.190, 9.330 Pt 5C.6: 6.310, 6.320 Ch 5D: 9.50 Ch 6D: 3.80, 3.140, 3.160, 3.180, 3.200, 3.270, 3.280, 6.10, 7.190, 8.80, 9.330, 9.370, 10.200, 10.360, 10.490 Ch 6CA: 10.200, 10.360

Ch 7: 6.10, 6.70, 6.90, 6.370, 7.50, 7.100, 7.170, 7.180, 7.190, 8.70, 9.10, 9.20, 9.76, 9.190, 9.200, 9.250, 9.260, 9.290, 9.310, 9.320, 9.330, 9.340, 9.370, 9.380, 9.430, 10.10, 10.40, 10.180, 10.190, 10.210, 10.360, 11.10, 11.20, 11.60, 11.80, 11.250 Pt 7.6: 9.10, 9.40 Pt 7.7: 10.10, 10.180, 10.220, 10.470, 10.480, 10.490, 10.500, 11.60, 11.150, 11.230 Pt 7.7 Div 3: 9.380 Pt 7.7A: 10.10 Pt 7.9: 6.10, 6.114, 6.185, 6.210, 9.330, 10.10, 10.180, 10.240, 10.360, 10.420, 10.470, 10.480, 10.490, 10.500, 11.60, 11.150 Pt 7.9, Div 2: 10.170 Sch 3: 4.190, 12.250 Sch 10C: 10.390

Corporations Amendment (Financial Advice Measures) Act 2016: 9.490, 10.95 Corporations Amendment (Financial Advice) Regulation 2015: 9.490

Corporations Amendment (Further Future of Financial Advice Measures) Act 2012: 9.490 Corporations Amendment (Future of Financial Advice) Act 2012: 9.490

Corporations Amendment Regulations 2010 (No 5): 6.117

Corporations Amendment (Revising Future of Financial Advice) Regulation 2014: 9.490 Corporations Amendment (Sons of Gwalia) Act 2010: 3.190

Corporations Amendment (Streamlining Future of Financial Advice) Regulation 2014: 9.490

Corporations Legislation Amendment Act 1991: 12.180 Corporations Legislation Amendment (Financial Services Modernisation) Act 2009: 7.105, 9.50, 9.310 Item 1: 3.230 Corporations Regulations 2001: 6.117 regs 5.6.06 to 5.6.10: 5.430 reg 5.6.11(2): 5.220 reg 6CA.1.01: 12.300

xxiii

Law of Investments and Financial Markets

Corporations Regulations 2001 — cont reg 7.1.04(1): 12.210 reg 7.1.04(2): 12.210 reg 7.1.04(3): 12.210 reg 7.1.06: 9.340 reg 7.1.08: 9.370 reg 7.1.08(1): 9.370 reg 7.1.08(3): 9.370 reg 7.1.29(3): 9.380 reg 7.1.29(4): 9.380 reg 7.6.01C(1)(e): 10.350 reg 7.7.02: 10.310 reg 7.7.02A: 10.310 reg 7.7.08C: 10.320 reg 7.7.09A(1): 10.320 reg 7.7.09A(10): 10.320 reg 7.7.11: 10.350 reg 7.7.12: 10.350 reg 7.7.12D: 11.270 reg 7.7A14: 11.270 reg 7.7A.15: 11.270 reg 7.8.11A: 11.270 reg 7.9.15DA: 10.410 reg 7.10.1: 12.40 reg 7.10.01: 12.230 reg 7.129: 9.380 reg 9.12.01(d): 12.300 Sch 2: 5.90 Sch 10E: 6.117 Form 509H: 5.90 10B 10B: 10.390 10D 10D: 10.390 10E 10E: 10.390

Financial Sector Reform (Consequential Amendments) Act 1998: 11.100

Financial Services Reform Act 2001: 7.180 Financial Services Reform Bill 2001: 9.270 Financial Transactions Reports Act 1988: 7.200 Income Tax Assessment Act 1936: 5.370 Life Insurance Act 1995: 6.50

National Consumer Credit Protection Act 2009: 11.100 Personal Property Securities Act 2009: 3.350, 3.490 s 8: 3.370 s 8(1)(f): 3.350 s 8(1)(j): 3.350 s 8(1)(ja): 3.350 s 10: 3.360 s 12: 3.370 s 12(3): 3.370 s 13: 3.370 xxiv

s 14: 3.450 s 19(1): 3.410 s 20: 3.400 s 21: 3.420 s 43: 3.470 s 53: 3.470 s 55: 3.440, 3.450 s 55(5): 3.410 s 56: 3.440 s 57: 3.460 s 62: 3.450 s 322: 3.430 Pt 2-5: 3.470

Personal Property Securities Amendment (Deregulatory Measures) Act 2015: 3.370 Privacy Act 1988: 11.280 s 6: 11.280 s 6C: 11.280 s 6D: 11.280 Sch 3: 11.280

Proceeds of Crime Act 1987: 5.610

Superannuation Industry (Supervision) Act 1993: 6.50 s 10: 12.230 s 18: 12.230 Superannuation Industry (Supervision) Regulations 1994 reg 1.04(5): 12.230 Trade Practices Act 1974: 8.70, 11.80, 11.130 s 52: 5.680

Trade Practices Amendment (Australian Consumer Law) Act (No 1) 2010: 11.145

NEW SOUTH WALES Law Reform (Miscellaneous Provisions) Act 1946 s 5: 4.80

VICTORIA Companies (Victoria) Code: 6.210

WESTERN AUSTRALIA Companies (Co-operative) Act 1943 Pt VI: 6.50

UNITED STATES Sarbanes-Oxley Act 2002: 4.10, 4.70

CHAPTER 1 The Nature of Investing in a Company [1.20]

Introduction ................................................................................................... 1 [1.20] Key points .......................................................................................................... 1 [1.30] Key terms ........................................................................................................... 2

[1.50]

Nature of companies.................................................................................... 2 [1.50] Formation of companies .................................................................................. 2 [1.60] Structure of companies .................................................................................... 3 [1.70] Limited liability ................................................................................................. 5 [1.80]

The company as a separate legal entity ........................................... 5

[1.90] Piercing the corporate veil .............................................................................. 6

[1.110]

[1.160]

[1.230]

Company ownership and control.............................................................. 6 [1.110]

Separation of ownership and management ............................................... 6

[1.120]

The role of the board of directors ................................................................ 8

[1.130]

The influence of investors on the board ..................................................... 8

[1.140]

Becoming a member ....................................................................................... 9

The investor’s equity interest ................................................................... 10 [1.160]

The company’s power to issue shares ...................................................... 10

[1.170]

Nature of equity interests ............................................................................ 10

[1.180]

Membership rights ............................................................................. 10

[1.190]

The nature of shares .......................................................................... 11

[1.200]

Nature of preference shares ........................................................................ 11

[1.210]

Nature of ordinary shares ........................................................................... 12

Other types of investment ........................................................................ 12 [1.230]

Debt interests in the company .................................................................... 12

[1.240]

Other asset classes – the need for diversification ................................... 13

[1.250]

Cash and fixed interest investments .............................................. 14

[1.260]

Government and non-government bonds ................................................ 15

[1.270]

Risk and investor implications ................................................................... 15

INTRODUCTION Key points [1.20] This chapter will provide a greater understanding of: • the nature of a company and its structure and formation; • the role of the board of directors and its relationship with investors; • the different types of interest that an investor may have in a company; and • the nature of shares, and the types of rights that attach to shares. [1.20] 1

Law of Investments and Financial Markets

Key terms [1.30] The key terms in this chapter are: • Company • Australian Securities and Investments Commission (ASIC) • Australian Securities Exchange (ASX) • Proprietary company • Public company • Registered office of a company • Constitution • Listed company • Stock exchange • Limited liability • Replaceable rules • Separate legal entity • Corporate veil • Equity interest • Debt interest • Bond • Debenture • Ordinary share • Preference share • Participating preference shares • Cumulative preference shares • Converting preference shares • Redeemable preference shares

NATURE OF COMPANIES Formation of companies [1.50] An Australian company is created pursuant to the provisions of the Corporations Act 2001 (Cth) by lodging the prescribed form for application of registration of a company, plus prescribed fee, with the Australian Securities and Investment Commission (ASIC). The form complies with s 117 of the Corporations Act 2001, 1 which sets out a number of requirements and matters that must be specified in the application, such as: the name and type of company, the names and addresses of directors and members, the number of shares held by each 1

All legislative references are to the Corporations Act 2001 (Cth), unless otherwise specified. This legislation can be reviewed at http://www3.austlii.edu.au/au/legis/cth/consol_act/ca2001172/

2 [1.30]

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| CH 1

member, the address of the registered office of the company (which is the place where documents can be served on a company), and whether the company has a company constitution. The application also needs to specify whether the company will be a proprietary company, or a public company. Different legal obligations apply to proprietary and public companies, and only public companies can be listed on a stock exchange. Public companies also have more onerous reporting requirements. There are around 2.25 million companies in Australia, of which about 2,140 are listed entities. 2 Listed companies have contractually agreed with a securities exchange (such as the Australian Securities Exchange, also known as the ASX) to comply with the exchange’s Listing Rules. Shares in such companies can be bought and sold through the securities exchange. For that reason, it is much easier for Australian investors to invest in publicly listed companies rather than in unlisted companies. Recent proposed amendments to the law to allow relatively small public and unlisted companies, with both gross assets and gross turnover under $5 million, to raise up to $5 million under a new “crowd-funding” disclosure regime with reduced disclosure requirements have lapsed before passing the Senate. The reforms are likely to resurface in the next parliamentary session. With provisions for facilitating the transfer of securities in such companies, without being listed, these reforms may change the preference for new company structures in the future.

Structure of companies [1.60] The most common type of company in Australia is a company limited by shares. 3 The investors in such companies are called “shareholders” because they own (hold) “shares” in the company. A share is property and can be transferred; in non-listed companies this occurs privately by private contract; in listed companies, the transfer of shares often occurs on a securities market such as the ASX. Companies limited by shares need to have at least one shareholder (s 114). There is no maximum number of shareholders for a public company. A proprietary company with more than 50 non-employee shareholders can be required to convert to a public company: s 113. Proprietary companies require a minimum of one director resident in Australia; public companies require a minimum of three directors, two of which must reside in Australia: s 201A. Public companies must have a company secretary; proprietary companies can choose whether or not to have a company secretary: s 204A. 2 3

ASIC Annual Report, 2014–2015. Section 9 of the Corporations Act 2001 defines a “company limited by shares” as a company formed on the principle of having the liability of its members limited to the amount (if any) unpaid on the shares respectively held by them. [1.60] 3

Law of Investments and Financial Markets

Another type of company is a company limited by guarantee. 4 Such a company does not have or issue shares; instead its investors invest a sum of money in the company (the “guarantee” amount). This amount may be paid at the time the investor invests in the company, or some or all of it may be promised to be paid at a future time. These companies are less common than companies limited by shares. Companies limited by guarantee are, by nature, public companies, however, companies limited by guarantee with annual or consolidated revenue of up to $1 million have lesser reporting obligations than other public companies. (Companies limited by guarantee with annual or consolidated revenue of under $250,000 have no requirement for financial reporting, auditing, directors’ reports, unless required by ASIC or a member). Some confusion can arise between the terms “shareholder”’ and “member”. A member of a company is an investor in the company — such as a shareholder, in a company limited by shares, or as a person promising to guarantee an amount, in a company limited by guarantee. Thus a shareholder will always be categorised as a member of the company, but not all members of companies are shareholders (because not all companies have shares). The term “member” is also broader than just the laws relating to companies — we also speak of “members” of an investment scheme (meaning investors in that scheme) or of a superannuation fund (meaning subscribers to that fund). Generally, a “member” is someone who has applied funds towards a common/shared form of investment, although the term has been specifically defined by the courts in some circumstances. This will be discussed later in this book. For now, it is worth noting the definition of “member of a company” in s 231: A person is a member of a company if they: (a)

are a member of the company on its registration; or

(b)

agree to become a member of the company after its registration and their name is entered on the register of members; or

(c)

become a member of the company under section 167 (membership arising from conversion of a company from one limited by guarantee to one limited by shares).

The relationship between the company, its members and its directors is governed by the company’s internal rules. The internal rules can be either a constitution, individualised to meet the company’s needs, or the default Replaceable Rules, which are default rules set out in the Corporations Act 2001. These default rules are located throughout the Corporations Act 2001, but are indexed in s 141, and are for companies without a constitution displacing them.

4

Section 9 of the Corporations Act 2001 defines a “company limited by guarantee” as “a company formed on the principle of having the liability of its members limited to the respective amounts that the members undertake to contribute to the property of the company if it is wound up”.

4 [1.60]

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Limited liability [1.70] Historically, companies came into existence for the purpose of accumulating capital from investors in order to exploit commercial opportunities. Initially, investors were personally liable for debts incurred as a result; nowadays the corporate structure and form provides protection to investors by means of a doctrine known as “limited liability”. This doctrine is so-named because an investor’s liability to the company is limited to the subscription price for their investment in the company (such as subscription for shares, or the amount agreed upon to be “guaranteed” to the company in a company limited by guarantee) — once that amount is agreed upon, the investor cannot normally be made liable for any additional amount required to pay the company’s debts. Where the subscription price of the investment was not fully paid at the time of the investment in the company, in the case of most companies, holders of those shares are contractually obligated to pay “calls” on those shares until the price is fully paid: s 254M. A “call” on shares is a demand by the company for payment of some or all of the unpaid balance of the issue price of the shares. This is an important issue for investors holding partly-paid shares, in that calls can be made on the shares at any time. Even (and especially) in a winding up, investors holding partly paid shares can be required to pay any unpaid balance. The exception to this is in the case of no-liability companies, confined to mining ventures (s 112(2)), where investors are not obligated to pay any call, but if they choose not to pay the call, will forfeit their shares pursuant to s 254Q. Thus, investors in partly-paid shares in a mining venture risk forfeiture of their shares and, consequently, loss of their investment if, when a call is made on those shares, they choose not (or are not in a financial position) to continue contributing to the company’s capital. However, one advantage is that, unlike partly-paid shareholders in other companies, they cannot be forced to pay the balance of the subscription price in the event of a liquidation.

The company as a “separate legal entity” [1.80] Once registered, a company becomes a “legal person” (that is, a person recognised by the law). It is a legal entity that is separate and distinct from those who have incorporated it. This principle of “separate legal entity” is the cornerstone of company law, and is demonstrated by ss 119 and 124 of the Corporations Act 2001, which specifically provide that a company is created by registration and after registration is able to own property, enter contracts and sue and be sued, all in its own name. Likewise, any contracts entered into by the company are binding on the company, and will not bind any shareholder personally unless the shareholder becomes a party to the contract. As discussed above, a share may be fully paid for at the time of subscription, or partly-paid. The rights attaching to shares will depend on the nature of the interest in the company issued by the company. Most shares are known as “ordinary shares” but some shares will have special rights. [1.80] 5

Law of Investments and Financial Markets

Piercing the “corporate veil” [1.90] There are certain exceptions to this principle of “separate legal entity” found in legislation and in the various case law emanating from the courts. When an exception is recognised by either the courts or statute, this is described as “piercing” or “lifting” the “corporate veil” which (theoretically) separates the relevant legal person (that is, the company) from separate and distinct legal persons (eg, the company’s directors and members). This concept of “lifting or piercing the corporate veil” is just a description of the process whereby the court or legislation can, by recognising an exception to the principle of separate legal entity, make a person other than the company liable for the company’s contractual obligations; or allow a person other than the company (eg, a member) to exercise some of the company’s rights. One statutory example of “lifting the corporate veil” is found in s 588G of the Corporations Act 2001, which (together with other sections) make company directors personally liable for company debts which the directors allowed the company to incur at a time when the company was insolvent. An investor that is a “holding company” can be similarly liable for an insolvent company’s debts under s 588V. An example of “lifting the corporate veil” under the common law is the “phoenix” company — that is, where one company rises out of the ashes of another company. If the new company takes on all the assets of the old company, but not its liabilities, the courts will sometimes require the new company to honour the legal obligations of the original company. Because the principle of “separate legal entity” is so fundamental to the nature of companies, the veil will not be lifted lightly; there needs to be some policy reason for it. However, it can alleviate some of the harsh results that can result from abuse of the corporate form and, as such, for public policy reasons the doctrine represents a valuable addition to the laws relating to companies.

COMPANY OWNERSHIP AND CONTROL Separation of ownership and management [1.110] Sometimes, particularly in small proprietary companies, the directors are also the shareholders and therefore also “own” the company. In larger companies there is usually a separation of management from ownership. The ability to separate ownership from management becomes important when investment capital is sought from broad and disparate groups of investors who will not be part of the management team nor join the board of directors. (Of course, the opportunity exists for investors with sufficient capital and negotiating power to also negotiate the right to participate in the management of the company.) It is possible for investors who do not participate in management, and who have vested control of their investment and the company’s decision-making in a management group primarily, but not exclusively, consisting of the directors, to 6 [1.90]

The Nature of Investing in a Company

| CH 1

still have continuing rights under both the Corporations Act 2001 and the company’s internal rules. These are further discussed in Chapter 2, “Members’ Rights”. When investors in a company are only shareholders without any involvement in management, they have, in a practical sense, very little control over their investment. They will have the right to vote at the general meeting of the company (ie, the meeting of shareholders); however, such rights are exercisable infrequently. In addition, institutional investors, such as insurance companies and superannuation funds, hold most of the shares in Australian listed companies. Each year, the ASX publishes its research on the attitudes of the persons holding shares listed on the ASX. This publication details not only the number of Australians owning shares, but their various attitudes and approaches to investment, investment research and advice. 5 Some findings in the 2015 research include: • In 2014, 36% of adult Australians (6.48 million Australians) directly or indirectly owned listed investments.

• This comprised 3% (0.54 million) with only indirect investments, 26% (1.26 million) with only direct investments, and 7% (4.68) with direct and indirect investments. 6

• Total participation of retail investors in the sharemarket is trending downwards, from 38% to 36% in 2014, with indirect investment falling faster than direct investment, 7 however, of that direct investing, there is a slight increase in preference for listed investments other than shares. 8

• Australian investors are demonstrating a slight increase in their preference for international shares, up to 13% in 2014, from 10% in 2012. 9

• Typically, investors enter the market in their late twenties or thirties. 10 • 28% of adult male Australians are direct share owners, while only 27% of adult female Australians are share owners. 11

• Perhaps unsurprisingly, tertiary education increases the likelihood of investing, and income appears correlated with investment 12 and direct investment is more commonly found in capital cities rather than regional areas. 13

5 6 7 8 9 10 11 12 13

See for example, the 2015 Australian Share Ownership Study, available at http://www.asx.com.au/ documents/resources/australian-share-ownership-study-2014.pdf (accessed 26 April 2016) hereafter cited as “2015 Share Ownership Study”. See 2015 Share Ownership Study, pp 8–9. See 2015 Share Ownership Study, pp 10–11. See 2015 Share Ownership Study, p 13. See 2015 Share Ownership Study, p 14. See 2015 Share Ownership Study, p 17. See 2015 Share Ownership Study, p 17. See 2015 Share Ownership Study, pp 18–19. See 2015 Share Ownership Study, p 20.

[1.110] 7

Law of Investments and Financial Markets

The role of the board of directors [1.120] It is the role of the board of directors to develop the corporate strategies and policies of the company and to implement guidelines to ensure that such strategies are achieved. The board of directors meets on a regular basis to monitor the performance of management and, importantly, examine the financial state of the company. Typically, the board of directors decides on the scope of the company’s business activities and the best possible manner in which the company’s capital can be applied to attain those pursuits, including the most appropriate capital structure for the company. For instance, it may be necessary to raise further finance, either through an issue of shares or by creating debt finance. Legal principles relating to financing the company’s operations are discussed in Chapter 3. In addition to deciding the strategic direction of the company, the board also oversees the implementation of that policy by monitoring the performance of the persons who have been delegated management tasks (typically, employed managers). It is usual for a company’s constitution or the Replaceable Rules (s 198A) to confer on the board of directors the power to manage the affairs of the company and to exercise all the powers of the company.

The influence of investors on the board [1.130] The board cannot totally ignore the wishes of investors, since not only do investors appoint and remove directors from the board, but the members in the general meeting are given specific powers under the Corporations Act 2001. For example, the members in the general meeting are the only persons who can decide such things as whether to amend the constitution, to give a financial benefit to a director, or to buy back shares. Historically, the directors of a company in the 19th century were regarded as the mere agents of the investors. However, this has changed as investors have realised the benefits of having companies managed by professional managers. An illustration of this occurred in the English case of Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame. 14 In that case, a shareholder purported to negotiate the sale of the company’s assets to another party. He convened a meeting of the shareholders for the purpose of having his actions endorsed and requiring the board of directors to enter contracts for the disposal of the company’s assets. The court concurred with the board’s view that they could not be forced by the shareholders to dispose of the assets as the company’s constitution conferred the power of management of the company on the board of directors, not the shareholders. This case makes the demarcation between the two roles very clear. 14

Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34.

8 [1.120]

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| CH 1

Institutional investors who hold a significant stake in a publicly listed company are in a position to exercise considerable influence in respect of the corporate governance of that company. Although they traditionally have not played a major role, evidence indicates that they now feel it incumbent upon themselves to play a larger role. An example of this occurred at the News Ltd 2003 Annual General Meeting where, due to objections from both institutional and individual investors, the issue of directors’ share options was shelved despite the fact that management controlled sufficient shares to pass the resolution. The increased role of institutional investors is perhaps a response to perceived poor corporate governance practices and, as a consequence, reduced returns to investors. Members of a company can also have a role in circumstances where the board of directors is deadlocked and lacks the capacity to make decisions. For instance, they are able to institute legal proceedings in circumstances where the company is under the control of the wrongdoers. Further, members can ratify some actions by directors. Members’ rights are more fully discussed in Chapter 2.

Becoming a member [1.140] Upon the initial registration of a company, a person can become a member if they are named on the original application to ASIC for registration. If the company is a company limited by shares, the application for registration must include the class of shares that investors consent to take up: s 117(2)(k). A person can also become entitled to request that their name be entered on the register of members if the person acquires shares previously issued by the company from another shareholder (whether by way of inheritance, a gift, or a sale of those shares, or by way of conversion of a prior guarantee). Sales of shares can occur either on a market (such as the ASX) for listed companies, or privately. A person also becomes a member if they are the recipient of shares issued by the company: s 231 (outlined above). Once a person becomes a member, they become bound to the company’s internal rules (which will either be the company’s constitution or, if the company does not have a constitution, the Replaceable Rules). The Replaceable Rules are set out throughout the Corporations Act 2001 and are indexed by s 141. Some older companies are still governed by the legislation (and default rules contained in that legislation) which preceded the Corporations Act 2001. Such companies will have a personalised memorandum of association and articles of association, or rely on default rules known as “Table A” articles or “Table B” articles. Either way, the company’s internal rules govern the relationship between the company, each director and each member, and between each member and each other member. The company in general meeting can amend the constitution by special resolution (which requires 75% of votes in favour): s 136. [1.140] 9

Law of Investments and Financial Markets

THE INVESTOR'S EQUITY INTEREST The company's power to issue shares [1.160] Every company limited by shares has the legal capacity to issue shares: s 124. The Corporations Act 2001 also gives companies the power to allot shares with different kinds of rights: s 254B. The reason for the ability to issue different types of shares is that, in order to be competitive companies need to be able to cater for the needs of particular kinds of investors. For instance, some investors, by nature, take a conservative approach in assessing the risks associated with investing money. Others may wish to own interests in the company that are more akin to loan capital. In smaller companies the initial controllers may wish to maintain control of the company and, in order to achieve this, vary the voting rights of some classes of shares. It is common to vary the rights of shares for tax reasons. Some shareholders may be interested in shareholder discounts at the company’s stores; others may be only concerned about voting and dividend entitlements. In broad terms, the differences between classes of shares are reflected in: • the entitlement to a dividend; • the right to priority in payment of a dividend; • voting rights; • the right to priority of repayment of capital in the event of a winding up; and/or • the right to participate in a distribution of surplus assets on winding up. Generally, companies set out the different rights in their constitution. Companies without a constitution generally pass a special resolution adopting such rights. The procedures involved in a company issuing debt interests or equity interests are more fully discussed in Chapter 3. Note also the directors’ obligations to issue shares for a proper purpose, discussed in Chapter 4.

Nature of equity interests [1.170] There are a number of types of equity interests a person may have in a company, and different rights apply to each of them.

Membership rights [1.180] The rights which flow to an investor by virtue of membership of a company are rights arising under the company’s constitution, the Corporations Act 2001 and the common law. These include (but are not limited to) the right to participate in a distribution of the company’s profits, if any, and the right to vote at the company general meetings. An investor who holds an equity interest in the company is known as a “member”, and the entitlements of the investor arise after the person becomes a member. As discussed above, this generally occurs following entry of their name on the company’s register of members: s 231. All companies are required by s 169 to establish a register of members and to keep it up to date. 10 [1.160]

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| CH 1

The precise nature of those rights held by any member of a company depends on the agreement between the company and the prospective investor at the time the shares are issued, and may either be set out in the company’s constitution, or may be the subject of a separate agreement between the company and the investor.

The nature of shares [1.190] Legally, a share is classified as a chose in action, which is, in effect, intangible personal property. A share can be transferred, subject to limitations contained in the company’s constitution (or the Replaceable Rules, if they apply) and the Corporations Act 2001. As discussed above, a share may be fully paid for at the time of subscription, or partly-paid. The rights attaching to shares will depend on the nature of the interest in the company issued by the company. Most shares are known as “ordinary shares” but some shares will have special rights.

Nature of preference shares [1.200] The specific rights attaching to preference shares will depend very much on the rights given to those shares in the constitution and in any resolution pursuant to which the shares were issued. However, the holders of preference shares will generally have a preferential right to receive dividends before the holders of ordinary shares. They will also generally have the right to receive a fixed percentage of the issue price of the shares by way of annual dividend. In most cases, preference shareholders will enjoy the right of having their investment repaid in priority to the holders of ordinary shares – eg where the company undertakes a capital reduction, share buy-back or enters into voluntary or involuntary liquidation. The rights attached to preference shares must include the matters specified in s 254A(2) of the Corporations Act 2001, namely: • repayment of capital; • participation in surplus assets and profits; • cumulative and non-cumulative dividends; • voting; and • priority of payment of capital in relation to other shares or classes of preference shares. Preference shares can be offered to investors in a variety of forms. The different types are: • Participating preference shares. An investor is said to be “participating” if they have an entitlement to receive additional dividends over and above the preferential entitlement. The constitution has to expressly provide that the shares have a right to participate: see Will v United Lankat Plantations. 15 15

Will v United Lankat Plantations [1994] AC 11. [1.200] 11

Law of Investments and Financial Markets

• Cumulative preference shares. This means the investor is entitled to have an arrears in dividend made up in subsequent years. All preference shares are presumed to be cumulative unless the company’s constitution states otherwise: see Webb v Earle. 16

• Converting preference shares. These shares have the same rights as those associated with preference shares but allow for conversion to ordinary shares. The terms of issue will require conversion at the expiration of a certain period.

• Redeemable preference shares. These preference shares are similar to loan capital and can be redeemed at a certain time at the option of the company or the shareholder, or both: s 254A(3). As with loan capital (where the loan has to be paid regardless of the company’s performance), the redeemable nature of these shares ensures that the investor can recover the capital that was invested in the company (assuming solvency of the company). However, unlike loan capital (where interest is payable even if the company is not profitable), the return on the preference shareholder’s investment is by way of dividend, and because dividends can only be paid out of profits, the holder of redeemable preference shares can only receive a return on the investment if the company is profitable. Section 254K governs how the shares are to be redeemed and the money used for a redemption must come from company profits or the proceeds of a new issue of shares.

Nature of ordinary shares [1.210] The holders of ordinary shares have a right to share equally in any dividends declared. However, they rank after the holders of preference shares and have the least priority to a return of capital upon a winding up. If a company does not perform well financially, ordinary shareholders’ prospects in gaining a return on their investment can be bleak as dividends can only be paid, amongst other requirements, if the company’s assets exceed its debts: see s 254T for more detail. On the other hand, if the company is prosperous, they may conceivably obtain a higher return than preference shareholders (if the preference shareholders are to receive a fixed dividend rate).

OTHER TYPES OF INVESTMENT Debt interests in the company [1.230] An investor can also invest in a company’s debt. This investment could be by way of a loan whereby the investor simply loans the company money under a loan agreement. Normally, the loan is fully repayable on a date specified in the agreement, and usually the investor receives a return on the loan by way of interest on the outstanding balance, calculated according to a formula specified in the agreement. The relationship between the company and the investor is contractual, and the lender does not become a member of the company. Sometimes, the loan will be agreed to be secured by means of collateral over either real or personal property. In the case of real property, this means a 16

Webb v Earle (1875) 20 Eq 556.

12 [1.210]

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| CH 1

registered mortgage, and in the case of personal property, may likely mean a registered personal property security interest. These are discussed in later chapters. An investor can also invest in a company’s debt by way of the company issuing a “debenture”. A debenture holder has certain rights; and a company’s ability to issue debentures is restricted by the Corporations Act 2001. These procedures and requirements are more fully discussed in Chapter 3.

Other asset classes – the need for diversification [1.240] This last part of the chapter will focus on the investor’s ability to hold part of their investment funds in cash or fixed interest investments or government bonds. In any balanced approach to investment, an adviser will always argue for a diversified approach (cash and fixed interest and government bonds) to investment in a portfolio of investments. Such investment assets are regarded as having low risk in comparison to investments in a company and are used by advisers to balance out the portfolio so that the investments satisfy the risk profile of the investor. Most investors have some funds in a fixed term interest account or a normal savings account. These investments are found in every bank or financial institution and the general law of contract governs the terms and conditions of the payment of interest by the bank or financial institution and the ability by the investor to access the funds at the end of the term of investment. Figures 1.1 and 1.2 illustrate the importance of investing in cash and government bonds as part of an overall investment strategy if investors wish to reduce the overall risk associated with their investment portfolio. While most investors and investment advisers recognise the importance of diversification in investment, shares and property form only part of a balanced portfolio. The risk profile of the investor should then determine the various percentages of the overall investment fund invested in the different classes of assets.

[1.240] 13

Law of Investments and Financial Markets

Figure 1.1: Low-risk portfolio

Figure 1.2 shows a medium-risk portfolio of investments, which has a substantial reduction in investment in cash and bonds. It illustrates the fact that in any balanced approach to investment, the investor and the investment adviser must be prepared to invest in cash or bonds. This allows the investor quick access to cash if required but also provides a return on investment in difficult economic circumstances. Figure 1.2: Medium-risk portfolio

Cash and fixed interest investments [1.250] The investor must appreciate that money invested with a bank or financial institution that is licensed to accept deposits is not entirely free from risk. The risk is that the bank or financial institution may be placed into liquidation and eventually wound up. 14 [1.250]

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| CH 1

The Commonwealth Government does not guarantee the financial stability of banks, although in the wake of the 2008 global financial crisis, the Commonwealth introduced schemes to guarantee certain bank deposits of up to $1 million in eligible banks, building societies and credit unions made between 12 October 2008 and 31 March 2010, to the earlier of either their maturity date, or in the case of at-call deposits, until October 2015. Liabilities created after 1 February 2012 were subject to a cap of $250,000 per person per institution, and the scheme has now completely closed. All banks and financial institutions are licensed and regulated under the Banking Act 1959 (Cth). The Australian Prudential Regulation Authority (APRA) is the government body charged with maintaining the “prudential standards” of banks, friendly societies, public offer superannuation funds, credit unions, building societies and insurance companies. If APRA is doing its job properly, then investors should feel that their money in a cash account or fixed term deposit is protected.

Government and non-government bonds [1.260] The Commonwealth and State governments and State government authorities are the main providers of government bonds for investors. Governments use bonds to raise finance for various projects where the investor is able to obtain a relatively secure stream of interest payments over the term of the bond. A market has been established to facilitate the sale and purchase of the bonds. Their value is linked to the interest rate payable on the bond and the current interest rates available from bank investment products. Large Australian public companies also issue bonds to investors as a means of raising capital. The bond provides a fixed rate of return with the interest paid yearly or twice yearly.

Risk and investor implications [1.270] While bonds and cash and term deposits are regarded as having very little risk attached to them as investments, the investor should be aware that they are not entirely risk-free. Similarly, debentures in a company are regarded as a relatively safe investment, but there are still inherent risks. However, in any balanced portfolio of investments, cash, bonds, debentures and shares are all necessary investments.

[1.270] 15

CHAPTER 2 Members' Rights [2.10]

Introduction ................................................................................................. 17 [2.20] Key points ........................................................................................................ 18 [2.30] Key terms ......................................................................................................... 18

[2.40] [2.60]

Policy reasons for protecting members’ interests................................. 18 Dividends..................................................................................................... 19 [2.60] [2.70] [2.80] [2.90]

[2.110]

As a return on the investment ...................................................................... 19 The process ....................................................................................................... 19 Funds available for dividend payment ....................................................... 20 Dividend policy ............................................................................................... 23

Specific rights .............................................................................................. 23 [2.110] Voting rights ................................................................................................... 23 [2.120] Role of general meetings .................................................................. 23 [2.130] Calling general meetings .................................................................. 24 [2.140] Notice of general meetings .............................................................. 24 [2.150] Attending general meetings ............................................................. 25 [2.160] Voting procedures at general meetings .......................................... 25 [2.170] Amending the constitution ......................................................................... 25 [2.180] Enforcing the constitution ........................................................................... 25 [2.190] Inspecting company books .......................................................................... 26 [2.200] Correcting the members’ register ............................................................... 26

[2.220]

Protecting members’ interests .................................................................. 26 [2.220] Policy reasons for protecting minority interests ..................................... 26 [2.230] Common law limits on the majority’s power .......................................... 27 [2.240] Oppressive conduct under the Corporations Act ................................... 28 [2.250] What is oppressive conduct? ........................................................... 28 [2.260] Remedies for oppression .................................................................. 30 [2.270] Statutory protection for the variation of class rights ............................. 30 [2.280] Winding up the company ............................................................................ 31 [2.300] Other statutory rights ................................................................................... 32 [2.300] Procedural irregularities ................................................................... 32 [2.310] Statutory injunction ........................................................................... 32

[2.320]

Derivative actions....................................................................................... 32

INTRODUCTION [2.10] As discussed in Chapter 1, the relationship between an investor in a company, and the company, is sourced in contract. Thus, the rights that attach to shares issued by the company to an investor can be negotiated between the company and the investor. [2.10] 17

Law of Investments and Financial Markets

Certain rights will also be set out in the company’s internal rules (whether a constitution, or the default Replaceable Rules set out in the Corporations Act 2001 (Cth)). These rights form part of the statutory contract between the investor and the company: s 140. The Corporations Act 2001 also sets out certain mandatory rights for members of companies. Some rights are based in a combination of the above sources. For example, the Corporations Act 2001 specifies when a company is empowered to pay a dividend. However, the rate of the dividend may be determined by a contract between the company and the investor, or be set out in the company’s constitution.

Key points [2.20] This chapter will provide a greater understanding of members’ rights. These rights stem from the nature of the shares themselves, from the Corporations Act 2001 (Cth) or from the company’s constitution (or a combination of these). Rights discussed in this chapter include: • dividend rights; • voting rights; and • the rights of a member under the Corporations Act 2001.

Key terms [2.30] The key terms in this chapter are: • Dividend • Member • Oppression • Variation of class rights • Minority shareholding

POLICY REASONS FOR PROTECTING MEMBERS' INTERESTS [2.40] Investors’ rights need to be viewed in the context of the need to protect members against wrongful conduct by directors. It is also necessary to protect minority interests, which can be out-voted at general meetings, from actions by the majority. This can occur when investors disagree with an ordinary or special resolution passed by the company at a general meeting. Thus, the law has developed to provide specific protection for minority interests against oppressive or commercially unfair or discriminatory or prejudicial conduct. The proposition that majority rule should prevail is largely adhered to; however, the law has developed principles to prevent the exploitation of small-scale investors. An example would be if the majority altered the company’s share capital to the detriment of the minority stakeholders. This could commonly occur if the majority issued to themselves additional shares at the expense of the minority, thus diluting these minority investors’ shareholdings. 18 [2.20]

Members' Rights

| CH 2

The majority could also use their position to ratify certain actions of the majority which negatively impact on the company’s minority investors. A further example would be where the company’s constitution is amended in circumstances that are disadvantageous to the minority. These examples will be discussed later in the chapter.

DIVIDENDS As a return on the investment [2.60] A dividend is a distribution of distributable assets, allocated by a company to its shareholders. 1 Clearly, many investors take up shares primarily in order to be paid a share of the company’s profits in the form of a dividend. (Of course, some investors may be more interested in the capital appreciation (also known as capital gain) that can be realised from a sale of the shares.) It is likely that most investors are interested in both types of return on their investment. Dividends are usually paid in cash, but it is common for companies to issue bonus shares or, for some, to institute a dividend reinvestment scheme. A dividend reinvestment plan allows shareholders to reinvest the amount of their dividend into the acquisition of additional shares in the company, usually at a slight discount to the current market price for those shares.

The process [2.70] Normally, dividends must be “declared” before they are paid. (This can be changed in a company constitution). Section 254U of the Corporations Act 2001 gives the board of directors the power to declare dividends and to determine the amount, the time for payment, and the method of payment. For companies with a constitution, the practice is for the directors to recommend the maximum amount payable and to have the shareholders declare this figure at a general meeting. In proprietary companies s 254W(2) allows the directors to pay dividends as they see fit. Companies can pay an interim and a final dividend. The difference between the two is that interim dividends can be altered or revoked prior to the date for payment: see Industrial Equity v Blackburn 2 while final dividends cannot normally be revoked (eg, for a company with a constitution, once a final dividend has been declared it becomes a debt enforceable against the company: s 254V(2). For a company operating under the Replaceable Rules, the assumption is that all dividends are interim until the time for payment arises — upon declaration of a dividend, no immediate debt is created (s 254V(1)) and so the company is able to revoke the dividend prior to the date for payment. 1

2

Churchill International Inc v BTR Nylex Ltd (1991) 4 ACSR 693 at 695. Industrial Equity v Blackburn (1977) 137 CLR 567.

[2.70] 19

Law of Investments and Financial Markets

The case of Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326 has confirmed that it is possible for a company to amend its constitution to provide for fixed, mandatory, enforceable dividends calculated by means of a formula, without any need for the dividends to be declared before becoming enforceable.

Funds available for dividend payment [2.80] The law changed on 28 June 2010 in relation to the funds from which dividends can be paid. Previous law Under the former s 254T, dividends could only be paid out of profits. This concept originated in the common law, and was also in line with the common law rule that companies must maintain their capital. These common law rules existed largely to protect the interests of creditors of the company, to ensure company assets were not distributed to shareholders ahead of creditors. A large number of company law cases considered the meaning of “profits” in this context. Rules were complex and were not necessarily consistent with the accounting standards. Current law On 28 July 2010, s 254T was amended so that it now states that: (1)

(2)

A company must not pay a dividend unless: (a)

the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and

(b)

the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and

(c)

the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.

Assets and liabilities are to be calculated for the purpose of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).

Paragraphs (b) and (c) seem to have been inserted into the Act as the result of submissions made by the Australian Institute of Company Directors on 9 June 2010 (and perhaps others). However, prior to the amendment, the company and its directors were already under obligations to act fair and reasonably to shareholders as a whole when conducting the company’s affairs (under s 232), to act in the best interests of shareholders as a whole and for proper purposes (s 181) and to not materially prejudice its ability to pay creditors (under s 588G) and these separate obligations remain. When determining whether to pay dividends, directors must be mindful of the operation of s 588G(1A), which deems the payment of a dividend as a deemed debt. If, as a result of the payment of the dividend, the company is rendered insolvent, the directors become personally liable to compensate the company unless one of a few limited defences apply under s 588H. 20 [2.80]

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| CH 2

Current case law Because the current s 254T is so new (2010), there have not been many cases considering its operation or interpretation. One case suggested that the current s 254T operates concurrently with, and has not displaced, the common law principle that dividends can only be paid out of profits: Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326 at [57]. This is significant as it suggests that dividend payments must satisfy both this common law principle as well as the requirements of s 254T). However, this is merely a “comment” by the court, and as such does not form binding legal precedent — at least, not yet. Another case considered how s 254T would operate, in circumstances where the company borrowed funds to pay a dividend to only one class of shareholders (who did have priority of dividends over the other class of shareholders). This case was KGD Investments Pty Ltd v Placard Holdings Pty Ltd [2015] VSC 712. The company, Placard, proposed to borrow $29 million to pay a $25 million dividend to the “A” shareholders (who controlled 76% of the company’s shares), with the extra $4 million to increase working capital of the company. The “B” shareholders (who controlled 24% of the company, and who were not entitled to share in the dividend under the terms of their shares) objected, arguing that increasing company debt for the purpose of a dividend (which they did not directly benefit from) did not satisfy the requirements of s 254T. They argued that the dividend was not fair and reasonable to shareholders as a whole, in that entering into the loan for such a purpose was risky and unfair to minority shareholders, who would find it more difficult to sell their shares in the company (given the company’s increased debt). They also argued that the dividend was oppressive under s 232. The court held that the dividend proposal breached neither s 254T nor s 232 because the the court did not consider the loan to be particularly risky in all the circumstances — the company was well-able to service the increased debt, the proposal was commercially justifiable and allowed for risk of non-renewal of contracts (which was low). The proposal would not negatively affect the company’s value, and the court specifically held that directors are able to pay dividends from any source permitted by law, provided they consider the dividend to be justified by the company’s finances. Proposed amendments This area of law continues to develop and further amendments are likely. 3 3

In April 2014, an exposure draft of the Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 was released for consultation. The Bill contained a proposed new section 254T and a new section 254TA, as follows: The draft section 254T initially proposed by the Bill was: 254T Circumstances in which a dividend may be declared or paid Declaration of dividends [2.80] 21

Law of Investments and Financial Markets

Dividend policy [2.90] Dividend policy is seen as a matter for the board of directors: see Burland v Earle. 4 The courts are reluctant to interfere with decisions of directors that are generally based on commercial considerations, such as the desire to build up the company’s working capital. If a refusal to pay a dividend is based on an ulterior motive and consequently amounts to oppression of some shareholders, legal action could be instituted pursuant to s 232 (discussed below).

4

(1) A company must not declare a dividend unless, immediately before the dividend is declared, the directors of the company reasonably believe that the company will, immediately after the dividend is declared, be solvent. Note: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G. Payment of dividends without declaration (2) A company must not declare a dividend unless, immediately before the dividend is declared, the directors of the company reasonably believe that the company will, immediately after the dividend is declared, be solvent. Note: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G. (3) Subsection (2) does not apply to a dividend that is declared. The draft section 254TA initially proposed by the Bill was: 254TA Share capital reductions by way of dividends (1) A company may reduce its share capital by declaring or paying a dividend, if: (a) the dividend is declared or paid, as the case may be, in accordance with section 254T; and (b) the reduction in share capital is an equal reduction. (2) For the purposes of paragraph (1)(b), the reduction is an equal reduction if: (a) it relates only to ordinary shares; and (b) it applies to each holder of ordinary shares in proportion to the number of ordinary shares they hold; and (c) the terms of the reduction are the same for each holder of ordinary shares, disregarding differences that are: (i) attributable to the fact that shares have different accrued dividend entitlements; or (ii) attributable to the fact that shares have different amounts unpaid on them; or (iii) introduced solely to ensure that each shareholder is left with a whole number of shares; or (iv) attributable to the use of dividend reinvestment plans. These proposals were eventually omitted from the final legislation passed by the Parliament in 2015 and thus, at present, do not form current law, but are likely to resurface in another Bill as they were expressly stated to have been omitted from the final version of the bill so that further consideration could be given to them. (Note: In the Senate Inquiry considering these proposed new sections 254T and 254TA, the omission was explained as facilitating the timely passage of other amendments in the original Bill, while enabling consideration of “alternative approaches” to dividends.) Accordingly, the above proposed sections 254T and 254TA (or some variation of them) may be inserted into the legislation in the future and accordingly, further reform to the legislation relating to dividends, is anticipated. Burland v Earle [1902] AC 83.

22 [2.90]

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| CH 2

In determining whether profits exist, the test is a comparison between the state of the business at both the beginning and the end of the relevant financial period. The law is concerned chiefly with the company’s “circulating capital”, ie what comes into the company during the pertinent time. This test is frequently contrary to the accounting and finance perception of what constitutes the profit of the company. Directors can rely on financial statements, but must also take account of the company’s finances as a whole, which may have changed since the financial statements were prepared.

SPECIFIC RIGHTS Voting rights [2.110] Investors are effectively the owners of the company and it is appropriate that they vote on changes to the company’s constitution and determine the composition of the board of directors. In Australia, it is rare for more than one-third of the investors to vote in meetings and it is quite common for shareholders who control 20% of the votes to effectively control the voting process at meetings of the company. In large, listed companies, small investor control does not exist.

Role of general meetings [2.120] The Corporations Act 2001 (Cth) sets out the following examples of corporate behaviour, which are regulated by the general meeting: • If the company proposed to alter a provision of its constitution s 136, or altering the company’s type (s 162), then the investors would have to pass a special resolution requiring a 75% majority vote of those present and proxies: s 9.

• Transactions which affect the company’s share capital, such as if a company proposes to buy back a certain proportion of shares (s 257B), reduce its share capital (s 256C), engage in providing financial assistance (s 260B) or vary class rights, where the company has issued shares with different rights attached to them (s 246B), all require investor approval.

• If a company proposes to issue new shares, this may constitute a variation of class rights by operation of the law (s 246C) or if a listed company proposes to issue additional shares, which would amount to 15% of the company’s issued capital, then investor approval is required (ASX (Australian Securities Exchange) Listing Rule 7.1).

• Investors have a right to have a vote on the appointment and removal of the company’s directors. For proprietary companies this is governed by ss 201G and 201H for appointment and s 203C for removal. The application of these procedures may be disturbed by a contrary intention inserted in the company’s constitution. For public companies, in particular listed companies, according to s 203D investors have the right to remove a director by the passage of an ordinary resolution (50% of those present and proxies). [2.120] 23

Law of Investments and Financial Markets

• If a company has adopted the Replaceable Rules, then under s 202A investors have the right to vote on the directors’ remuneration. CLERP 9 proposes that a non-binding vote can be taken in respect of directors’ salaries. This may morally influence the quantum of salary sought.

• Investors are also permitted to vote on the appointment and removal of auditors. There is no requirement for a proprietary company to have an auditor, but s 325 allows directors in a proprietary company to appoint an auditor if the members have not done so. A public company must have an auditor and while directors appoint the first auditor (s 325A), members have the right to vote on that appointment at the next company meeting and to fill subsequent vacancies at subsequent meetings: ss 327B and 329. If members do not appoint an auditor, the Australian Securities and Investments Commission (ASIC) can: s 327F. The independence of companies has received much adverse publicity in recent times as it was considered that the role of auditors was fundamental in the collapse of Enron in the United States and HIH in Australia. It should be added, however, that the role played by the auditors was by no means the sole reason for these spectacular collapses.

Calling general meetings [2.130] Normally directors call and convene the general meeting. In public companies, this is a mandatory right that cannot be taken away from any director. In addition, investors holding 5% of the votes that may be cast on a company resolution have the right to give the company notice that they propose to move an investor-initiated resolution (s 249N) and/or to require the company to call a general meeting: ss 249D and 249F. If the directors fail to comply with a s 249D request within 21 days, then investors holding more than 50% of the votes of those members requisitioning the meeting may call and hold such a meeting: s 249E. It should be noted that the requisition power should be exercised in good faith and not for an improper purpose: see Humes Ltd v Unity APA Ltd. 5 Additionally, directors are entitled to refuse to hold a meeting if the investors are trying to interfere with a power conferred on the board of directors under the constitution: NRMA v Parker. 6

Notice of general meetings [2.140] There are specific requirements set out in the Corporations Act 2001 in relation to the timing and content notice given to shareholders of meetings (normally a minimum of 21 days for non-listed companies and 28 days for listed companies: ss 249H and 249HA). Each shareholder is entitled to written notice, and the notice must contain sufficient information for the investor to decide whether to attend the meeting. 7 5 6 7

Humes Ltd v Unity APA Ltd [1987] VR 467. NRMA v Parker (1986) 6 NSWLR 517. The Treasury has recently released a Proposal Paper (May 2016) detailing proposed refroms to facilitate technology-neutral distribution of notices. This is available at http://www.treasury.gov.au/ ConsultationsandReviews/Consultations/2016/Technology-Neutrality (accessed 24 May 2016).

24 [2.130]

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| CH 2

Attending general meetings [2.150] All members are entitled to attend company meetings. Normally, ownership of a share includes the right to vote at company meetings. 8 Voting rights entitle the investor to vote at general meetings of the company. Previously all companies needed to hold a meeting each year; nowadays this obligation only applies to public companies. Annual general meetings (known as AGMs) need to be held shortly after the end of the company’s financial year, and the general meeting is entitled to consider the directors’ report, the financial report and any resolutions that are described in the notice of meeting.

Voting procedures at general meetings [2.160] Decisions of the general meeting are made by resolution. A special resolution is passed when 75% (or more) of the votes at the meeting are in favour of the resolution. This is to be contrasted with an ordinary resolution, which requires simply that a majority of the votes are in favour of the resolution. Generally, an ordinary resolution is required for most matters considered by the general meeting; a special resolution is only required if the Corporations Act 2001 or the constitution specifically require this. Voting at a meeting of the members is conducted by one of two methods: • A show of hands. Under this method every member, regardless of the number of shares held by the member, has one vote: s 250J (which is a replaceable rule).

• A poll. The chairman, five members or members holding 5% of the votes may demand that a poll be taken: s 250L. If a poll is demanded, the votes must be counted in accordance with the number of votes that each share carries, normally one vote: s 250E.

Members are entitled to appoint a proxy, which allows another person to attend and vote at a general meeting instead of the member.

Amending the constitution [2.170] The Corporations Act 2001 specifically provides that members can, by special resolution in a general meeting, amend the constitution: s 136.

Enforcing the constitution [2.180] A member has a right to enforce as a contract, the company’s constitution: s 140. For example, the investor can force the directors to comply with the various clauses of the constitution, such as accepting votes or paying dividends in the manner specified, or compel the directors to purchase the investors’ shares, if such a provision exists. The constitution has contractual effect also against the other shareholders and thus other shareholders can also be required to comply with the constitution. 8

In rare cases, some particular shares may not have voting rights attached to them. [2.180] 25

Law of Investments and Financial Markets

Inspecting company books [2.190] Investors also have personal rights to inspect a company’s minute book (s 251B) as well as a right to inspect the company’s register of members, although the purposes for which and means by which the register can be inspected are limited by legislation. Investors have a right under s 247A to apply to the court for an order that the person can inspect the company’s books. The investor has to make the application in good faith and for a proper purpose. Investigation of whether the directors have breached their duties would fall within these criteria: see Unity APA Ltd v Humes Ltd (No 2). 9 On the other hand, if the application were made to obtain confidential information or assist a takeover bid, it would be inappropriate.

Correcting the members' register [2.200] Section 175 of the Corporations Act 2001 (Cth) deals with corrections of the members’ register, entitling a member to apply to the court for correction of the register and compensation of any loss or damage suffered as a result of the incorrect register. Section 1071F allows directors to register a transfer of shares in the members’ register. Broadly, the refusal has to be exercised in good faith and for a proper purpose, but directors of companies are entitled to refuse to register a transfer of shares. This has the effect of preventing a person, who may have bought shares from an existing shareholder, from becoming a member.

PROTECTING MEMBERS' INTERESTS Policy reasons for protecting minority interests [2.220] As discussed above, minority interests can be out-voted at general meetings. This can occur when investors disagree with an ordinary or special resolution passed by the company at a general meeting. Because minority interests can be out-voted at a general meeting, the law has had to address the possibility that minority investors’ rights might from time to time require protection. The proposition that majority rule should prevail is largely adhered to; however, the law has developed principles to prevent the exploitation of small-scale investors. An example would be if the majority altered the company’s share capital to the detriment of the minority stakeholders. This could commonly occur if the majority issued to themselves additional shares at the expense of the minority, thus diluting these investors’ shareholding. They could also use their position to ratify certain actions of the majority which negatively impact on the company. A further example would be where the company’s constitution is amended in circumstances that are disadvantageous to the minority. 9

Unity APA Ltd v Humes Ltd (No 2) [1987] VR 474.

26 [2.190]

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| CH 2

In addition, because of the common separation between ownership and management of companies, there is a real need to protect members generally (not just minorities) from wrongful or oppressive conduct by directors. Thus, the statutory provisions relating to oppression relate not only to minority interests, but to any member interest.

Common law limits on the majority's power [2.230] The common law developed the principle that there should be an “equitable limitation on majority voting power”. The Corporations Act 2001 also provides for the adherence to several procedural requirements where a company wishes to pursue certain strategies that might not necessarily favour the minority. In addition, there are specific legislative provisions which provide protection for the small investor. The small investor also possesses personal and contractual rights which they can enforce against the company. All of these devices are designed to ensure that the actions of the majority do not go beyond what could be considered their legal powers. In recent years the courts have demonstrated a willingness to look after the interests of minority investors. This is illustrated by the High Court decision in Gambotto v WCP Ltd. 10 This case involved a decision by the majority to alter the company’s constitution to enable a company (Industrial Equity Ltd) holding 99.7% of the shares to compulsorily acquire the outstanding 0.3% of shares. The directors reasoned that this would save at least $4 million in taxation payments and would prune administrative costs. 11 Previously, if such an alteration to a company’s constitution could be reasonably argued to be “bona fide” and for the benefit of the company overall, it would be allowed to stand. The company as a whole was seen as being somewhat more important than its individual owners. In this case, the High Court overturned the alteration, notwithstanding that Industrial Equity Ltd refrained from voting and all minority investors present at the meeting voted in favour of the alteration. The High Court reasoned that the alterations had to be fair, in terms of price paid and procedure, and could not oppress the minority. Further, they found that such an alteration had to be for a proper purpose. This was defined to mean that the investor could only have their investment acquired if it could be demonstrated that their memberships of the company would create harm to the company or be detrimental to it. In other words, it would be incumbent upon the company in these circumstances to prove a “negative” and not a “positive”. This represented a fundamental shift from the previously applied rules. 10 11

Gambotto v WCP Ltd (1995) 182 CLR 432. The post-takeover power of a majority holder to compulsorily acquire remaining minority shares was not applicable in this case. [2.230] 27

Law of Investments and Financial Markets

Oppressive conduct under the Corporations Act [2.240] Investors are provided with a range of statutory remedies if they can satisfy a court they have been oppressed or unfairly treated. This does not only apply to minority interests being protected against the majority; it can also apply to all members who have been unfairly treated by the management of the company.

What is oppressive conduct? [2.250] Section 233 of the Corporations Act 2001 provides relief where the court is of the view that, under s 232, the conduct of the company’s affairs is either: • contrary to the interests of the investors as a whole; or • oppressive, unfairly prejudicial to, or unfairly discriminatory against, a member or members.

“Conduct” refers to actual or proposed acts or omissions. Hence, a company resolution may be oppressive or a failure to perform certain tasks may infringe s 232. While the remedy is available for all types of companies, it is usually resorted to in small proprietary companies where the investors are normally engaged in performing managerial functions. An investor contemplating recourse to this remedy must be a member at the time the legal action is commenced. Basically, the court has to be satisfied that there has been a visible departure from the standards of fair dealing. If, for example, the conduct complained of concerns a decision made by the directors of a company, the court would test the allegation on the basis of what reasonable directors would decide in the circumstances. If reasonable directors would not have arrived at such a decision, the conduct can be said to be “oppressive”. A dislike of management style and the refusal to purchase shares would be insufficient to constitute oppressive conduct: see Re G Jeffrey (Mens Store) Pty Ltd. 12 Oppressive or unfair conduct must not only be discriminatory or prejudicial, it must be unfairly so. This implies that, given certain circumstances, the management of a company can actively discriminate against members. The leading case in Australia relating to this aspect is Wayde v New South Wales Rugby League Ltd, 13 where the High Court held it was permissible for the company to banish certain members and clubs from the competition nationally, and to cull members who were not financially secure. The company was deemed to be acting for the benefit of the whole competition. Examples of oppressive or unfair conduct are as follows: • A breach of the law. • A breach of directors’ duties: Re JGS Investment Holdings Pty Ltd. 14 12 13

14

G Jeffrey (Mens Store) Pty Ltd (1984) 2 ACLC 421. Wayde v New South Wales Rugby League Ltd (1985) 180 CLR 459.

Re JGS Investment Holdings Pty Ltd [2014] NSWSC 1532.

28 [2.240]

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| CH 2

• Diverting corporate opportunities to another entity or associates of the directors or allowing a company to languish through a failure to supply essential materials to it: Cook v Deeks 15 and Scottish Co-operative Wholesale Society Ltd v Meyer. 16

• Diversion of profits. This could occur where directors pay excessively high remuneration to themselves, while paying no or very low dividends to investors: Sandford v Sandford Courier Service. 17

• An unfair exclusion from management. This would be the case if, when the company was formed, it was done so on a quasi-partnership basis and with the expectation that management would be shared. An improper removal would attract relief: Re Wondoflex Textiles Pty Ltd. 18

• Conduct of board meetings. Examples would be if a policy were implemented without the approval of the board or if matters were discussed without sufficient notice.

• Directors refusing to call a meeting and denying investors relevant information. • Altering the company’s constitution to restrict an investors’ voting power: Mamouney v Soliman. 19

• Issuing shares for the purpose of diluting certain investors’ shareholding: Re Dalkeith Investments Pty Ltd. 20

• Where there is a failure on the part of directors to act in the interests of the company. This is illustrated in the cases of Re Spargos Mining NL 21 and Jenkins v Enterprise Gold Mines NL, 22 where both companies were taken over by Independent Resources Ltd who effectively controlled the boards of directors of both companies. Independent Resources caused the two companies to enter into transactions, the purpose of which was to provide money to Independent Resources at the expense of Spargos and Enterprise Gold Mines. This was achieved through the making of loans and the acquisition of shares. The loans could never be repaid and the shares were of no value. The directors had acted in the interests of Independent Resources and, as such, their actions were oppressive. The court held that a receiver/manager be appointed to control the affairs of the companies and investigate breaches of directors’ duties.

• Failure to comply with shareholder rights specified in the constitution. For example, in Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326, the New South Wales Court of Appeal held the company’s failure to declare dividends to specific shareholders, whose rights to dividends were enshrined in the constitution, constituted oppression under s 232.

Remedies for oppression [2.260] Pursuant to s 233 of the Corporations Act 2001, the court has wide powers to make orders it deems appropriate. The court orders can include the following relief: 15 16 17 18

Cook v Deeks [1916] AC 554. Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324. Sandford v Sandford Courier Service (1987) 5 ACLC 394. Re Wondoflex Textiles Pty Ltd [1951] VLR 458.

22

Jenkins v Enterprise Gold Mines NL (1992) 10 ACLC 136.

19 20 21

Mamouney v Soliman (1992) 10 ACLC 1674. Re Dalkeith Investments Pty Ltd (1985) 3 ACLC 74. Re Spargos Mining NL (1990) 3 WAR 166.

[2.260] 29

Law of Investments and Financial Markets

• winding up of the company; • altering the company’s constitution; • regulating the future conduct of the company; • ordering the shares of an investor to be purchased; • ordering that the company institute or defend legal proceedings; • ordering the appointment of a receiver; and • restraining a person from engaging in specified conduct or requiring them to perform a specified act.

A share buy-out of a particular investor is the most frequently adopted order.

Statutory protection for the variation of class rights [2.270] A class of shares is a group of shares sharing the same rights. This occurs only where a company issues shares with different rights attached to them, or when the company changes the rights of some shares after they have been issued. For instance, a company may issue ordinary and preference shares. If a company has issued preference shares it must comply with the requirements of s 254A(2), which requires that the terms of issue stipulate whether the shares are cumulative and that investors have priority to a return of capital. This would ordinarily be specified in the company’s constitution. A variation of the rights attaching to preference shares (which are a class of shares) occurs if the company amends the constitution to remove the priority of preference shareholders to the return of their capital and which renders the shares to no longer be cumulative. If the vast majority of the shareholders in the company are ordinary shareholders, they would likely have sufficient votes at the general meeting to pass the special resolution (75% majority) required by s 136 for amendments to the constitution, thereby outvoting preference shareholders. What redress is now available to the disadvantaged investors holding preference shares? The company’s constitution can stipulate the procedure for varying the rights of a class of shares and, if it does so, this procedure must be complied with for the variation to be effective: s 246B(1). If the company’s constitution does not specify any procedure dealing with a variation of class rights, then the legislation sets out default procedures in s 246B(2). Section 246B(2) specifies that the rights attaching to the shares can only be cancelled or varied if the company as a whole passes a special resolution, plus a separate special resolution of the class of investors affected by the change. This second resolution needs to be at a separate meeting of that class of shareholders (often held immediately before or after the company’s general meeting) and would require at least 75% of the votes of the members of the class whose rights are varied or cancelled to be in favour of the resolution. There is additional protection for a situation where, say, the majority of investors holding preference shares are also ordinary shareholders and vote in that capacity believing the alteration to be favourable to their prospects as ordinary shareholders. Section 246D enables the holders of 10% of 30 [2.270]

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| CH 2

the shares to apply to the court to have the alteration overturned within one month of the change. Further, s 246F(3) requires a copy of the resolution to be lodged with ASIC.

Winding up the company [2.280] It is possible for investors to apply to the court to have the company wound up: s 461. This would happen if, under s 461: • directors are acting in their own interest; • affairs of the company are being conducted in an oppressive manner; • there is an omission or resolution which would be oppressive; or • it is just and equitable in the circumstances that the company be wound up. Most commonly, a disgruntled investor will bring an action to wind up a company with an action also alleging oppression. Note that pursuant to s 233, discussed above, the court has the discretion to make a vast range of orders. In an application for a winding up there is but one order, which may not be granted. Indeed, under s 467(4) courts are specifically directed not to wind up a company where it is believed there is a more suitable remedy available. Also, courts are reluctant to wind up companies that are solvent where the winding up would adversely impact upon other investors. The court will only grant an order that the company be wound up if it is just and equitable for them to do so. The following examples are circumstances in which a court may order a winding up: • A breakdown of mutual trust and confidence. The circumstances would be that a person is removed from management contrary to a perceived understanding. For example, in Ebrahimi v Westbourne Galleries 23 the dismissed director was not able to receive a share of profits as a shareholder because the constitution provided that only directors could share in a division of profits.

• Deadlock. This occurs where the company experiences inertia because its management will no longer converse with each other. While the court is empowered to order a company meeting to take place without a quorum being present (s 249G), it can only do this for a limited period of time: see Re Sticky Fingers Restaurant Ltd. 24 Eventually, the court would have little alternative but to wind up the company.

• Fraud or misconduct. In this case, the reason the company was incorporated was to perpetuate a fraud on its investors. In Loch v John Blackwood Ltd, 25 the directors denied financial information to the minority shareholders because the controllers ultimately wished to purchase the investors’ shares at an undervalued price.

• Failure of the company’s sub-stratum. This occurs where the company is no longer in a position to pursue the commercial objects for which it was established. For example, in Re German Date Coffee Company 26 the object of the company was to seek a patent in 23 24 25

26

Ebrahimi v Westbourne Galleries [1973] AC 360. Re Sticky Fingers Restaurant Ltd (1992) ACLC 3011. Loch v John Blackwood Ltd [1924] AC 783.

Re German Date Coffee Company (1882) 20 Ch D 169. [2.280] 31

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respect of making coffee out of dates. This of course was not possible. The company was unable to attain its stated objects and was wound up.

Other statutory rights Procedural irregularities [2.300] A procedural irregularity occurs where the company may have passed resolutions in circumstances not complying with the procedures required. Normally, the court will not require rigid compliance with procedures, but where a substantial injustice has occurred as a result of the irregularity, the court will invalidate such resolutions. For example, in Mamouney v Soliman, 27 a resolution was declared invalid because it was deficient in terms of time and did not give members the 21 days notice required by s 249H; the notice was also insufficient in distribution and content: s 249L. In Chew Investment Pty Ltd v General Corp of Australia Ltd, 28 a proxy demanded that a vote be taken by a poll, rather than on a show of hands. Section 250L requires that such a demand be complied with, but the chairman wrongfully rejected this request. A declaration was sought from the court to have the resolutions overturned on the basis that a poll should have been called and that the resolutions would have been defeated on a poll. The court agreed.

Statutory injunction [2.310] Pursuant to s 1324, a court has discretion to grant an injunction restraining a party from breaching the Corporations Act 2001. The court also has the ability to grant an interim (temporary) injunction. In that sense it can be viewed as an expedient remedy to, say, prevent a continuing breach of directors’ duties. It can also restrain an anticipated breach of the Corporations Act 2001. Investors and ASIC are entitled to apply for an injunction: see Airpeak Pty Ltd v Jetstream Ltd. 29 For example, under s 1324(1A) investors may apply for an injunction if they perceive that a share buy-back (s 257A), financial assistance (s 260A) or a share capital reduction (s 256) is unfair. Under s 1324(1B), the onus of proving fairness in these processes is on the company.

DERIVATIVE ACTIONS [2.320] Derivative actions enable an investor to bring an action in the courts on behalf of a company. This is where, for example, the directors of the company have breached their duty to the company. In that situation, under the now abolished rule in Foss v Harbottle, 30 the company was the plaintiff. That is, it was 27 28 29

30

Mamouney v Soliman (1992) 10 ACLC 1674. Chew Investment Pty Ltd v General Corp of Australia Ltd (1998) 6 ACLC 87. Airpeak Pty Ltd v Jetstream Ltd (1997) 73 FCR 161; 15 ACLC 715.

Foss v Harbottle (1843) 67 ER 189.

32 [2.300]

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| CH 2

up to the company to commence legal action to recover compensation. The individual investors were not competent to bring an action on behalf of the company. Section 236(3) has abolished the operation of this rule. An investor or director is now permitted to bring a derivative action on behalf of the company and, if they are successful, compensation is paid to the company, not to the individual investor or director. It is said that “they stand in the shoes of the company” and this is what is meant by a “derivative action” on behalf of the company. In order to limit the possibility of vexatious or frivolous claims being litigated by investors, a member wishing to bring an action on behalf of the company must satisfy a court that leave should be granted for the derivative action to proceed. The court will then consult the “check list” in s 237(2), which includes the requirement that the applicant is acting in good faith in the interests of the company and for proper purposes. It also requires that the company itself will not litigate and has been served, 14 days previously, with a notice of the applicant’s intention to proceed. It should be demonstrated that litigation is in the best interests of the company and there is a serious issue to be tried. The substantive issue does not have to be proven at that stage, as the applicant must only demonstrate that proceedings should be taken. If the applicant satisfies these criteria, litigation ensues, even if the substantive case is lost. Section 242 gives the court a broad discretion to award costs. Section 240 makes it impossible for an applicant to discontinue or settle the proceedings without the permission of the court.

[2.320] 33

CHAPTER 3 Funding Company Operations [3.10]

Introduction ................................................................................................. 36 [3.20] Key points ........................................................................................................ 37 [3.30] Key terms ......................................................................................................... 37

[3.50]

Capital structure ......................................................................................... 38 [3.50] Balance between equity and debt ................................................................ 38 [3.60] Gearing ratio .................................................................................................... 39 [3.70] Distinction between share capital and loan or debt capital .................... 39

[3.110]

[3.80]

Share capital ........................................................................................ 39

[3.90]

Loan or debt capital .......................................................................... 40

Equity fundraising...................................................................................... 41 [3.110] Power to issue shares ................................................................................... 41 [3.120] Restrictions on the ability to issue shares ................................................ 41 [3.130] Restrictions in the internal rules of the company ........................ 41 [3.135] Contractual Restrictions .................................................................... 42 [3.140] Restrictions in the Corporations Act .............................................. 43 [3.150] Restrictions in the Listing Rules ...................................................... 44 [3.160] Chapter 6D – disclosure documents .......................................................... 44 [3.170] Requirements ...................................................................................... 45 [3.180] Contents ............................................................................................... 45 [3.185] Reform history .................................................................................... 46 [3.190] Liability – claims by investors ......................................................... 47 [3.200] Basis of liability ............................................................................................. 48 [3.210] Case Study: Astra Resources ....................................................................... 49

[3.220]

Debt fundraising......................................................................................... 50 [3.220] Borrowing money ......................................................................................... 50 [3.230] What is a debenture? .................................................................................... 50 [3.240] What is an unsecured note? ........................................................................ 51 [3.250] Convertible debentures ................................................................................ 51 [3.270] Issuing debentures and notes ..................................................................... 51 [3.270] Requirements: Ch 6D ........................................................................ 51 [3.280] Requirements: Ch 2L ......................................................................... 52 [3.285] ASIC Requirements ............................................................................ 53 [3.290] Additional requirements ................................................................... 54 [3.300] Security interests ........................................................................................... 54 [3.310] The historical position: fixed charges and floating charges ....... 55 [3.320] Floating charges ................................................................................. 55 [3.330] Historical need for registration .................................................................. 56 [3.340] Historical position relating to competing priorities ............................... 57 35

Law of Investments and Financial Markets

[3.350]

The current position: security interests under Personal Property Security Act 2009 (Cth)......................................................................... 57 [3.360]

Personal property .......................................................................................... 58

[3.370]

Security interest .................................................................................. 58

[3.380]

Secured party and grantor ............................................................... 59

[3.390]

Collateral .............................................................................................. 59

[3.400]

Security agreement ............................................................................ 59

[3.410]

Attachment .......................................................................................... 59

[3.420]

Perfection ............................................................................................. 60

[3.430] Transitional security interests .......................................................... 61 [3.440] General priority rules under the PPSA ..................................................... 62 [3.450]

Specific priority rules – purchase money security interests ....... 62

[3.460]

Specific priority rules – perfection by control .............................. 62

[3.470]

Extinguishment rules ......................................................................... 63

[3.480] Security interests in an insolvency ................................................. 63 [3.490] Reform ............................................................................................................. 64

INTRODUCTION [3.10] A company can raise the funds necessary to carry on its business in two primary ways: • by borrowing funds from investors (known as “loan capital” or “debt capital”); or • by issuing equity interests (such as shares) to investors. The first method is called “debt financing” and the second is “equity financing”. Different laws apply to each type of financing. Companies are specifically empowered by s 124 of the Corporations Act 2001 (Cth) to borrow money, to grant security for such loans, and to issue shares. To facilitate effective operations of the company, company managers need to make and implement decisions about the capital needs of the company. Such decisions include the amount of capital required by the company, and the most effective source of that capital. Companies who wish to expand their future trading opportunities will inevitably have to finance those operations by raising sufficient funds through either a process of issuing shares, or borrowing money directly through the agency of a financial institution or by issuing debentures. Most companies will choose to finance their operations with a mix of debt and equity financing. Practical difficulties (eg difficulty in finding a willing financier) may impact the type of funding chosen. Contractual obligations may require the company to maintain its capital around a certain gearing ratio (the balance between the two types of funding). If the company elects to issue shares, the investor becomes a shareholder and, as such, a member of the company under s 231 of the Corporations Act 2001 (Cth). If funds are raised through borrowing money or issuing debentures, the provider of such funds is classified as an external creditor. 36 [3.10]

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| CH 3

Key points [3.20] This chapter will provide a greater understanding of: • how a company can raise money for its operations; • the differences between debt financing and equity financing; • the nature of, and legal requirements for, equity fundraising; and • the nature of, and legal requirements for, secured and unsecured debt fundraising.

Key terms [3.30] The key terms in this chapter are: • Debt financing • Equity financing • Disclosure • Prospectus • Offer information statement • Short form prospectus • Disclosure document • Fundraising • Due diligence • Share capital • Gearing ratio • Debenture • Unsecured note • Charge • Personal property • Security interest • Personal property security interest • Personal property security register • Transitional security interest • Attachment • Perfection • Purchase money security interest • Priority • Collateral

[3.30] 37

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CAPITAL STRUCTURE Balance between equity and debt [3.50] Directors and controllers of companies need to decide which amount, type and balance of capital structure best suits the company’s operations, both current and into the future. As mentioned above, a company can finance its operations through equity, debt (although finding and financing a wholly debt-financed operation may be problematic) or, most commonly, a mixture of both equity and debt. Other circumstances may constrain these decisions. For example, a company which has little prospect of profits in the short term may find it difficult to adequately service debt or, indeed, to find a financier willing to finance such operations. Likewise, the financing of high-risk operations may be difficult to obtain or may be only obtainable on very expensive terms, thus leaving managers of such operations with little choice but to resort to equity financing. A company with few assets may find debt financing wholly unobtainable, at least without the financier negotiating the benefit of personal guarantees of that debt from the company’s directors. It is quite usual for a financier to require a proprietary company’s directors to personally guarantee the company’s loan. A company which urgently needs short-term funds may have little alternative but to raise a loan through debt financing from external sources. The preferences of a prospective investor (whether investing by way of debt or equity) may also impact this decision. For example, an investor may prefer the relative certainty of a return on their investment by way of regular, calculable interest on a loan to the company, instead of the rather less certain prospect of sharing in the company’s profits (if there are any) by means of an unknown dividend in the indefinite future. On the other hand, if an investor considers that the company is likely to be the next Google, they may wish to invest in equity, thus benefiting from what the investor hopes will be astronomical returns on their investment in a very profitable company. Alternatively, an investor in a strong bargaining position may negotiate that their investment will be in the form of a convertible debenture. This form of investment allows the investor to profit from the less risky, more certain debt investment initially, and to have the option of converting the debenture into equity at some defined point in the future, when the company’s profits may be more visible. A convertible debenture can also be to the advantage of the company, which benefits from tax deductions for the interest paid to the investor in the initial stages of the investment (compared to equity investments, where no tax deductions are available for dividends paid to the investor). Further, convertible debentures are less risky for the investor than solely equity financing, yet give the investor the potential to share in profit, which may enable the company to negotiate lower financing costs than would be the case in either solely debt or solely equity financing. 38 [3.50]

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| CH 3

Existing shareholders may have concerns which can also impact a company’s decision in regard to capital structure. An additional issue of shares may be seen by existing investors as resulting in a dilution of their control over their investment; may, depending on the issue price of the shares, may be seen as a dilution of the value of their investment; and potentially may adversely affect the expected return on their investment – particularly if the new share issue is of preference shares rather than ordinary shares. Thus, when deciding the ideal capital structure for the company, managers will need to consider not only the ideal gearing ratio for the company, but also the company’s ability to negotiate and obtain finance from sources that are available, affordable, and acceptable to its existing shareholders.

Gearing ratio [3.60] If a company has borrowed a large amount of money relative to its issued share capital, it is described in corporate finance theory as being highly geared. Conversely, companies which borrow little and consequently carry a small amount of debt finance relative to their share capital, are said to be lowly geared. The gearing ratio will potentially influence the return available for distribution to the investors. Provided a lowly geared company can satisfactorily service repayments of its debts, it is able to offer a relatively higher dividend to its investors than a highly geared company with similar profits. However, if a highly geared company’s income declines, its investors face the prospect of the repayment of debt eroding the company’s profit, reducing not only their return on their investment, but also eating into the company’s capital, potentially bringing about the ultimate liquidation of the company. For this reason, lenders will usually insist that the amount borrowed is well within the company’s ability to repay. For instance, the company may only be permitted to borrow up to a certain percentage of the company’s assets in order to ensure that repayment of the principal is feasible. The financier may negotiate the right to cause the loan to become payable on demand, if the company’s gearing ratio falls outside a permitted range. This would, if the loan is secured (eg by a mortgage or company charge), allow the financier to seize and sell company assets and to use the sale proceeds for repayment of the loan.

Distinction between share capital and loan or debt capital [3.70] Each of these forms of capital investment in a company has distinct differences. It should be noted, however, that frequently companies may issue shares or equities which possess (on face value) many of the attributes of debt finance. These are generally referred to as hybrid equities.

Share capital [3.80] The difference between the “issue” and the “sale” of shares is important. An investor becomes an equity investor on subscribing for and being issued shares in a company. This involves the creation of new shares in the company by [3.80] 39

Law of Investments and Financial Markets

the company and has specific requirements under the Corporations Act (eg, the potential requirement for a disclosure document under Chapter 6D). Because the subscription creates new capital for the company, normally the capital of the company will increase in line with the new issue. Alternatively, an investor may acquire shares in a company from an existing shareholder. There are no disclosure requirements in this case, and the relationship between the “old” shareholder and “new” shareholder is governed purely by contract and, if the company is listed, by the relevant listing rules applicable to the company. Such transactions do not represent any change to the company’s capital structure and accordingly, the company’s assets do not increase by virtue of such a sale of shares. The market price of the shares will normally depend on the market’s perception of the company’s value, rather than any valuation placed on the shares by the company. Equity investors will only be entitled to a return on their investment if the company makes a profit, since companies are prohibited from paying dividends except to the extent to which their assets exceed their liabilities, and dividends can only be paid if fair and reasonable to shareholders and will not materially prejudice the company’s ability to pay its creditors: s 254T. However, even if such profits exist, shareholders cannot force a dividend to be paid; the decision to declare a dividend will generally rest with the board of directors. (See s 254U, which is a Replaceable Rule; and also Burland v Earle). 1 If a company becomes “insolvent” (which is defined as being unable to pay debts when they fall due: s 95A) and goes into liquidation, creditors of the company are entitled to repayment of their debts ahead of equity investors (with certain creditors having priority over other creditors under s 556), so equity investors are most unlikely to have their investment returned, since by virtue of the definition of “insolvency”, an insolvent company is unable to repay all of its creditors, let alone have funds left over for its equity investors.

Loan or debt capital [3.90] The money lent to the company (the principal) will have to be repaid at the expiration of an agreed period. Ordinarily, the lender is also contractually entitled to be paid a return, in the form of interest. The amount of interest is negotiated between the company and the lender, and is specified in the loan contract. It can be a fixed rate, or a variable rate of interest, or can be calculated by means of a formula specified in the contract. The dates for payment will be a matter of negotiation between the lender and the company. The interest rate for any given loan generally reflects the market rate, plus the perceived risk of lending the money to the particular company. The date(s) that interest must be paid, is a matter for negotiation between the company and the lender and normally all of these matters are specified in the loan contract between the company and the lender. 1

Burland v Earle [1902] AC 83. See also Ampol Petroleum Ltd v RW Miller (Holdings) Ltd [1972] 2 NSWLR 85 and Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821.

40 [3.90]

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| CH 3

The payment of interest is a tax deduction for the company, unlike the return on a shareholder’s investment in the company. Dividends paid to shareholders are not tax deductible. Additionally, unlike shareholders, the lender receives this interest regardless of how well the company performs. Interest is a debt that becomes due and owing to the lender, and is thus also enforceable in a court if necessary, even if the company is not profitable. This contrasts starkly with the entitlements conferred on shareholders who only receive a return if the company makes a profit, and they cannot force the company to pay this return on their investment. Because a lender is a creditor of the company, in a liquidation the lender will have a right to priority repayment of their funds ahead of investors in shares. However, as discussed above, an insolvent company in liquidation is unlikely to be able to repay all of its creditors in full. Secured creditors will be repaid ahead of unsecured creditors – hence, the lower cost of borrowing money under a loan which is secured by a mortgage, company charge, or other security. Of course, this priority of repayment of a loan, is still only a priority. If the company is insolvent, there may be no funds remaining to pay creditors at all.

EQUITY FUNDRAISING Power to issue shares [3.110] Section 124(1)(a) and (c) of the Corporations Act 2001 (Cth) empowers companies to issue and cancel shares (and options over unissued shares). Any company has the power to issue shares to any person at any time, but only a public company can offer to issue shares to the public. A proprietary company can only issue shares to individual persons known to the company. If a company wishes to issue new shares, it is generally regarded as a matter within the competence of the board of directors. This is based on the assumption that an injection of capital is necessary for the financial operations of a company from time to time. Section 254A(1) of the Corporations Act 2001 (Cth) specifies that the power to issue shares includes bonus shares (for no consideration), preference shares and partly-paid shares (with some restrictions).

Restrictions on the ability to issue shares [3.120] Certain restrictions do apply to the right to issue shares, and in many cases specific requirements, including a formal disclosure document, must be adhered to before the shares can be issued. Several exemptions to these requirements exist and these are set out below.

Restrictions in the internal rules of the company [3.130] Restrictions can be self-imposed by the company’s internal rules. For instance, the company may have placed restrictions in its constitution on its [3.130] 41

Law of Investments and Financial Markets

future ability to issue certain types of shares. The Replaceable Rules (which apply by default to a multi-shareholder company without a constitution) include s 254D of the Corporations Act 2001, which requires a proprietary company wishing to issue shares to first offer those shares to existing shareholders in the proportions in which they currently hold shares. This pre-emptive rights provision protects shareholders against dilution of their interest in the company through future share issues. It is quite common for proprietary companies with constitutions to have similar provisions in the constitution. It is important to note that the internal rules are known as a “statutory contract” because they are regulated by statute, and made enforceable by statute. Important provisions in this regard are s 136, which sets out how a company may amend a constitution (by a special resolution of members) ands 140, which provides that the internal rules are binding as if they were a contract between the company and each member, and between each member and each other member.

Contractual Restrictions [3.135] Restrictions can be self-imposed by the company agreeing in a binding, enforceable contract, completely separate and outside its internal rules, to certain contractual requirements relating to the issue of shares in the future. Such a contract could be with an unrelated company, such as a financier, or with one or more of the company’s shareholders. These contracts are different to internal rules because the normal rules of contract law apply — for example, every person bound by the contract must have agreed to be bound by it, at the time it was made. (There are many other rules relating to contract law that also apply, such as intention to create a legal relationship, consideration, legal capacity, etc). Contrastingly, the internal rules are a set of rules which apply to a company, which are chosen by the company in general meeting. Unlike a contract under contract law, the internal rules bind all future shareholders who acquire shares in the company, even if they were not shareholders at the time the rules were made or amended. The process for amending contracts — which requires the agreement of every person bound by the contract — is also different to the s 136 process for amending internal rules — where a majority vote of 75% can bind the other 25% who may not agree with the amendment. The consequences of breach of contract are also different to breach of internal rules. Members can enforce internal rules, but not normally claim damages for breach. However, a contracting party who has suffered loss as a result of a breach of contract can claim damages for the amount of loss suffered as a result of the breach. Where a company forms an agreement with all of its shareholders, outside the scope of the internal rules, this is known as a “shareholders agreement”. The company may do this to avoid restrictive corporate law principles that can restrict the circumstances in which a member can enforce the internal rules (such as the requirement that the rule relate to the member’s shareholding). Such an 42 [3.135]

Funding Company Operations

| CH 3

agreement is also more stable, in that it cannot be amended by majority voting later on (internal rules can be amended by special resolution). Some shareholder agreements may contain provisions that the company will refrain from issuing shares (or issuing shares in specified circumstances). For example, the company could contractually promise to not issue shares for a certain period of time, or to only issue shares if certain specified conditions are met, or to only issue shares to specified people or classes of people, or to only issue shares if another specified person consents in advance. Generally such provisions are enforceable — before the shares are issued. Once the shares are issued, they exist, and if the holder of the shares is an innocent third party who acquired the shares in good faith, the creation of existence of the shares cannot be undone, although other remedies for the breach of contract may exist, such as damages.

Restrictions in the Corporations Act [3.140] Other restrictions are contained in the Corporations Act 2001. For example, a company cannot issue shares where the issue would be oppressive towards existing shareholders: s 232. Directors must not issue shares for an improper purpose such as to assist or frustrate a takeover: s 181(1)(b). 2 The case of Ampol Petroleum Ltd v RW Miller (Holdings) Ltd 3 emerged out of a takeover battle for control of RW Miller (Holdings) Ltd. Ampol and Bulkships Ltd controlled 55% of Miller’s issued capital. Between them, they wished to acquire all other shares in Miller (Holdings). Miller’s response was to cause the directors to issue to Howard Smith, who had made its own takeover bid, 4.5 million shares, which reduced the Ampol and Bulkship shareholding to 36%. The directors contended that they had acted for proper purposes in that the Howard Smith takeover bid was more favourable to the company. However, this argument was rejected by the court and the share issue was invalidated on the basis that the directors had breached their duty to act for proper purposes. A company can only issue preference shares if its constitution sets out the particular rights of those preference shares: s 254A(2). Further, a company cannot, by an issue of shares, vary the rights of an existing class of shareholder without following procedures set out in the company’s constitution (or in s 246B(2), if there is no constitution or if the constitution is silent on this matter). Certain issues of shares are deemed to vary the rights of existing shareholders under s 246C – eg an issue of preference shares ranking equally with existing preference shares will be deemed to vary the rights of existing shareholders unless the constitution provides otherwise: s 246C(6). As discussed above, a proprietary company must not offer to issue shares to the public: s 113(3). Only a public company can offer to issue shares to the public, and only if the issue complies with Ch 6D of the Corporations Act 2001. 2 3

See also Ampol Petroluem Ltd v RW Miller (Holdings) Ltd [1972] 2 NSWLR 850 and Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821. Ampol Petroleum Ltd v RW Miller (Holdings) Ltd [1972] 2 NSWLR 850.

[3.140] 43

Law of Investments and Financial Markets

Restrictions in the Listing Rules [3.150] A publicly listed company wishing to increase the company’s issued capital will need to comply with the relevant listing rules of the securities exchange on which the company is listed. In the case of a public company listed on the ASX, any increase in issued capital by more than 15% in a single year will require a vote of the members under ASX Listing Rule 7.1.

Chapter 6D – disclosure documents [3.160] Since proprietary companies cannot solicit money from the public for the subscription of shares in the company (s 113(3)), this discussion relates only to public companies. Chapter 6D of the Corporations Act 2001 provides protection for investors wishing to subscribe for new securities (which includes shares) in a company by requiring that, unless certain exceptions apply, all relevant information is disclosed to the investor (through a disclosure document) before the investor can acquire shares in the company. This is to enable potential investors to ascertain whether they wish to pursue the investment. The most common form of disclosure document is known as a prospectus, but the disclosure document can take other forms as follow: (a)

Short Form Prospectus. Section 712(1) enables a prospectus to refer to material already lodged with the Australian Securities and Investments Commission (ASIC) – eg financial reports. These documents are taken to be part of the prospectus and copies must be made available.

(b)

Profile Statements. This applies to certain industries, but a prospectus still has to be lodged: s 709(2). An example would be a managed investment scheme (MIS). The profile statement and not the full prospectus may be supplied to investors.

(c)

Offer Information Statement. This deals with situations involving small fundraising scenarios: s 709(4). The company is able to raise the first $10 million making minimal disclosure by means of an Offer Information Statement. However, s 715(1) requires that the document, amongst other things, directs investors to obtain their own professional advice prior to deciding whether to invest or not.

To combat potential avoidance of these provisions by the company issuing to a related party/senior manager, who then soon after on-sells to a person who would have been entitled to a disclosure document, these obligations also apply, in certain circumstances, to sales of recently-issued securities: see ss 707 and 708A. In March 2016 ASIC released new and consolidated guidance about disclosure documents in a new Regulatory Guide 254: Offering Securities under a disclosure document. 4 This 89-page regulatory guide contains far more detail than the scope of this book allows, but in summary sets out the reasons for disclosure and the 4

Available at http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-254offering-securities-under-a-disclosure-document/ (accessed 4 May 2016).

44 [3.150]

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| CH 3

circumstances in which disclosure documents are required, and the types of documents that can be used to provide disclosure. It considers other associated requirements, including the exposure period (the period immediately after release of the prospectus, in which the company is prohibited from processing applications for securities), the manner in which time periods are calculated, restrictions on advertising, the need for supplementary or replacement disclosure documents, ASIC’s powers and approach to the regulation of disclosure documents and various other matters associated with these provisions.

Requirements [3.170] If a company is offering to issue new securities, it must prepare a disclosure document (s 706) and lodge it with ASIC (s 718) unless the offer is exempted under s 708 or s 708A. Some important exemptions are: • small-scale offers where fewer than 20 persons subscribe for less than $2 million worth of securities (excluding other exempted issues) in any rolling 12-month period;

• where the subscribers are regarded as sophisticated investors – ie those who subscribe $500,000 or have net assets of $2.5 million or annual gross income of over $250,000 (and this has been certified by an accountant in the last six months);

• where the subscribers are regarded as professional investors – ie listed companies, superannuation funds, banks etc, or a person controlling gross assets of over $10 million;

• where the offer is made through a licensed dealer; • where the offer is made to persons associated with the company, such as existing shareholders under a dividend reinvestment plan or bonus share plan, or to senior managers of the company (and their relatives and associated companies);

• where the offer is a rights issue to existing holders of listed securities which are currently traded on a securities market, such as the Australian Securities Exchange (ASX), and from a company which is subject to the continuous disclosure obligations applicable to most listed companies.

It is also worth noting that ASIC has issued a class order significantly widening the ambit of employee share schemes without the need for a formal disclosure document. 5

Contents [3.180] Section 710 is a general disclosure requirement, which obliges the entity to disclose all information investors and their advisers would reasonably expect the prospectus to contain, to aid their decision in relation to whether or not to 5

See Class Order 14/0000 Employee incentive schemes: Listed bodies, available at: https:// www.legislation.gov.au/Details/F2015C00910 (accessed 4 May 2016); Class Order 14/1001 Employee incentive schemes: Unlisted bodies, available at: https://www.legislation.gov.au/Details/F2015C00911 (accessed 4 May 2016) and Regulatory Guide 49: Employee Incentive Schemes, available at http:// asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-49-employee-incentiveschemes/ (accessed 4 May 2016). [3.180] 45

Law of Investments and Financial Markets

acquire the securities. In Fraser v NRMA Holdings Ltd, 6 it was held that by not including in the prospectus the case against restructuring, the company had failed to provide the information required by s 710. Section 711 sets out a long list of specific matters that must also be included in the prospectus. This list includes, eg disclosure of any interests in the company which any person associated with the prospectus has, has had, or has agreed to receive. The application form must be attached to the prospectus: s 721. If circumstances change during the life of the prospectus, or if a mistake is discovered, there is provision for the issuing of a supplementary prospectus: s 719. Under s 739, ASIC can issue a “Stop Order” if the prospectus is inaccurate or does not comply with Ch 6D. By the very nature of a prospectus, it will include forecasts, where the outcome of such information is uncertain. If this is so, it is very important that the persons making such forecasts have reasonable grounds for making them, otherwise the statement will be deemed to be misleading and deceptive under s 728(2) and those persons will be liable for any loss suffered by investors as a result. ASIC has updated its previous guidance on the content requirements of s 710 in a new Regulatory Guide 228 Prospectuses: Effective disclosure for retail investors. 7

Reform history [3.185] The current version of Regulatory Guide 228 8 was released on 17 March 2016. The current version maintains the general approach from the 2011 version that disclosure must be “clear, concise and effective” rather than including every possible detail in the prospectus. The guide requires an investment overview, and includes guidance as to the types of written and photo communication that can be used to ensure clarity, as well as discussing the need to highlight principal risks, rather than listing every conceivable risk. It also sets out guidelines and safeguards for electronic disclosure documents. The 2016 version contains several changes to the former (November 2011) version, which was the version discussed in the last edition of this book. Some changes are new, and others consolidate other existing regulatory documents into the one place, Regulatory Guide 228. The November 2011 version of Regulatory Guide 228 represented one of the biggest regulatory changes to prospectuses in twenty years, in that it emphasized clarity over length. Since 2011, a company issuing a disclosure document has no longer been able to satisfy its disclosure obligations by 6 7 8

Fraser v NRMA Holdings Ltd (1995) 55 FCR 452; 13 ACLC 132. Available at: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/ rg- 228-prospectuses-effective-disclosure-for-retail-investors/ (accessed 5 May 2016). Available at: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/ rg-228-prospectuses-effective-disclosure-for-retail-investors/ (accessed 5 May 2016).

46 [3.185]

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including every detail that is in any way possibly material, making the document full but unwieldy (which was the case previously). The November 2011 version of Regulatory Guide 228 stemmed from submissions received on Consultation Paper 155, 9 and the associated draft regulatory guide released at the same time. ASIC’s response to those submissions was Report 261, 10 which (in part) noted the need for revision of the provisions relating to electronic disclosure documents. This issue then resurfaced for public consultation in Consultation Paper 211, 11 issued on 17 June 2013, which then resulted in ASIC’s Report 385 on Submissions to Consultation Paper 211 12 and ultimately the March 2016 revision of Regulatory Guide 228. 13

Liability – claims by investors [3.190] Section 729 entitles a person who has suffered loss or damage as a result of relying on information contained in disclosure documentation to claim compensation against the company, the directors and underwriters. A claim can also be made against any person who is named with their consent in the prospectus as making a statement in the prospectus (typically, this would be experts acting in a professional capacity) or any person involved in the preparation of the prospectus, but only in respect of statements included with their consent. Of course, practical concerns remain for an investor. For instance, an investor may have an entitlement to recover his or her loss from persons associated with the company, but effective recovery also requires that the person liable has the necessary funds to pay a compensation order. This can also be affected in the event of a company’s insolvency. The 2007 High Court case of Sons of Gwalia Ltd v Margaretic 14 held that claims by shareholders for the recovery of losses due to a company’s misleading prospectus can rank equally with the claims of unsecured creditors. This decision was contentious because it characterised shareholders (who normally rank last in a liquidation) as creditors where the shareholders have a claim against the company. This benefited shareholders, and potentially disadvantaged creditors, who can be exposed to greater risk of reduced funds available for repayment of their debt. The issues raised by this case were referred to the 9 10 11 12 13 14

Available at: http://asic.gov.au/regulatory-resources/find-a-document/consultation-papers/cp-155prospectus-disclosure-improving-disclosure-for-retail-investors/. Available at: http://asic.gov.au/regulatory-resources/find-a-document/reports/rep-261-response-tosubmissions-on-cp-155-prospectus-disclosure-improving-disclosure-for-retail-investors/ (accessed 5 May 2016). Available at: http://asic.gov.au/regulatory-resources/find-a-document/consultation-papers/cp-211facilitating-electronic-offers-of-securities-update-to-rg-107/ (accessed 5 May 2016). Available at: http://asic.gov.au/regulatory-resources/find-a-document/reports/rep-385-response-tosubmissions-on-cp-211-facilitating-electronic-offers-of-securities-update-to-rg-107 (accessed 5 May 2016). Available at: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/ rg-228-prospectuses-effective-disclosure-for-retail-investors/ (accessed 5 May 2016). Sons of Gwalia Ltd v Margaretic (2007) 81 ALJR 525; [2007] HCA 1.

[3.190] 47

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Corporations and Markets Advisory Committee (CAMAC) 15 for analysis, and eventually led to the passage of new legislation to reverse this court decision in late 2010. The Corporations Amendment (Sons of Gwalia) Act 2010 (Cth) was passed in late 2010 and came into effect on 18 December 2010. The Act introduced a new s 247E which specifically states that a person is not prevented from obtaining damages or compensation from a company merely because the person is or was a shareholder or member. The Corporations Amendment (Sons of Gwalia) Act 2010 (Cth) also repealed the existing s 563A (as interpreted in the Gwalia decision), replacing it with a new s 563A which said that any claims for any debts owed by the company that related to a person’s capacity as a member of the company (whether by way of dividends, profits or otherwise), or any other claim arising from the purchase, sale or dealing of company shares, would be postponed until all other claims against the company were fully satisfied. In effect, in an insolvency, this makes shareholder claims subordinate to non-shareholder claims and reinstates the position that was understood to exist prior to the Gwalia decision.

Basis of liability [3.200] The basis of liability for claims for financial loss by investors is contained in s 728. This provision prohibits a person from offering securities under a disclosure document if there is a misleading or deceptive statement in, or an omission from, such a document. In terms of predictions and forecasts, a statement is regarded as misleading if reasonable grounds did not exist for making the statement: s 728(2). If a person contravenes s 728(1), they can be ordered to pay compensation and are subject to criminal sanctions, including imprisonment. The defences to claims for financial loss by investors are contained in ss 731 – 733, which provide uniform defences for all persons potentially liable. Section 731 applies to prospectuses and provides a “due diligence defence” against s 729 liability where the party involved made all reasonable inquiries and reasonably believed the statement was not misleading or deceptive or that there was no omission of required information. Because of this defence, most companies who propose to issue securities under a prospectus will form a due diligence committee, which is responsible for the contents of the prospectus and 15

Note the current proposal to abolish CAMAC: see the Australian Securities and Investment Commission Amendment (Corporations and Markets Advisory Committee Abolition) Bill 2014. The Bill passed the House of Representatives on 2 March 2015 and in the Senate was referred to the Senate Standing Committee on Economics. This committee issued its report on 16 March 2015, but so far (as at 6 April 2016), no amendments have been processed and the Bill has not passed the Senate. For details on the Bill’s progress, see http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/ Bills_Search_Results/Result?bId=r5386 (accessed 5 May 2016). However, although not formally abolished yet, CAMAC has effectively been disbanded by its non-appearance in the federal budgetary allocations.

48 [3.200]

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which collates information supporting and evidencing the reasonableness of the committee’s belief that the prospectus complies with Ch 6D. Section 732 applies to Offer Information and Profile Statements and provides a defence if the party concerned did not know that the statement was misleading or deceptive. This reflects a reduced disclosure requirement. Section 733 applies to all disclosure documents where it is demonstrated that there was reasonable reliance on another person supplying information. It is also a defence if it is proved a party was unaware of a new matter or they withdrew their consent.

Case Study: Astra Resources [3.210] In May 2014, ASIC brought civil proceedings 16 against a UK company, Astra Resources PLC (“AR”) and against its subsidiary Australian company, Astra Consolidated Nominees Pty Ltd (“AN”), as well against three directors of AR, for non-compliance with s 727(1) of the Corporations Act 2001. ASIC submitted that AR had distributed application forms for shares in itself, without a disclosure document, and AN had offered its own shares in AR for sale to investors, without a prospectus. As a result of an initial hearing, the court found (in a judgment on 24 July 2015) that AN was an intermediary through which AR shares were transferred to investors. The court found that s 707 applied, required a disclosure document of the sale transaction, and had been breached through the lack of such disclosure. Subsequent declarations to this effect were made by the court on 14 September 2015. In the 24 July 2015 judgment, the court specifically found that the contemporaneity of the date of incorporation of AN, and its entry into a share sale agreement with AR one late later, allowed the court to infer that this share acquisition was the primary purpose of AN’s incorporation and existence. 17 The court also relied on the existence of common directorships and other coordinated conduct, as well as correspondence between the two, to conclude that the purpose of the issues to AN was the on-sale of those shares. 18 ASIC had also submitted that the former directors should be disqualified from managing corporations, due to their failure to take due care to prevent the illegal fundraising. An appeal from the declarations made on 14 September 2015, did not delay the separate hearing in relation to the directors, which occurred on 30 November and 1 December 2015. (On 2 November 2015, AR had entered liquidation in the UK). The remaining claims against AN, and the directors, were 16 17

18

Australian Securities and Investments Commission v Astra Resources plc [2015] FCA 759 available at http://www.judgments.fedcourt.gov.au/judgments/Judgments/fca/single/2015/2015fca0759 (accessed 5 May 2016). Australian Securities and Investments Commission v Astra Resources plc [2015] FCA 759 at [57]. Australian Securities and Investments Commission v Astra Resources plc [2015] FCA 759 at [83].

[3.210] 49

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heard in January 2016 and as at the date of this book, judgment has been reserved. The appeal against the 14 September 2015 judgment has been stayed until that judgment is released. 19

DEBT FUNDRAISING Borrowing money [3.220] A company can borrow money directly from a financier, similar to any other person. Such loans can be secured or unsecured. Alternatively, a company can borrow money from investors, by issuing debentures or notes.

What is a “debenture”? [3.230] Section 124 of the Corporations Act 2001 (Cth) empowers companies to issue debentures and to borrow money through the use of debentures. A “debenture” is the right to enforce a company’s undertaking to repay a debt: s 9. Previously, the Corporations Act 2001 defined “debenture” as the evidence of a company’s indebtedness – hence, the instruments or documents by which companies borrow funds are today still referred to as “debentures”. Technically, however, a debenture is the right to enforce the debt; the instrument or document creates that right. 20 Debentures are intangible personal property, and therefore are readily transferable. Debentures can be listed on the ASX. In order for them to be listed it is necessary that they (and the company) comply with the ASX’s Listing Rules. The following enforceable rights are excluded from the s 9 definition and thus are not “debentures”: • an undertaking to repay money deposited with or lent to the company by a person who ordinarily carries on business which involves the depositing or lending of money, and the company does not borrow the money for the purpose of a business of borrowing money and providing finance;

• an undertaking by an Australian authorised deposit-taking institution (ADI) to repay money deposited with it;

• an undertaking to pay money under a cheque, bill of exchange, or money order; and • an undertaking to pay money to a related body corporate. Previously, the definition also encompassed “an undertaking to pay money under a promissory note of at least $50,000” but this was deleted on 6 November 2009. 21 The debt is usually secured by a security interest (formerly known as charge) over company assets in order to ensure that the debt is repaid. A company 19 20 21

Astra Resources PLC v ASIC [2016] FCA 8, available at http://www.judgments.fedcourt.gov.au/ judgments/Judgments/fca/single/2016/2016fca0008 (accessed 5 May 2016).

There are some exclusions from the definition, discussed below. See Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 , Schedule 3, Item 1.

50 [3.220]

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cannot offer to issue debentures to the public (ie invite the public to loan the company money by way of debenture) unless the debentures will be secured by the security interest, otherwise the company commits an offence under s 283BH. The purpose of this principle is to provide the investing public with additional protection. Section 283BH recognises that a debenture may be described as either: • a “mortgage debenture” if it is secured by a first mortgage over land and the amount borrowed is no greater that 60% of the land’s value;

• a “debenture” if it satisfies the requirements for a “mortgage debenture”, or is secured by a charge over the whole or part of the company’s assets that is likely to be sufficient for repayment of the debentures; or

• an unsecured note or unsecured deposit note, in any other case.

What is an unsecured note? [3.240] If a debt is not protected by a security such as a charge or mortgage, it is known as an “unsecured note”. An unsecured note is still enforceable, but the holder merely possesses a contractual right to enforce payment of the debt, and will have no recourse against the company’s assets. To that extent, the noteholder is in the position of an unsecured creditor. Technically, an unsecured note is still a debenture for the purposes of the Corporations Act 2001. This has the important result that the laws relating to debentures still apply to unsecured notes, but the company cannot describe an unsecured note as a debenture when talking to, or issuing documents for, the public. The differences in description reflect the risk the investor or holder of the debenture takes, with the mortgage debenture affording the highest degree of protection and the unsecured note offering no level of protection in the event of default by the company.

Convertible debentures [3.250] Debentures can be issued as convertible securities, whereby the holder is entitled to convert them into shares. In such a case, the convertible note would take the form of a hybrid investment, in that it is a loan and equity investment. The decision to convert by the investor would depend on the financial performance of the company and whether the value of the listed shares has increased; also whether the investor expects the company to be profitable in the future.

Issuing debentures and notes Requirements: Chapter 6D [3.270] As a debenture falls within the definition of “securities” contained in s 92, any offer to issue debentures to the public is governed by the fundraising provisions in Ch 6D of the Corporations Act 2001. For example, s 727 prohibits an [3.270] 51

Law of Investments and Financial Markets

individual or entity from making offers for the issue of securities (including debentures) or distributing application forms for such offers, unless a disclosure document for the offer has been lodged with ASIC in accordance with Ch 6D, or the offer is exempted from such requirements. There are strict content requirements for the issue of a disclosure document (discussed above) and harsh penalties if these requirements are contravened. For clarification, this also applies to notes, as the section 9 definition of debenture includes notes. ASIC has issued Regulatory Guide 156 (which specifically relates to the advertising of mortgage debentures, debentures, secured and unsecured notes and unsecured deposit notes) 22 and Regulatory Guide 69 (which relates to improving disclosure for retail investors). 23

Requirements: Chapter 2L [3.280] In addition to the Ch 6D requirements, which apply equally to all types of securities that are offered to the public, Ch 2L applies expressly to offers of debentures to which Ch 6D applies. Chapter 2L applies even where no disclosure document is required under Ch 6D, due to an exemption in s 708 applying. 24 Before a company can issue debentures, Ch 2L obliges the company to make arrangements for the appointment of a trustee and subsequently enter into a trust deed with the trustee: s 283AA. Section 283AC limits the type of entity that can act as a trustee. A trustee can only be the Public Trustee, a trustee company, probate corporation, bank or life assurance company. Section 283BB obliges the company to carry on its business in an appropriate and efficient manner, and to make its financial records available for inspection by the trustee. Additionally, the company must notify the trustee in respect of any charges over company property it creates (under s 283BE) and to provide the trustee and ASIC with quarterly reports about certain specific information relevant to the company’s affairs, including quarterly financial reports: s 283BF. The trustee is obliged, under s 283AB, to protect the interests of debentureholders and, to this end, the trustee has the right under the trust deed to enforce the company’s duty to repay the debt. The trustee is the trustee for the debenture-holders in respect of the holding of any charge or security for repayment of the debentures. Under s 283DA, the trustee must also exercise reasonable diligence to monitor the company’s behaviour to ensure that the company complies with the terms of the debenture, the trust deed and the Corporations Act 2001. The trustee has to determine whether any breaches have occurred and, if so, to notify the company and ASIC. To aid this process, ss 318 22 23 24

Available at: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/ rg-156-advertising-of-debentures-and-notes-to-retail-investors/ (accessed 5 May 2016).

Available at: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-69debentures-and-notes-improving-disclosure-for-retail-investors/ (accessed 25 May 2016). However, due to Corporations Act 2001 (Cth) s 283AA(1)(a), Ch 2L does not apply to an offer of debentures that is exempted under s 708(14), which is the provision relating to the roll-over of existing debentures.

52 [3.280]

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and 313 confer on the trustee the right to receive a copy of the company’s financial report and auditor’s report. ASIC must also maintain a register of trustees for debenture holders: s 283BCA. It would be usual for the trust deed to specify that the company will be in breach of the trust deed if it enters into arrangements to borrow funds from another source, or fails to keep the value of charged property above a minimum amount. The trust deed may also include a “negative pledge”, which is a promise by the company pursuant to which the company restricts its ability to enter into subsequent borrowing or security arrangements.

ASIC Requirements [3.285] In February 2012, ASIC issued Regulatory Guide 156 25 in relation to the advertising of ‘debentures’, ‘mortgage debentures’, ‘secured notes’, ‘unsecured notes’ and ‘unsecured deposit notes’. The guide sets minimum standards for advertising. In particular, it sets out the following table of requirements at page 5: Table 1: Advertising standards for issuers of notes to retail investors Area Summary of standard Repayment of principal investment To avoid common misconceptions about the risk profile of notes, all advertisements for notes that are offered to retail investors should include a prominent statement to investors that there is a risk that investors could lose some or all of their money. Comparisons with bank deposits Advertisements for notes should state that the note is not a bank and ‘risk free’ suggestions deposit. They should also not suggest that the note is, or compares favourably to, a bank deposit; or there is little or no risk of the investor losing their principal or not being repaid. Warning statements generally Warning statements in advertisements should be prominent to help ensure investors have a balanced impression of the note offering. Suitability statements Advertisements for notes should not state or imply that the investment is suitable for a particular class of investor. Consistency with prospectus dis- Statements in advertisements for notes should be consistent with closure the corresponding disclosures on that subject matter in the prospectus. Telephone inquiries Statements made in response to inquiries are subject to the same regulation regarding misleading and deceptive conduct as the advertisements.

The Regulatory Guide 156 also makes it clear that ASIC will hold publishers and other media conduits accountable for breaches of these advertising rules, stating that publishers should have systems in place to detect and refuse advertisements that breach these rules. Publishers who actively contribute to content (eg by writing advertorials), will bear primary responsibility for misleading and deceptive conduct offences, summarised in the following table on page 11:

25

See http://download.asic.gov.au/media/1240814/rg156-published-8-february-2012.pdf (accessed 5 May 2016). [3.285] 53

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Table 2: Examples of misleading or deceptive conduct Description of conduct Legislation reference Making statements that are materially false or materially mis- s 1041E, Corporations Act leading and are likely to induce persons to apply for financial products. Contravention of this provision is an offence. Engaging in conduct, in relation to a financial product or a s 1041H, Corporations Act financial service, which is misleading or deceptive or is likely to mislead or deceive. In trade and commerce, engaging in conduct, in relation to s 12DA, ASIC Act financial services, which is misleading or deceptive or is likely to mislead or deceive. Engaging in conduct that is liable to mislead the public as to the s 12DF, ASIC Act nature, characteristics, suitability for their purpose or quantity of any financial services. This provision is a strict liability offence.

Note: Section 734 of the Corporations Act also contains restrictions on advertising of notes.

Table 3 (in Regulatory Guide 156, at page 12) outlines ASIC’s regulatory options: Table 3: Examples of regulatory options Option Issue a stop order on any misleading or deceptive statements in an advertisement for notes. Seek an injunction against a note issuer for note advertising that constitutes misleading or deceptive conduct.

available to ASIC Legislation reference s 739(6), Corporations Act

For example, s 739(6), Corporations Act, and s 1324, Corporations Act Issue a public warning notice containing a warning about the s 12GLC, ASIC Act conduct of an issuer relating to consumer protection provisions in the ASIC Act. Investigate potential criminal and civil action for contraventions of For example, s 1041E, Corporations certain provisions in Div 2 of Pt 7.10 of the Corporations Act or Act; and s 12DF, ASIC Act in Div 2 of Pt 2 of the ASIC Act.

Additional requirements [3.290] Under s 171, each company issuing debentures is required to establish a register of debenture-holders.

Security interests [3.300] A company charge is a type of security interest over the company’s personal property, which secures the company’s repayment of a debt. A charge or other security interest often secures the repayment of debentures. Personal property is property other than real property (which is an interest in or over land). It is important to note that a charge grants rights over personal property only; if real property is used as security for a loan, the rights over that property need to be in the form of a mortgage, not a charge. Mortgages are discussed in Chapter 7. The term ‘charge’ is now outdated, due to legislation which came into effect in January 2012 and totally overhauled this area of the law, replacing ‘charges’ with ‘security interests’ and replacing registration of some charges at ASIC under the Corporations Act with the need to register all security interests on the personal property securities register under the Personal Properties Securities Act 2011. 54 [3.290]

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Because the change is so recent, there are many documents called ‘charges’ still in existence that have not been altered since the legislation. Also, the transitional phase of the legislation only ended on 1 January 2014, so it is important to understand both regimes, and particularly how older documents (which may not have been changed) operate under the new regime.

The historical position: fixed charges and floating charges [3.310] The law used to distinguish between fixed and floating charges. A fixed charge attaches to specific property owned by the company and was particularised or specified in the charge. Typically, such property would include plant and equipment belonging to the company. The significance of a fixed charge being granted over a company asset was that the company could not dispose of the charged property without first obtaining the consent of the lender. Because of this very important aspect of fixed charges, it was be extremely unlikely for stock in trade to be covered by a fixed charge. If, after granting the charge, the company subsequently acquired more property that fits the charge’s description of the charged property, then the charge would cover that after-acquired property and the lender would also have rights over that property.

Floating charges [3.320] Floating charges, on the other hand, “hovered” over a category of assets specified in the charge, eg assets such as trading stock or debtors. Unlike a fixed charge, the assets covered by a floating charge,could be disposed of in the ordinary course of the company’s business without the company needing to obtain the lender’s prior written consent. Accordingly, the floating charge hovered over company assets, which flowed in and out of the company’s possession. Sensibly, this arrangement enabled the company to carry on with its normal business operations without seeking the permission of the lender to dispose of the assets subject to the charge. The charge was described as “ambulatory and shifting in nature, hovering over and … floating with the property … until some event occurs which causes it to settle on the … [charged] property”: Illingworth v Houldsworth. 26 The event referred to is an event that is specified in the charge as triggering the process of crystallisation. “Crystallisation” was the process whereby a floating charge became a fixed charge. Typical crystallisation events (named in a charge) occurred when: • interest owing was not paid; • another party appointed a receiver to the company for the purpose of realising its assets to pay another party;

• the company created a subsequent charge in breach of a negative pledge; or • the company was threatened with a winding up order. 26

Illingworth v Houldsworth [1904] AC 355 at 358. [3.320] 55

Law of Investments and Financial Markets

Crystallisation was often automatic, but some charges require a notice to be given before crystallisation occurs. Once a floating charge had crystallised, the interests of the investor or holder were protected – ie the company is prevented from disposing of the relevant assets.

Historical need for registration [3.330] The Corporations Act 2001 used to require that certain charges be registered with ASIC. The purpose of registration was twofold: 1.

it enables parties proposing to enter into lending arrangements with the company to be alerted to the fact that the company property, which is proposed to be the subject of a charge, is already the subject of a charge with other parties; and

2.

in the event that a number of parties have lent money to the company, the timing of registration establishes the order of priorities amongst the various holders. Registration also eases the process of winding up a company; it establishes whether certain charges are valid and enforceable.

The former section 262 27 used to set out a list of all charges that need to be registered to be enforceable. Under the former s 262, if the following charges were not registered, they were not enforceable: • floating charges; • charges over uncalled share capital, and charges over calls made but not paid; • charges over personal chattels (other than registered ships); • charges on goodwill, patent, trademarks, copyright, design or a licence to use any of these;

• charges on book debts; • charges on marketable securities; • charges on negotiable instruments; and • charges on crops, wool mortgages and stock mortgages. Notification of the creation of a charge needed to be lodged for registration with ASIC within 45 days, under the former s 264 28. Failure to lodge the charge did not render the charge invalid (s 262(11)) but failure to register it within 45 days of its creation (or within any extension of this time) meant that the chargee would be categorised as an unsecured creditor if the company was placed in liquidation within six months of the charge being registered, under the former s 266. 29 The company granting the charge bore the primary responsibility for registration, but typically the chargee, who had the benefit of the charge, would register it to ensure its interests were protected. It is therefore important to lodge notification of the existence of the charge to ASIC if the holder is to be in a position to execute the charge against the company’s assets. 27 28

29

Section 262 has now been deleted from the Corporations Act 2001 (Cth). This section has now been deleted from the Corporations Act 2001 (Cth).

This section has now been deleted from the Corporations Act 2001 (Cth).

56 [3.330]

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Historical position relating to competing priorities [3.340] The Corporations Act 2001 used to prescribe default priority rules which applied to charges that were competing with each other to enforce rights over the same assets. These default rules were able to be overridden by a deed (known as a “deed of priority”) executed by each of the competing chargees: s 279(2). 30 The former section 280 provided for the following general rules to apply to two competing charges of the same type: • registered charges took priority over unregistered charges; • the first registered charge prevailed over later registered charges; • a registered charge was postponed to a charge created prior to it if the chargee can prove there was notice of the earlier created charge; and

• with unregistered charges, the first created will prevail. In relation to the priority between fixed and floating charges, s 279(3) stipulated that for a prior created floating charge to take priority over a subsequently created fixed charge, it must have been registered with ASIC before the fixed charge, it must contain a restriction on the company’s ability to create subsequent charges (a negative pledge clause), and notice of the negative pledge must have appeared on ASIC’s register of charges. Pursuant to s 433, the receiver appointed by the holder of a floating charge was required to first satisfy the claims of company employees to whom certain types of debts are owed. In liquidation, the liquidator owes similar duties under s 561. Thus, even the holder of the sole charge over the company assets could not be sure that those assets would be entirely available to meet the debt underlying the charge.

THE CURRENT POSITION: SECURITY INTERESTS UNDER PERSONAL PROPERTY SECURITY ACT 2009 (CTH) Overview

[3.350] As discussed above, major reform to this area of law occurred in January 2012, when the Personal Property Securities Act 2009 (Cth) (PPSA) extended its reach to cover charges (which had previously been covered by the Corporations Act), as well as liens and pledges, and indeed other interests outlined below. It is thus much broader than the Corporations Act’s prior regulation of company charges. Indeed, the PPSA regime applies to all security interests, whether granted by a company or not. (There are a few exceptions, such as interests in land including fixtures and an interest taken by a pawnbroker, where the value of the interest is under $5000: ss 8(1)(f), 8(1)(j) and 8(1)(ja) respectively). A charge created before or after the PPSA is still a valid security interest. It may be enforced under the PPSA similar to any other security interest under 30

This section has now been deleted from the Corporations Act 2001 (Cth). [3.350] 57

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PPSA. Now that the transitional arrangements have ended, distinctions between floating charges and fixed charges will become irrelevant for priority purposes, although these concepts will still reflect which assets are covered by the charge. The PPSA provides that a reference to a ‘floating charge’ is deemed to be a security interest in a ‘circulating asset’.

Personal property [3.360] The PPSA regulates security interests in ‘personal property’, and therefore does not regulate land or interests in real property. Section 10 of the PPSA defines personal property as all property other than real estate and fixtures to that real estate. This definition includes financial instruments, investments and intangible property such as copyright and other intellectual property rights. Intangible property also includes accounts receivable or book debts, and credit card receivables. The definition of ‘personal property’ specifically includes ‘financial property’, which is defined by s 10 to include mean ‘chattel paper, currency, documents of title, investment instruments and negotiable interests’. ‘Chattel paper’ is defined as a document or documents that evidence a monetary obligation and a security interest in or lease of specific goods (for example, a hire purchase agreement).

Security interest [3.370] Under s 12, a security interest is an interest in personal property that in substance requires payment of a debt or other obligation, regardless of the form of the transaction. It includes company charges (both fixed and floating), mortgages over personal property, retention of title clauses, finance leases allowing for ownership acquisition, factoring agreements, consignment arrangements, lease of a car, boat or aircraft for less than three months, or lease of other property for more than a year, a pledge, a trust receipt, a lease of goods, a transfer of title, and a conditional sale agreement. Furthermore, certain commercial interests are deemed to be security interests under s 12(3). These include the interest of a transferee under a transfer of an account or chattel paper, the interest of a consignor who delivers goods to a consignee under a commercial consignment; and the interest of a lessor or bailor of goods under a personal property security lease (which is defined as a lease of more than a year, provided for value, as part of the business of a person regularly engaged in the business of leasing goods: s 13 PPSA). An earlier provision, requiring registration of leases of serial numbered goods, if the duration of the lease was 90 days or less, was deleted from the legislation effective 1 October 2015. 31 However, short-term leases which in substance secure payment or performance of an obligation, will be securities interests, despite the length of the lease. Thus a short-term hire purchase agreement will remain a security interest, even if the length of the agreement is under one year. 31

Personal Property Securities Amendment (Deregulatory Measures) Act 2015 (Cth).

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The courts have displayed a willingness to remove registration of “interests” which do not actually constitute security interests under the legislation: see for example, Capital Finance Australia Limited v Clough [2015] NSWSC 1327. In that case, the court made it clear that a purchaser’s right to delivery of an item is a purchaser’s lien and not a registerable interest under s 8. The absence of written documentation, together with a lack of possession or control, combined to deny the purchaser a security interest in the property. It is also important to note that the PPSA still operates in conjunction with other laws. This means it does not stand alone and it does not overrule other legislation that may also relate to a particular transaction. Also, other legislation can define terms that are used in the PPSA. For example, it may be important for the purposes of time limits and priorities under the PPSA to know when title to goods passes from the seller to the buyer. The PPSA does not regulate this, and to solve this problem, one must refer to the state legislation relating to the sale of goods which is relevant to that particular transaction, to determine when a sale takes place for the purposes of the PPSA: see Lewis v LG Electronics Australia Pty Ltd [2014] VSC 644, a case involving lay-by sales.

Secured party and grantor [3.380] Under the PPSA, a ‘secured party’ is a person benefiting from the security. It includes persons known as chargee, lender, lessor and mortgagee. The ‘grantor’ is a person granting a security interest to the secured party. The grantor includes persons previously known as a chargor, mortgagor, or borrower.

Collateral [3.390] ‘Collateral’ is secured property, for example property covered by the security interest.

Security agreement [3.400] ‘Security agreement’ is an agreement creating the security interest, for example the charge, mortgage, financing agreement, lease agreement, and the like. To be enforceable against persons other than the grantor (for example creditors), the security agreement must be in writing and signed by the grantor: PPSA s 20.

Attachment [3.410] The PPSA applies where a ‘security interest’ has ‘attached’ to ‘collateral’. ‘Attach’ means where the grantor has rights in the collateral (or the power to transfer rights in the collateral to the secured party) and by conduct (for example, accepting money or other value) creates the security interest. The rights [3.410] 59

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of the grantor do not need to be ownership rights, but there needs to be some form of rights, else the security interest cannot be created. 32 If the security interest does not attach to collateral, it is unenforceable between the debtor and the secured party: s 19(1) PPSA. However, the security interest can cover future property, so attachment does not need to occur before ‘perfection’ (discussed below). If the security interest is registered before attachment occurs, perfection starts at the time of registration, not at the time of attachment: s 55(5) PPSA. ‘Attachment’ is governed by the terms and conditions of the security interest and thus relates to the relationship between the secured party and the grantor.

Perfection [3.420] The ‘perfection’ of a security interest is the last requirement to preserve the priority of a security interest. Because it relates to priority, it relates to the position of the secured party compared to the position of other creditors of the grantor. Compared to ‘attachment’, perfection is paramount because it ensures the security interest survives the bankruptcy or insolvency of the grantor. Perfection cannot occur unless there is a valid security interest, which attaches to the underlying collateral (which must be personal property). Section 21 provides that: (1)

A security interest in particular collateral is perfected if: (a)

(b)

(2)

32

the security interest is temporarily perfected, or otherwise perfected, by force of this Act; or all of the following apply: (i)

the security interest is attached to the collateral;

(ii)

the security interest is enforceable against a third party;

(iii)

subsection (2) applies.

This subsection applies if: (a)

for any collateral, a registration is effective with respect to the collateral; or

(b)

for any collateral, the secured party has possession of the collateral (other than possession as a result of seizure or repossession); or

(c)

for the following kinds of collateral, the secured party has control of the collateral: (i)

an ADI account;

(ii)

an intermediated security;

(iii)

an investment instrument;

(iv)

a negotiable instrument that is not evidenced by a certificate;

(v)

a right evidenced by a letter of credit that states that the letter of credit must be presented on claiming payment or requiring the performance of an obligation;

(vi)

satellites and other space objects.

Chrysler Credit Canada Ltd v MVL Leasing Ltd (1993) 5 PPSAC (2d) 92.

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(3)

A security interest may be perfected regardless of the order in which attachment and any step mentioned in subsection (2) occur.

(4)

A single registration may perfect one or more security interests.

Essentially, thus, perfection occurs when the security interest has attached to the collateral, it is enforceable against third parties, and: (a)

the security interest is registered on the personal property security register (‘perfection by registration’); or

(b)

the collateral is in the actual or apparent possession of the secured party (‘perfection by possession’); or

(c)

the collateral is in the control of the secured party and is one of the following types: ADI account, intermediated security, investment instrument, negotiable instrument without certificate, right under a letter of credit, satellite, space object. This is known as ‘perfection by control’ but this method of perfection only works for these types of collateral.

Perfection can occur by more than method – for example, by both registration and possession.

Transitional security interests [3.430] The PPSA provided for a two year transition period, with the aim of ensuring that security interests that existed elsewhere (for example, company charges) prior to the commencement of the PPSR regime on 30 January 2013, were protected after introduction of the PPSA and did not lose priority to interests created after the PPSR regime commenced. All charges registered at ASIC on or before 30 January 2012 had their registration automatically transferred across from ASIC’s register of charges to the personal property securities register. This occurred from October 2011 until 30 January 2012. This was achieved by defining a ‘transitional security interests’ (‘TSI’) as an interest which existed on 30 January 2012 (or which was created by an agreement dated before 30 January 2012, although the security interest arose after 30 January 2012). Each TSI was deemed to have ‘attached’ to the collateral immediately before 1 February 2012, satisfying the attachment requirement. The PPSA also provided for temporary perfection. Each TSI was deemed to be perfected until the earlier of (a) when it is perfected under the PPSA or (b) 30 January 2014: s322 PPSA. This allowed for a period of 2 years where TSIs had priority over all security interests created under the PPSA. If the holder of a TSI does not perfect their security interest before 30 January 2014, the security interest will now have become ‘unperfected’ on that date and will loses priority to any security interest which has attached to the same collateral and which has been perfected under the PPSA. Priority rules are discussed in more detail below. Although at first glance, the transitional arrangements may appear irrelevant as the transitional period has now ended, that is not the case. Persons who hold [3.430] 61

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registrable interests, who have not registered their interest under the PPSA regime, can still do so, or perfect their interest by other means. It is important to understand the impact and effect of all interests, whether registered under the PPSA or not, so that the appropriate steps can be taken to protect the interests of the beneficiary of that interest. It is also important to understand that documents do not necessarily mean what they say on the face of the document. A ten year old company charge may state that the charge was a first priority over certain assets. However, if the charge has not since been perfected under the PPSA, it may not have the effect that it says it does. Thus, in interpreting written security documents, it is important to understand not only the new regime, but also the effect of the transitional regime on interests that existed prior to its commencements.

General priority rules under the PPSA [3.440] Obviously, two security interests only compete for priority if they both cover the same (or some of the same) property as collateral. The PPSA sets out both general priority rules and specific priority rules. The general rules apply only if no more specific rule applies. Under s 55 PPSA, the default rules are: • A perfected security interest has priority over an unperfected security interest; • For two competing perfected security interests – the interest that was perfected earlier in time takes priority over the one that was perfected later in time;

• For two competing but unperfected security interests – the one that was attached earlier takes priority over the one that was attached later.

As discussed above, in the period from 30 January 2012 to 30 January 2014, a TSI will be deemed to be perfected prior to any interest that is not a TSI and thus a TSI will always take priority over a security interest that is not a TSI. Continuous perfection is required: s 56. This is not difficult with perfection by registration, but needs to be attended to if one of the other methods of perfection is used.

Specific priority rules – purchase money security interests [3.450] One of the more specific rules relating to priority, relates to purchase money security interests (‘PMSI’). Under s 14, these are security interests which secure all or part of the purchase price of the collateral. The interest will not be a PMSI if the grantor intends to use the collateral for personal, household or domestic purposes, or if it is part of a sale and lease back arrangement, or the collateral is an investment instrument. A PMSI that is perfected after an earlier security interest which is not a PMSI, will take priority over the earlier interest: s 62PPSA. This is an exception to the general rule that earlier perfected interests take priority over later ones: s 55 PPSA.

Specific priority rules – perfection by control [3.460] Another exception to the general rules is where the perfection occurs by control (which only applies to particular types of collateral, as discussed above). 62 [3.440]

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A security interest which is perfected by control takes priority over a security interest which is perfected by other means, regardless of the timing of perfection: s 57 PPSA.

Extinguishment rules [3.470] A buyer or lessee of property which is collateral to an unperfected security interest to which the buyer or lessee is not a party, takes that property free from the security interest: s 43 PPSA. There are various other specific provisions for extinguishment of particular types of collateral in particular circumstances under Part 2-5 of the PPSA. Where the property is taken free from that security interest, the holder of the security interest does not lose the interest outright, and instead is merely subrogated to the interests of the buyer or lessee: s 53 PPSA.

Security interests in an insolvency [3.480] Certain provisions in the Corporations Act 2001 can cause security interests to become “void as against the liquidator” when a company enters into an insolvent liquidation. This effectively renders the security interest unenforceable, as the liquidator controls the company in the liquidation. This does not apply to the underlying debt; it only applies to the security interest which secures the debt. Thus, the underlying debt does not become void; only the charge which secures the debt becomes void, with the effect that the holder of such a security interest will be regarded as an unsecured creditor, who as such is unlikely to have the debt repaid in full (as by definition, an insolvent company has insufficient assets to repay all of its liabilities when they fall due). Any security interest in favour of a director which is registered less than six months before the company enters liquidation, will be unenforceable against the liquidator unless the court specifically allows enforcement: s 267 of the Corporations Act 2001 (Cth). In addition, under s 588FE of the Corporations Act, the following security interests can be void against the liquidator if the liquidator chooses to render them void: • any security interest which is granted in the six months before the company enters liquidation, if the company was insolvent at the time or the security interest causes the company to become insolvent;

• any security interest granted in the two years before the company enters liquidation, if the company was insolvent at the time or the security interest causes the company to become insolvent, and the security interest was entered into on uncommercial terms;

• any security interest granted to a related party in the four years before the company enters liquidation;

• any security interest which is granted in the four years before the company enters liquidation, to a director or an entity related to a director, which is on unreasonable terms given the benefits and disadvantages to the company; and

• any security interest granted in the ten years before the company enters liquidation, if the charge was granted for the purpose of defeating, delaying or interfering with the rights of any or all of its creditors. [3.480] 63

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Reform [3.490] On 18 March 2015, a final report on the statutory review of the Personal Property Securities Act 2009 was tabled in the federal parliament. 33 The report made 39 recommendations for improvement to the PPSA and PPSR. We can thus expect further law reform in this area.

33

Available at: https://www.ag.gov.au/consultations/pages/StatutoryreviewofthePersonalProperty SecuritiesAct2009.aspx (accessed 5 May 2016).

64 [3.490]

CHAPTER 4 Corporate Governance [4.10]

Introduction ................................................................................................. 66 [4.20] Key points ........................................................................................................ 67 [4.30] Key terms ......................................................................................................... 67

[4.40]

Corporate governance ............................................................................... 67 [4.50] Aims of corporate governance regulation .................................................. 67 [4.60] The corporate governance debate ................................................................ 67 [4.70] Corporate collapses and legislative reform ................................................ 68

[4.80]

General law duty to exercise reasonable care ....................................... 69 [4.90] Contractual duties ........................................................................................... 70

[4.140]

[4.190]

[4.100]

Tortious duties ............................................................................................... 70

[4.110]

Equitable duties ............................................................................................. 71

[4.120]

Defences .......................................................................................................... 72

Fiduciary duties .......................................................................................... 72 [4.140]

Nature of fiduciary duties ........................................................................... 72

[4.150]

Duty to act in good faith in the interests of the company .................... 72

[4.160]

Duty to act for proper purposes ................................................................ 73

[4.170]

Duty to not fetter discretions ...................................................................... 75

[4.180]

Duty to not have conflicts of interest ........................................................ 76

Statutory duties........................................................................................... 77 [4.200] Statutory duty to act in the company’s interest and for proper purposes ............................................................................................................... 78 [4.210] Statutory duty to not misuse position or information ........................... 79 [4.220]

Statutory duty to exercise due care, skill and diligence ........................ 79

[4.230]

Statutory duty to disclose conflicts of interest ........................................ 80

[4.240]

Exceptions ............................................................................................ 81

[4.250] Giving standing notice ...................................................................... 82 [4.270] Voting where a conflict exists ..................................................................... 82

[4.320]

[4.270]

Public companies ............................................................................... 82

[4.280]

Proprietary companies ...................................................................... 82

[4.290]

Other provisions useful to directors .......................................................... 83

[4.300]

Breach of statutory duty .............................................................................. 84

[4.310]

Case Study: James Hardie’s directors ....................................................... 84

[4.315]

Case Study: Fortescue Metals ..................................................................... 87

Derivative actions....................................................................................... 88

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INTRODUCTION [4.10] As discussed in Chapter 1, there is a separation of management from ownership in a company. A company is, collectively, “owned” by its members; however, it is the company’s board of directors that decides the strategic direction of the company. Because of the separation of ownership and management, certain constraints on the conduct of directors are necessary to protect members’ interests. Although it is normal for a company’s constitution or the replaceable rules (s 198A) to confer on the board of directors the power to manage the affairs of the company and to exercise all the powers of the company, this power is limited by the power of the investors, which is exercised in general meetings (eg to appoint and remove directors). However, investors cannot normally use this mechanism to wrest control of the company away from the directors. 1 Accordingly, specific duties are imposed on directors, both by the general law and by the Corporations Act 2001 (Cth), in order to protect investors. Many of these duties evolved in the courts, but the concepts have since been encapsulated in legislative form in the Corporations Act 2001, and so consideration of case law is fundamental to an understanding of how these legislative provisions apply in practice. In addition, directors of listed entities must comply with the Listing Rules of the relevant stock exchange, which can impose additional requirements in rules such as the Listing Rules of the Australian Securities Exchange (ASX). There can also be non-binding rules published, such as the ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations. 2 Although these Principles, now in their third edition, are not legislative in nature, entities listed on the ASX agree, as a condition of their listed status, pursuant to ASX Listing Rule 4.10.3, to benchmark their performance against the recommended practices and report any failure to adhere to them. Entities which operate internationally, and particularly entities that are listed on stock exchanges in more than one country, will also be subject to requirements imposed by the other jurisdiction. Most notably, the United States Sarbanes-Oxley Act 2002 (US), and related rules published by the United States Securities and Exchange Commission (SEC), affect not only companies with their shares listed on a United States national securities exchange, but also foreign companies which are subsidiaries of publicly traded United States companies. Companies that were registered in Australia are listed on the ASX (and not a United States exchange) even though they have operations based in the United States requiring the filing of reports with the SEC. However, this chapter will concentrate on the Australian laws that are applicable to directors. 1 2

Automatic Self-Cleansing Filter Syndicate Co Ltd v Cunninghame [1906] 2 Ch 34. Available on the ASX website: http://www.asx.com.au/documents/asx-compliance/cgc-principlesand-recommendations-3rd-edn.pdf (accessed 12 May 2016).

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Key points [4.20] This chapter will provide a greater understanding of: • the concept of corporate governance; • the definitions of “director” and “officer”; • the nature of duties imposed on directors by the general law and the Corporations Act 2001; and

• the nature of the defences available for directors when they make decisions relating to the company.

Key terms [4.30] The key terms in this chapter are: • Corporate governance • Director • Officer • Fiduciary duty

CORPORATE GOVERNANCE [4.40] The notion of “corporate governance” describes the methods by which companies are controlled and managed. The aim of corporate governance regulation is to achieve “best practice” with the intended goals being economic efficiency and investor protection. The essence of the notion of corporate governance revolves around the fact that directors should be accountable for their actions and their decisions should be, as far as possible, transparent. Requirements that certain information be disclosed to investors, coupled with investors rights to, eg remove directors from their directorships, is regarded as aiding this process.

Aims of corporate governance regulation [4.50] Corporate governance regulation attempts to ensure that the controllers of companies make decisions which benefit the company and do not engage in activities which would be detrimental to the company, since detrimental conduct causes indirect loss to investors in the company through the consequential reduction in the value of their investment. This is most visible in listed companies by a fall in the market price of the particular company’s shares, but it applies equally (if not so visibly) to unlisted companies.

The corporate governance debate [4.60] Recent debate about corporate governance regulation has not been so much aimed at altering the broad substance of the duties imposed upon directors (after all, the concept that directors should act in the company’s interests and not prefer their own personal interests, is scarcely debatable!). [4.60] 67

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Instead, the debate circles around the issue of how much regulation is required. How much is too much? How much is too little? The amount of regulation imposed upon directors needs to be sufficient to ensure that investors and/or regulators can discover any such misconduct before it is too late (and the penalties need to be sufficient to adequately deter such conduct). However, regulation still needs to allow directors to make honest and appropriate decisions on behalf of the company without the benefit of hindsight and without fear of later prosecution for those decisions (which might deter directors from accepting directorships in the first place). Further, regulation should not impose so much compliance that the profits otherwise generated by business activities are absorbed in measures for compliance with regulation. Reporting and information disclosure needs to be sufficiently detailed to achieve the goals of corporate governance, but without requiring so much detail that the important information is hidden in disclosure which is far too detailed or complex to achieve those goals. No-one seriously debates the value of corporate governance regulation, but much regulation is criticised as excessive, requiring too much compliance for little actual corporate governance benefit. However, finding an appropriate balance has proven difficult.

Corporate collapses and legislative reform [4.70] Corporate governance has attracted much interest over the last couple of decades. Its importance is emphasised when huge corporate collapses occur, such as the very public collapses of HIH in Australia and of Enron in the United States, which in turn trigger much debate about current regulation of directors’ conduct. The issue is very political when investors lose hundreds of millions, or even billions, of dollars. 3 There is often a knee-jerk reaction following a collapse and it is assumed that the existing regulation was insufficient (because the collapse occurred), followed by a quick legislative response (such as the Sarbanes-Oxley Act 2002 (US) in the United States). In Australia, the government established the HIH Royal Commission, tasking it with investigating: (a)

whether and, if so, the extent to which, decisions or actions of HIH or any person contributed to the failure of HIH or involved or contributed to undesirable corporate governance practices;

(b)

whether those decisions or actions might have constituted a breach of any law of the Commonwealth, a State or a Territory and, if so, whether the question of criminal or other legal proceedings should be referred to the relevant agency;

3

The final report of the HIH Royal Commission (available at http://www.hihroyalcom.gov.au/ finalreport/index.htm) noted (in Pt 3.7) that the total net asset deficiencies of the HIH group, as at 15 March 2001, were between $3.6 billion and $5.3 billion.

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(c)

the appropriateness of the manner in which powers were exercised and responsibilities and obligations discharged under Commonwealth, State and Territory laws; and

(d)

whether the regulatory regime should be amended.

The final report of the HIH commission generated much interest, and was published both in printed form and on the internet. 4 Many of the recommendations of the Royal Commission found their way into legislative reform, such as CLERP 9. Not that it directly relates to corporate governance, but it is a measure of the fluidity and political nature of this area of the law that, just as this current edition is being finalised, the current federal opposition Labor party is calling for a royal commission into banking practices, and in response, the government has announced new powers and resources for ASIC to implement a user-pays system to upgrade ASIC’s technology and data systems and surveillance and enforcement, including the need for banks to consider customer needs when they design and sell products. The government also has announced reviews into ASIC’s enforcement and penalty regime; dispute resolution mechanisms and in lifting dispute caps to facilitate greater access to the banking ombudsman by small business and individuals. 5 Because corporate governance regulates every decision made by directors, it attracts substantial interest and debate. Unfortunately, this chapter can only provide a glimpse of some of the principles and debate underpinning this very interesting area of the law.

GENERAL LAW DUTY TO EXERCISE REASONABLE CARE [4.80] Every director is obliged, under the general law, 6 to exercise reasonable care, skill and diligence. This obligation has various sources. Common law courts have always enforced contracts, including duties imposed by express or implied terms in the contract between a director and a company. The law of negligence (which is a tort) applies to everyone, including 4

5 6

At the time this edition is being finalised (May 2016), it appears that the final report is no longer currently electronically available in its entirety on the www.hihroyalcom.gov.au website, although a summary remains on the site and the entire report remains accessible through the internet archival services such as wayback machine (see http://web.archive.org/web/20040402005438/http:// www.hihroyalcom.gov.au/finalreport/index.htm (accessed 12 May 2016, mimicking a date of 4 April 2004). See http://www.afr.com/news/politics/banks-accept-tougher-industry-cop-but-labor-still-wants-aroyal-commission-20160419-goaflo (accessed 12 May 2016).

Historically, the court system had two different branches of courts: common law courts (which developed common law principles and applied common law remedies) and courts of equity (which developed equitable principles and applied equitable remedies). Today, the jurisdictions of both have been merged into one court system, which applies both sets of principles and remedies, now known as the “common law” or “general law”. (This concept of “common law” (which includes laws of equity) should not to be confused with the earlier, historical notion of “common law” (which was separate from, and excluded, the laws of equity.) The term “general law” is now often used as a synonym for “common law” to avoid this potential confusion.) [4.80] 69

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directors. The laws of equity impose additional duties, both general equitable duties to exercise reasonable care and skill, and the more onerous fiduciary duties to act honestly, loyally, in the company’s best interests, in good faith and for proper purposes, without a conflict of interest. The same facts can trigger multiple breaches of similar, but not identical, duties originating from different historical legal sources of law. The source of a particular duty is not only important for the purposes of determining the standard of care, but also in terms of the remedy available to the company for breach of that duty. Thus, the duties can, because of their different legal origins, at times allow a company, which is suing a director for breach of duty, to access different types of remedies. For example, damages for breach of a common law (non-equitable) duty, compensate for only loss actually suffered. However, equity allows more wide-reaching remedies, such as return of an asset, even if it may have increased in value. 7 Legislative restrictions on damages for torts can apply to damages for negligence, but not to damages for breach of equitable duty. 8 In addition, the Corporations Act 2001 adds another (concurrent/simultaneous) level of regulation in addition to the laws developed by the courts.

Contractual duties [4.90] Executive directors operate under an express or implied contract of service with the company. That contract will usually include an express term that the director will exercise reasonable diligence, care and skill and may include other express duties. Even if the contract does not include an express term to this effect, such a term will be implied into the contract, imposing a common law contractual duty on the director. 9 A non-executive director (ie a director who is not involved in the day-to-day aspects of management of the company) might not have a contract with the company and, even if such a contract exists, any such contract may not include express terms regulating the director’s conduct. However, the laws of equity will impose a duty to exercise reasonable care and skill upon the director. 10 This duty is not a “fiduciary duty” 11 and co-exists with the general law duties to avoid negligence, and to comply with contractual obligations (including implied contractual terms).

Tortious duties [4.100] As is expected of everyone, the law of negligence also imposes on directors a duty to exercise reasonable care and to take reasonable precautions to 7 8 9 10 11

Re Dawson (deceased) [1966] 2 NSWR 211 at 215–216. For example, see the Law Reform (Miscellaneous Provisions) Act 1946 (NSW) s 5 concerning rights of contribution from joint tortfeasors. Lister v Romford Ice and Cold Storage Co Ltd [1957] AC 555. Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187; 14 ACSR 109. Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187; 14 ACSR 109 at 237 (WAR), 156 (ACSR).

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avoid foreseeable risks that are likely to cause harm to persons who will foreseeably be detrimentally affected by their actions. The applicable standard of care is objective – ie the deceptively simple standard of reasonable care of an ordinarily prudent person. 12 Recent cases have made clear that this does not permit a director to hide behind a standard of honest, but inept, behaviour. For example, in Commonwealth Bank of Australia v Friedrich, 13 Tadgell J said: A director is expected to be capable of understanding the company’s affairs to the extent of actually reaching a reasonably informed opinion of its financial capacity … He is required by law to be capable of keeping abreast of the company’s affairs, … and to act appropriately if there are reasonable grounds to expect that the company will not be able to pay all its debts in due course. 14

Equitable duties [4.110] To a large extent, the equitable duty overlaps with the duty sourced in tort. In Daniels v Anderson, 15 the court referred to the following excerpt from the opinion of the Supreme Court of New Jersey, in Francis v United Jersey Bank 16 as eloquently expressing what the law (“not only in the United States, but in Australia and elsewhere”) requires of directors: As a general rule, a director should acquire at least a rudimentary understanding of the business of the corporation. Accordingly, a director should become familiar with the fundamentals of the business in which the corporation is engaged … Because directors are bound to exercise ordinary care, they cannot set up as a defence lack of the knowledge needed to exercise the requisite degree of care. If one “feels that he has not had sufficient business experience to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or refuse to act.” Directors are under a continuing obligation to keep informed about the activities of the corporation. Otherwise, they may not be able to participate in the overall management of corporate affairs. … Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect. … Directorial management does not require a detailed inspection of day-to-day activities, but rather a general monitoring of corporate affairs and policies … Accordingly, a director is well advised to attend board meetings regularly. … While directors are not required to audit corporate books, they should maintain familiarity with the financial status of the corporation by a regular review of financial statements … The review of financial statements, however, may give rise to a duty to inquire further into matters revealed by those statements … Upon discovery of an illegal course of action, a director has a duty to object and, if the corporation does not correct the conduct, to resign. 12

13 14 15

16

In Re City Equitable Fire Insurance Company Ltd [1925] Ch 407 at 428–429 per Romer J.

Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115. Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115 at 126. Daniels v Anderson (1995) 37 NSWLR 438. Francis v United Jersey Bank 432 A 2d 814 (NJ 1981) at 821–823.

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Defences [4.120] The statutory duties, and defences, are discussed below. However, s 180(2) is unusual in that it is a statutory defence that applies to breaches of both statutory and general law duties. Thus, s 180(2) can provide a defence to conduct that would otherwise breach the common law, tortious and/or equitable duties to exercise reasonable care and skill. This defence is discussed below.

FIDUCIARY DUTIES Nature of fiduciary duties [4.140] Fiduciary duties are owed to the company, not to individual shareholders, 17 unless special circumstances exist. 18 The standard of care required to satisfy a fiduciary duty is normally higher than an equitable or tortious or contractual duty. It requires “not honesty alone, but the punctilio of an honour the most sensitive”. 19 If directors breach a fiduciary duty, the possible remedies available to the company include rescission of a contract, an order requiring property to be held on constructive trust for the benefit of the company, damages and compensation or injunctive relief.

Duty to act in good faith in the interests of the company [4.150] Every director owes a fiduciary duty to the company, to act in its best interests. This includes not only a positive aspect to the duty, but also an obligation not to disregard the company’s interests (eg by providing a bonus to a retiring employee). The “company” is normally considered to be “the members as a whole” (ie existing members, viewed collectively, without preferring the interests of any one member over the interests of other members). If a decision will affect different classes of members differently, the directors must ensure that both classes are treated fairly. 20 The “company” can include the company’s creditors if the company is nearing insolvency. 21 It can also include future members. However, there is no established principle that this includes the company as a “going commercial concern” or that it includes the interests of the company’s employees (to the extent that this is not required to avoid industrial unrest), its customers, or the 17 18

19 20

21

Percival v Wright [1902] 2 Ch 421. According to Brunninghausen v Glavanics (1999) 46 NSWLR 538, a director may owe a personal duty to a shareholder where this will not compete with any duty owed to the company and either the director has assumed the duty to the shareholder or the circumstances are such that the law imposes such a duty on the director. Meinhard v Salmon 249 NY 458 (1928) per Cardozo CJ. Mills v Mills (1938) 60 CLR 150. Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722.

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community at large. It also does not generally include the interests of the corporate group of which the company is a member. In a corporate group situation, the directors of each company are obliged to consider that company’s interests, independent of the group – unless of course the group’s fate is so entwined with the company’s fate that to ignore the group’s fate would also damage the company’s future prospects. This principle is now affected by s 187, which provides that: A director of a corporation that is a wholly-owned subsidiary of a body corporate is taken to act in good faith in the best interests of the subsidiary if: (a)

the constitution of the subsidiary expressly authorises the director to act in the best interests of the holding company; and

(b)

the director acts in good faith in the best interests of the holding company; and

(c)

the subsidiary is not insolvent at the time the director acts and does not become insolvent because of the director’s act.

Duty to act for proper purposes [4.160] Every director also owes a fiduciary duty to the company, to act for proper purposes. Honest belief in the propriety of the director’s purpose is not a defence; the purpose must actually be proper, viewed objectively. Of course directors often do have multiple purposes for choosing any particular conduct or path of action. The legal test obliges directors to not have a substantial purpose that is improper. 22 Courts will examine whether an identified improper purpose was “causative, in the sense that, but for its presence, the power would not have been exercised”. 23 Proving an improper purpose can be difficult, as directors who deliberately act improperly rarely leave evidence of their subjective and improper purpose; however courts can infer an improper purpose from the factual circumstances surrounding a decision. For example, making a share issue to defeat a known existing or impending takeover bid, is an improper purpose. However, making a share issue to raise much-needed capital is a proper purpose. The case of Howard Smith Ltd v Ampol Petroleum Ltd 24 is a good illustration. In that case, two associated companies (A and B) together controlled 55% of the shares in a company (M), which was a takeover target. The remaining 45% was held by other shareholders. Company A made a takeover bid to acquire all of Millers’ issued shares. Another company, HS, announced a rival offer at a higher price. The target company’s directors announced their intention to recommend that shareholders reject A’s offer and accept HS’s offer. A and B announced that they would never sell to HS (thus preventing HS from ever obtaining control). To prevent this, and to facilitate HS’s takeover, M’s directors issued 4.5 million 22

23

24

Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187; 14 ACSR 109 at 137 (ACSR).

Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285 at 294, citing Dixon J in Mills v Mills (1938) 60 CLR 150 at 186. Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821.

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shares to Howard Smith, causing A and B’s collective 55% voting majority to fall to 36.6%. A applied for a court order, declaring that the share issue was for an improper purpose. The directors argued that the primary reason for the issue was to raise much-needed capital. After considering all the facts, the court found that the directors had acted honestly, in what they considered was the best interests of the company, and that they had not been motivated by any purpose of personal gain or advantage or by a desire to retain their positions on the board. The court also found that the company needed to raise capital. However, given the timing, the concurrent takeover bid, and the identity of the recipient of the share issue (HS), the court found that the primary purpose of the allotment was to reduce A and B’s collective shareholding so that HS could make an effective takeover offer. The court said: [W]here the self-interest of the directors is involved, they will not be permitted to assert that their action was in the interest of the company … But it does not follow that the absence of self-interest is enough to make an issue valid. Self-interest is only one, though no doubt the commonest, instance of improper motive: and, before one can say that a fiduciary power has been exercised for the purpose for which it was conferred, a wider investigation may have to be made. Where the question is one of abuse of powers, the state of mind of those who acted, and the motive on which they acted, are all important, and you may go into the question of what their intention was, collecting from the surrounding circumstances all the materials which genuinely throw light upon that question of the state of mind of the directors so as to show whether they were honestly acting … in the interests of the company or were acting from some bye-motive, possibly of personal advantage, or for any other reason. On the other hand … it is … too narrow … to say that the only valid purpose for which shares may be issued is to raise capital. The law should not impose such a limitation. To define exact limits in advance is impossible. The variety of situations … cannot be anticipated … [This can also not] be done by the use of a phrase – such as “bona fide in the interest of the company as a whole,” or “for some corporate purpose.” Such phrases, if they do anything more than restate [general principles], at best serve, negatively, to exclude from the area of validity cases where the directors are acting sectionally, or partially: ie improperly favouring one section of the shareholders. … It is necessary to start with … the power in question, in this case a power to issue shares. … Having defined as can best be done the … limits within which it may be exercised, it is then necessary for the court … to examine the substantial purpose for which it was exercised, and to reach a conclusion whether that purpose was proper or not. In doing so it will give credit to the bona fide opinion of the directors, if such is found to exist, and will respect their judgment as to matters of management; [but] the ultimate conclusion has to be [on which] side of a fairly broad line, the case falls. 25

This case can be contrasted with the case of Harlowe’s Nominees Pty Ltd v Woodside (Lakes Entrance) Oil Co NL, 26 where a company’s share issue to a large 25

26

Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 at 834–835.

Harlowe’s Nominees Pty Ltd v Woodside (Lakes Entrance) Oil Co NL (1968) 121 CLR 483 at 493.

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oil company secured the company’s financial stability. This defeated a shareholder’s attempt to secure control by buying the company’s shares, but was not improper because: [A]lthough primarily the power is given to enable capital to be raised when required, there may be occasions when the directors may fairly and properly issue shares for other reasons, so long as those reasons relate to a purpose of benefiting the company as a whole, as distinguished from a purpose, for example, of maintaining control of the company in the hands of the directors themselves or their friends. Whether additional capital was presently required is often most relevant; but [the] ultimate question must always be whether the issue was made honestly in the interests of the company. Directors [are vested with] the right and the duty of deciding where the company’s interests lie and how they are to be served may be concerned with a wide range of practical considerations, and their judgment, if exercised in good faith and not for irrelevant purposes, is not open to review in the courts. Thus in the present case it is not a matter for judicial concern, if the allotment … would frustrate the ambitions of someone who was buying up shares as opportunity offered with a view to obtaining increased influence on the control of the company, or even that the directors realised that the allotment would have that result and found it agreeable to their personal wishes.

Duty to not fetter discretions [4.170] Directors owe a duty to retain control over their discretions. They can employ agents to carry out board policy, but cannot delegate the functions of the board except to the extent that this is permitted by the company’s constitution or by s 198D of the Corporations Act 2001, which provides that unless the company’s constitution provides otherwise, the directors of a company may delegate any of their powers to: (a)

a committee of directors;

(b)

a director;

(c)

an employee of the company; or

(d)

any other person.

The delegation must be recorded in the company’s minute book (s 251A); the delegate must exercise the powers delegated in accordance with any directions of the directors (s 198D(2)); and the delegate’s exercise of the power is as effective as if the directors had exercised it (s 198D(3)). However, directors remain responsible for the actions of their delegates (except to the extent that a defence applies, see below). However, delegation to committees is quite common, particularly in large public companies, which usually have an executive committee (who acts for the board between board meetings), an audit committee, a finance committee, and a remuneration committee (which advises on director remuneration). Such committees have become quite common since the publication of the ASX’s Corporate Governance Principles. [4.170] 75

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Duty to not have conflicts of interest [4.180] In essence, the director is obliged to avoid conflicts of interest. Any conflict must be real and not merely theoretical, remote or contingent, for the duty to be breached. 27 Other formulations of the rule require a “real or substantial possibility of conflict” 28 or a “significant possibility of conflict”. 29 An ephemeral association or interest is insufficient. 30 The duty has been phrased strictly – ie the director owes a duty to the company to not place himself or herself in a position of even potential conflict between the director’s duty to act in the company’s interest and the director’s personal interest. 31 On this formulation of the duty, it is not necessary even to prove that the director benefited from the conflict, 32 or acted dishonestly. Other formulations of the fiduciary duty oblige a director to not take advantage of a conflict, if it arises. 33 Whatever the exact formulation of the fiduciary duty, given the attention paid to corporate governance today, a wise director will disclose any potential conflict that may arise. (The duty to disclose conflicts is itself both a fiduciary duty and a duty imposed by the Corporations Act 2001 and, as such, is discussed below in relation to statutory duties.) A conflict can arise in multiple ways. These aspects are neatly distilled by Ford’s Principles of Corporations Law: • directors must not have a personal interest (or be interested in a third party interest) except with the company’s fully informed consent (“the conflict rule”);

• directors must not misuse their position for their own or a third party’s possible advantage, except with the company’s fully informed consent; and they must account to the company for any profit made in connection with their directorship (“the profit rule”); and

• directors must not misappropriate the company’s property for their own, or another person’s benefit (“the misappropriation rule”). 34

The conflict can be indirect, 35 and it can occur when a director holds multiple directorships of competing companies, 36 although holding multiple directorships will not of itself cause a conflict to occur. Conflict is more likely if those 27 28 29 30 31 32

33 34 35

36

ASIC, RG 76: http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-76related-party-transactions/ (accessed 4 April 2016). Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 at 103 per Mason J. Chan v Zacharia (1984) 154 CLR 178 at 199 per Dean J. Baker v Palm Bay Island Resort Pty Ltd (No 2) [1970] Qd R 210 at 221. Boardman v Phipps [1967] 2 AC 46; confirmed in Gemstone Corp of Aust Ltd v Grasso (1994) 62 SASR 239. Green v Bestobell Industries Pty Ltd [1982] WAR 1 per Burt CJ.

Chan v Zacharia (1984) 154 CLR 178 per Deane J; Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 per Mason J. R Austin and I Ramsay, Ford’s Principles of Corporations Law (13th ed, LexisNexis Butterworths, 2007) at [9.020]. Walker v Nicolay (1991) 4 ACSR 309. Fitzsimmons v The Queen (1997) 23 ACSR 355.

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companies are engaging in business together, in which case it is practically impossible for a director to act in the best interests of each company. A conflict may also arise where a director’s duty of confidentiality to one company conflicts with his duty to act in the best interests of the other company. A director in such a situation can avoid liability by full disclosure immediately when the conflict becomes apparent. The courts also consider the extent of the interest held by the director. A director of a company which is borrowing money from a large publicly listed bank would be unlikely to have a conflict if the director happened to have a very small shareholding in the bank. This is because the value of the director’s shareholding is unlikely to be affected by the bank’s transaction with the company. The situation would be very different if the financier was privately owned, and the director owned 50% of the bank’s shares. An honest director who inadvertently and perhaps reasonably allowed a conflict to occur but remedied the conflict as quickly as could be expected, in circumstances where the conflict caused no loss to the company or benefit to the director, might well be excused by the court under s 1318 of the Corporations Act 2001, which allows a court to relieve a director from liability if the court considers that the director acted honestly and ought fairly to be excused from liability. The nature of these duties in regard to conflicts of interest, and their associated disclosure obligations, will be further explored below, particularly the rules relating to directors’ dealings with companies.

STATUTORY DUTIES [4.190] Statutory duties are similar to, and operate concurrently with, general law duties. 37 While fiduciary duties are now reflected in ss 181 – 183 of the Corporations Act 2001, the contractual, tortious and equitable duty to exercise due care and skill is contained in s 180(1). Criminal liability is defined in s 184. A defence can apply to breach of s 180(1), but there are no defences applicable to breach of ss 181 – 183. The duties to disclose actual and potential conflicts of interest, and the provisions relating to directors voting on matters where a conflict exists, are set out in ss 191 – 195. In addition, directors incur personal liability if they allow a company of which they are a director to trade whilst insolvent: s 588G. The legal consequences of breach of statutory duty are different to those for breach of fiduciary duty. Not only is criminal liability a concern for directors dishonestly or recklessly breaching a s 181, 182 or 183 duty, 38 but the 37 38

See Corporations Act 2001 (Cth) s 185, which expressly provides that the statutory duties do not replace general law duties. See Corporations Act 2001 (Cth) s 184.

[4.190] 77

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Corporations Act 2001 also provides for “civil penalties” of up to $200,000 for each breach – plus a further penalty of up to five years imprisonment. 39 The statutory duties differ in another respect from the fiduciary duties: they expressly apply not only to “directors”, but unlike fiduciary duties, also apply to “officers”. Both terms are defined in s 9 of the Corporations Act 2001. A “director” is a person who is appointed to the position of a director, or is appointed to the position of an alternate director and is acting in that capacity. It does not matter what the position is actually called: s 9. It also includes a person who is not validly appointed as a director, but who acts in the position of a director (known as a “de facto director”), and any person in accordance with whose wishes the directors of the company are accustomed to act (known as a “shadow director”). 40 An “officer” is defined in s 9 as: (a)

a director or secretary of the corporation; or

(b)

a person: (i)

who makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation; or

(ii)

who has the capacity to affect significantly the corporation’s financial standing; or

(iii)

in accordance with whose instructions or wishes the directors of the corporation are accustomed to act (excluding advice given by the person in the proper performance of functions attaching to the person’s professional capacity or their business relationship with the directors or the corporation); or

(c)

a receiver, or receiver and manager, of the property of the corporation; or

(d)

an administrator of the corporation; or of a deed of company arrangement executed by the corporation; or

(f)

a liquidator of the corporation; or a trustee or other person administering a compromise or arrangement made between the corporation and someone else.

Statutory duty to act in the company's interest and for proper purposes [4.200] Section 181(1) of the Corporations Act 2001 obliges: [a] director or other officer of a corporation … to exercise their powers and discharge their duties:

39 40

(a)

in good faith in the best interests of the corporation; and

(b)

for a proper purpose. See ss 1317E – 1317J and Sch 3 of the Corporations Act 2001 (Cth). A person does not become a director merely because they give advice or perform functions attaching to the person’s professional capacity, or the person’s business relationship with the directors or the company, although such a person can be a director if the advice given goes beyond a purely arm’s length professional relationship.

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Thus the fiduciary duty discussed in [4.40] is reproduced in the legislation. Case law that considers the standard of the fiduciary duty is still relevant to an interpretation of the appropriate standard of the statutory duty.

Statutory duty to not misuse position or information [4.210] Section 182(1) states: A director, secretary, other officer or employee of a corporation must not improperly use their position to: (a)

gain an advantage for themselves or someone else; or

(b)

cause detriment to the corporation.

Section 183(1) states: A person who obtains information because they are, or have been, a director or other officer or employee of a corporation must not improperly use their position to: (a)

gain an advantage for themselves or someone else; or

(b)

cause detriment to the corporation.

These duties expressly apply to employees as well as officers; they also apply to ex-employees and ex-directors.

Statutory duty to exercise due care, skill and diligence [4.220] Section 180(1) provides: A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they: (a)

were a director or officer of a corporation in the corporation’s circumstances; and

(b)

occupied the office held by, and had the same responsibilities within the corporation as, the director or officer.

The standard of this duty is generally considered to be the same as the equivalent fiduciary duty, 41 and will depend on the size of the company, as well as the nature of the role the officer has accepted in the company. 42 An officer who would otherwise contravene s 180(1) (or the equivalent fiduciary duty) 43 can avoid liability under “the business judgment rule”, which is set out in s 180(2): A director or other officer of a corporation who makes a business judgment is taken to meet the requirements of subsection (1), and their equivalent duties at common law and in equity, in respect of the judgment if they: 41 42

43

Daniels v Anderson (1995) 37 NSWLR 438. In the case of a failure to notice an anomaly in the company’s accounts, different standards of duty might well be applied towards a non-executive director with no accounting qualifications in a small proprietary company with an annual turnover of $40,000 per year, and an executive director with accounting qualifications holding the position of chief financial officer in a large publicly listed company. Corporations Act 2001 (Cth) s 180(2).

[4.220] 79

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(a)

make the judgment in good faith for a proper purpose; and

(b)

do not have a material personal interest in the subject matter of the judgment; and

(c)

inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and

(d)

rationally believe that the judgment is in the best interests of the corporation. The director’s or officer’s belief that the judgment is in the best interests of the corporation is a rational one unless the belief is one that no reasonable person in their position would hold.

A “business judgment” is defined as “any decision to take or not take action in respect of a matter relevant to the business operations of the corporation”: s 180(3). This defence represents an important “safe harbour” in which officers can be sure that they do not risk liability for decisions they make on behalf of the company. To protect themselves, many directors nowadays collate evidence, each board meeting, of matters they have considered relating to the company, including information they have requested in relation to each judgment. They may even maintain a directors’ diary which provides a daily record of the reasons for each business judgment and why it is considered to be in the best interests of the company.

Statutory duty to disclose conflicts of interest [4.230] A conflict of interest occurs where a person’s loyalties are, or might reasonably be perceived to be, swayed in at least two opposing ways. For example, this can occur when a bribe is offered to make a decision that would otherwise be made in a different way, or where a director (or his/her family, friends, related company etc) would benefit from a decision made in a particular manner. A conflict of interest can also occur when a director of a company personally enters into a contract with that company. Section 191(1) (which applies to all companies other than proprietary companies with only one director) 44 provides: A director of a company who has a material personal interest in a matter that relates to the affairs of the company must give the other directors notice of the interest unless subsection (2) says otherwise.

The notice must be given at a directors’ meeting as soon as practicable after the director becomes aware of their interest in the matter. It must be recorded in detail in the minutes of the meeting, and must provide the details of both the nature and extent of the interest, and how the interest relates to the affairs of the company. 44

See Corporations Act 2001 (Cth) s 191(5).

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There is little case guidance as to what constitutes a “material” “personal interest” but the case of Grand Enterprises Pty Ltd v Aurium Resources Ltd [2009] FCA 513 clarifies that “material” refers to a matter that is sufficiently substantial to affect the director’s vote.

Exceptions [4.240] Section 191(2)(a) states: The director does not need to give notice of an interest under subsection (1) if the interest: (i)

arises because the director is a member of the company and is held in common with the other members of the company; or

(ii)

arises in relation to the director’s remuneration as a director of the company; or

(iii)

relates to a contract the company is proposing to enter into that is subject to approval by the members and will not impose any obligation on the company if it is not approved by the members; or

(iv)

arises merely because the director is a guarantor or has given an indemnity or security for all or part of a loan (or proposed loan) to the company; or

(v)

arises merely because the director has a right of subrogation in relation to a guarantee or indemnity referred to in subparagraph (iv); or

(vi)

relates to a contract that insures, or would insure, the director against liabilities the director incurs as an officer of the company (but only if the contract does not make the company or a related body corporate the insurer); or

(vii)

relates to any payment by the company or a related body corporate in respect of an indemnity permitted under section 199A or any contract relating to such an indemnity; or

(viii)

is in a contract, or proposed contract, with, or for the benefit of, or on behalf of, a related body corporate and arises merely because the director is a director of the related body corporate …

Alternatively, disclosure is not required if “the company is a proprietary company and the other directors are aware of the nature and extent of the interest and its relation to the affairs of the company” 45 or if standing notice has been given under s 192, 46 or if all of the following conditions are satisfied: 47

45 46 47

(i)

the director has already given notice of the nature and extent of the interest and its relation to the affairs of the company under subsection (1);

(ii)

if a person who was not a director of the company at the time when the notice under subsection (1) was given is appointed as a director of the company – the notice is given to that person; or

(iii)

the nature or extent of the interest has not materially increased above that disclosed in the notice.

Under Corporations Act 2001 (Cth) s 191(2)(b). See Corporations Act 2001 (Cth) s 191(2)(d). Under Corporations Act 2001 (Cth) s 191(2)(c).

[4.240] 81

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Giving standing notice [4.250] Under s 192(1), a director of a company who has an interest in a matter may give the other directors standing notice at any time of the nature and extent of the director’s interest in that particular matter, even if the director’s interest at that time is not a material personal interest. Such a notice must be given to every director, and be given at either a directors’ meeting or be tabled at a meeting and given to each director individually, 48 and needs to set out details of the nature and extent of the interest: s 192(2). The notice also needs to be recorded in the meeting minutes: s 192(4). It will cease to have effect under certain circumstances. 49 However, it should be noted that s 193 expressly states that ss 191 and 192 do not affect any general law principle relating to conflicts of interest.

Voting where a conflict exists Public companies [4.270] A director of a public company who has a material personal interest in a matter that is being considered at a directors’ meeting must not be present while the matter is being considered at the meeting or vote on the matter: s 195(1). This only applies to interests that require disclosure under s 191, 50 and will not apply if s 195(2) applies or if the Australian Securities and Investments Commission (ASIC) allows the director to vote. Section 195(2) allows the director to be present and vote if directors who do not have a material personal interest in the matter have passed a resolution that: (a)

identifies the director, the nature and extent of the director’s interest in the matter and its relation to the affairs of the company; and

(b)

states that those directors are satisfied that the interest should not disqualify the director from voting or being present.

If the result of the operation of this rule is that there are insufficient directors to form a quorum for a directors’ meeting, any director may call a general meeting, which can pass a resolution to deal with the matter. Directors of public companies should also be aware of the provisions of Ch 2E of the Corporations Act 2001, which regulate the procedures necessary before the director (or a related party) can obtain a financial benefit from the company. The application of these provisions is more fully discussed in ASIC’s Regulatory Guide 76. 51

Proprietary companies [4.280] Under s 194, which is a Replaceable Rule, if a director of a proprietary company to which this Replaceable Rule applies, has a material personal interest 48 49 50 51

Corporations Act 2001 (Cth) s 192(3). For example, if the amount or nature of the interest changes: Corporations Act 2001 (Cth) s 192(6).

Corporations Act 2001 (Cth) s 195(1A)(b). Available at http://download.asic.gov.au/media/1239851/rg76-published-11-may-2011.pdf (accessed 12 May 2016).

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in a matter that relates to the affairs of the company and either the director discloses the nature and extent of the interest under s 191, or the interest is one that does not need to be disclosed under s 191: (c)

the director may vote on matters that relate to the interest; and

(d)

any transactions that relate to the interest may proceed; and

(e)

the director may retain benefits under the transaction even though the director has the interest; and

(f)

the company cannot avoid the transaction merely because of the existence of the interest.

Section 194 (or an equivalent provision in the company’s constitution) does not excuse a director from complying with other fiduciary and statutory duties. Even if a director has a material personal interest in a matter, the director is still obliged to exercise their power to attend meetings and vote, in the company’s best interests and for proper purposes (and pursuing a personal interest to the company’s detriment will always be an improper purpose).

Other provisions useful to directors [4.290] Section 189 allows a director to rely on information or professional or expert advice given or prepared by: (i)

an employee of the corporation whom the director believes on reasonable grounds to be reliable and competent in relation to the matters concerned; or

(ii)

a professional adviser or expert in relation to matters that the director believes on reasonable grounds to be within the person’s professional or expert competence; or

(iii)

another director or officer in relation to matters within the director’s or officer’s authority; or

(iv)

a committee of directors on which the director did not serve in relation to matters within the committee’s authority;

if the reliance was made in good faith; and after the director made an independent assessment of the information or advice, having regard to the director’s knowledge of the corporation and the complexity of the structure and operations of the corporation. This reliance will be deemed to be reasonable in any legal proceedings for breach of statutory duty or equivalent general duty, unless the contrary is proved. The effect of this provision is to shift the onus of proof away from the director, and onto the person alleging that the director’s reliance was unreasonable. Section 190(1) echoes the general law rule that a director who has delegated a power is responsible for the exercise of the power by the delegate as if the power had been exercised by the directors themselves. However, s 190(2) provides another safe harbour – ie such a director is not responsible if the director believed: (a)

on reasonable grounds at all times that the delegate would exercise the power in conformity with the duties imposed on directors of the company by this Act and the company’s constitution (if any); and [4.290] 83

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(b)

on reasonable grounds, in good faith, after making proper inquiry if the circumstances indicated the need for inquiry, that the delegate was reliable and competent in relation to the power delegated.

Breach of statutory duty [4.300] If a statutory duty is breached: • either the company or ASIC can apply to the court under s 1317E(1) for a declaration of contravention: s 1317J. Once a declaration has been obtained, it is conclusive evidence of the contravention (s 1317F) and the director may be liable for both a pecuniary penalty of up to $200,000 (s 1317G) and to pay compensation to any person who suffered loss as a result of the breach of duty: s 1317H. The officer can also be banned from managing companies in the future: s 206C;

• any person “affected” by the breach can apply to the court for an injunction to restrain the breach: s 1324; and

• if the director was reckless or dishonest in the breach of duty, criminal prosecution can follow: s 184.

If a court considers that a director acted honestly and ought fairly to be excused from liability, the court has this power under s 1318.

Case Study: James Hardie's directors [4.310] James Hardie Industries Ltd is well known for its building products, many of which contained asbestos, a harmful substance which causes illness and death to persons exposed to it. The directors of the James Hardie company group made an announcement about the extent of the company’s liability to potential plaintiffs who had suffered from asbestos exposure. Peter Macdonald was the managing director and CEO. The non-executive directors were Michael Brown, Michael Gillfillan, Meredith Hellicar, Martin Koffel, Geoffrey O’Brien, Gregory Terry and Peter Willcox. Peter Shafron was joint secretary and general counsel and Phillip Morley was its chief financial officer. At a board meeting in February 2001, the directors decided to vest the company’s shares in two subsidiary companies into a trust (to be created for this purpose), with $3 million, and to enter into legal arrangements necessary to set up a legal indemnity so that the trust, and only the trust, would be liable to plaintiffs in relation to asbestos claims. The board also approved an ASX announcement which would inform shareholders about the extent of the company’s asbestos liabilities. ASIC initiated legal proceedings against the directors and the company in February, claiming that the ASX announcement misled investors by stating that the trust was fully funded to meet present and future asbestos claims. ASIC also claimed the company should have immediately disclosed the indemnity to the ASX (but in fact, it delayed several months).

84 [4.300]

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The first decision: NSW Supreme Court (Gzell J) The NSW Supreme Court trial judge, Gzell J, found that ASIC had established contraventions of s 180(1) of the Corporations Act 2001. 52 The NSW Supreme Court adopted analysis by Brereton J in Australian Securities and Investments Commission v Maxwell, 53 namely that: • ss 180(1), 181 and 182 duties reflect, and to some extent refine, duties at general law – the content of which is essentially the same as statutory duty;

• in determining whether a director has exercised reasonable care and diligence, the circumstances of the particular corporation concerned are relevant to the content of the duty, including: – type of company, the provisions of its constitution, the size and nature of the company’s business, the composition of the board, the director’s position and responsibilities within the company, the particular function the director is performing, the experience or skills of the particular director, the terms on which he or she has undertaken to act as a director, the manner in which responsibility for the business of the company is distributed between its directors and its employees, and – the circumstances of the specific case;

– – – – – – – –

• directors are not required to show greater degree of skill in performing their duties than may be reasonably expected for persons of commensurate knowledge and experience, in the relevant circumstances: ASC v Gallagher; 54

• while directors are required to take reasonable steps to place themselves in a position to guide and monitor the management of the company, they are entitled to rely upon others, at least except where they know, or by the exercise of ordinary care should know, facts that would deny reliance;

• s 180(1) would be contravened if a director did not exercise a reasonable degree of care and diligence (in the exercise of his powers or the discharge of his duties), even if there was no actual damage, – if it was reasonably foreseeable that the conduct might harm the company – that is, the company itself, the shareholders, and, where the financial position of the company is precarious, the creditors of the company;

• when determining whether the duty had been breached, it was necessary to balance foreseeable risk of harm against potential benefits which could reasonably be expected to accrue to the company from conduct;

• “participating in conduct that carries with it a foreseeable risk of harm to the company’s interests will not necessarily mean breach of duty … however, … the management and direction of companies involve taking decisions and embarking upon actions which may promise much … but which are also … fraught with risk inherent in 52 53

54

Australian Securities and Investments Commission v Macdonald (No 11) [2009] NSWSC 287 and granted relief, including banning orders, in Australian Securities and Investments Commission v Macdonald (No 12) [2009] NSWSC 714. Australian Securities and Investments Commission v Maxwell (No 11) [2009] NSWSC 287. Australian Securities Commission v Gallagher (1993) 11 WAR 105; (1993) 10 ASCR 43; (1993) 11 ACLC 286. [4.310] 85

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the life of industry and commerce. … Legislature did not intend to dampen business enterprise and penalise legitimate but unsuccessful entrepreneurial activity…”; 55

• the court will “ask what an ordinary person, with knowledge and experience of the defendant might be expected to have done in circumstances if s/he was acting on their own behalf…”; 56

• “corporation’s circumstances” in s 180(1)(a) will include the competence of a company’s management and advisers and the distribution of responsibilities within the company, including as between the directors and as between the directors and officers;

• a director or officer’s “responsibilities within the corporation” in s 180(1)(b) include not only matters of specific delegation but also the manner in which work is distributed in fact within the corporation and the expectations placed by those arrangements on the shoulders of the individual director or officer including arrangements flowing from the experience and skills that the director brings to his or her office and any arrangements within the board, or between the director and executive management affecting the work that the director would be expected to carry out;

• the “same responsibilities” in s 180(1)(b) requires a consideration of the work in fact undertaken by the relevant director or officer and of the whole of the position occupied. If the person has dual roles as, for example, a director and chief executive, both roles are to be taken into account.

The court declared that all directors had breached their s 180(1) duty to exercise reasonable care and diligence and in addition, Peter Macdonald, the executive director, had breached his s 181(1) duty to act in the company’s best interests. The appeal: NSW Court of Appeal All of the directors, except executive director Peter Macdonald, appealed to the New South Wales Court of Appeal, who allowed the appeals of the non-executive directors and cancelled the declarations of contravention against their names. However, the court only partially allowed the appeal by Peter Shafron (joint secretary and legal counsel) and denied the appeal by Phillip Morley (CFO). The court found that there was insufficient evidence of the communication between board members and the draft press release. The court was not convinced that the non-executive directors actually approved the draft ASX announcement. It was not convinced about the reliability of the minutes of the meeting, or that the draft announcement had been discussed and approved. It was also critical of ASIC’s decision to not call crucial witnesses, considering that this undermined the cogency of its case and perhaps ASIC had not acted fairly in this high-profile case. However, the court approved the reasoning in the lower court’s decision, stating that if it had been proven that the draft announcement was approved at the board meeting, the non-executive directors would have breached their duties to act with care and diligence under s 180(1) of the Corporations Act 2001 (Cth). This would apply to both directors who were physically present at the meeting, and those who attended via teleconference. 55

56

Australian Securities and Investments Commission v Macdonald (No 11) [2009] NSWSC 287 at [236]. Australian Securities and Investments Commission v Macdonald (No 11) [2009] NSWSC 287 at [239].

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Shafron was held to be an officer of the company, and responsible for advising the board about the need to disclose the indemnity to the ASX and accordingly, the court found that he had breached his duty under s 180(1) in this regard, and also by failing to advise the board that the best estimate contained in a report and an estimate supporting the trust had not taken into account superimposed inflation and that a prudent estimate would have done this. Morley was also held to be an officer of the company because as CFO he participated in its decisions for the purposes of s 180(1). Although Morley inaccurately conveyed the impression that unlimited reviews of the cash flow model were being conducted when only limited reviews were actually being conducted, this did not amount to a breach of the s 180(1) duty. The court found that he did not know, and neither should he have known, that superimposed inflation had not been taken into account but should have been. The court thus found that he did not breach his duties under s 180(1). The further appeal: The High Court of Australia ASIC appealed to the High Court and won, the High Court reversed the Court of Appeal’s conclusion that the non-executive directors had not breached their duties of care and diligence, and upheld the Court of Appeal’s decision relating to Mr Shafron. The High Court concluded that the minutes, although not recorded within one month, were nonetheless evidence that the directors had approved the announcement. The directors did not contest that the announcement was misleading. Taken together, this meant that the High Court referred back to Gzell J’s conclusions that the non-executive directors had breached their duties in approving the announcement in such circumstances. 57

Case Study: Fortescue Metals [4.315] In late 2004, Fortescue Metals Group Ltd announced it had entered into binding agreements with Chinese enterprises to build, transfer and fund construction work for a large Pilbara mining project. Although the agreements stated that they were binding, they were light on detail and clearly contemplated further more detailed agreements to be negotiated. After reviewing a copy of one contract, ASIC commenced proceedings against the group for misleading conduct, alleging that the announcement was misleading as the agreements were not in fact binding. ASIC also proceeded against the company’s CEO Andrew Forrest, alleging that he had been involved in Fortescue’s breach, and, in allowing the company to breach the law, had also breached his own duty to the company to exercise reasonable care. The trial judge considered the announcements as statements of opinion made with a reasonable basis, and therefore held that the announcements had not been misleading. 57

Australian Securities and Investments Commission v Hellicar [2012] HCA 17; Shafron v Australian Securities and Investments Commission [2012] HCA 18. [4.315] 87

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On appeal, the Full Federal Court found that the agreements were not actually legally enforceable, and thus the announcement constituted misleading conduct. Furthermore, by failing to correct the announcement, Fortescue breached its obligations of continuous disclosure to the market, and that consequently, by allowing the company to do so, Mr Forrest had breached his duty of care and diligence. On a further appeal, the High Court found that the announcement was not misleading or deceptive, and thus there had been no breach of duty by Mr Forrest. 58 Since this case, the ASX and ASIC have rewritten their guidance on continuous disclosure, providing more detailed information and guidance to companies. 59

DERIVATIVE ACTIONS [4.320] Directors owe their fiduciary duties and statutory duties to the company. Accordingly, the company is normally the only person entitled to commence private legal proceedings against the director for any breach of duty (although of course ASIC now also has the power to commence civil penalty proceedings or criminal proceedings). Investors in a company do not normally have the right to personally pursue a director for breach of duty to the company, even if the director’s conduct has caused the investor loss – eg as a result of a decline in the value of the investor’s shareholding. However, ss 236 – 239 do allow a member of a company, under certain limited circumstances, to bring an action on behalf of a company (that is, where the member is the person initiating litigation on behalf of the company, in the name of the company). This is known as a “derivative action” because the member’s right to bring the action derives from the company’s personal right to bring the action – in other words, the member is really exercising the company’s right, on behalf of the company, for the benefit of the company. Derivative actions are discussed in more detail in Chapter 2, but are mentioned here because one of the circumstances in which a court may allow a member to bring an action on behalf of the company is where the company is controlled by the very persons who are alleged to have breached their duties to the company (which means that the company would be unlikely to commence legal proceedings against those directors). Thus a member bringing an action on behalf of the company against the company for breach of directors’ duties, would be a common type of derivative action permitted by the courts.

58 59

Forrest v Australian Securities and Investments Commission [2012] HCA 39. See the 78-page ASX Guidance Note 8, available at http://www.asx.com.au/documents/about/ guidance-note-8-clean-copy.pdf (accessed 10 May 2016) and note also ASIC’s Regulatory Guide 198 in relation to the continuous disclosure obligations of unlisted disclosing entities.

88 [4.320]

CHAPTER 5 Corporate Insolvency [5.10]

Introduction ................................................................................................. 90 [5.20] Key points ........................................................................................................ 91 [5.30] Key terms ......................................................................................................... 91

[5.50]

Solvency ....................................................................................................... 92 [5.50] Definition in s 95A .......................................................................................... 92 [5.60] Presumption of insolvency ............................................................................ 92 [5.80] Statutory demands .......................................................................................... 93 [5.80] When a statutory demand can be served ...................................... 93 [5.90] Formalities ........................................................................................... 93 [5.100] When a company can apply to the court to set aside the demand ............................................................................... 94

[5.110]

Voluntary administration .......................................................................... 95 [5.130] Significance of placing a company into administration ........................ 95 [5.130] Sign of insolvency .............................................................................. 95 [5.140] Protecting directors from liability ................................................... 95 [5.160] Effect of a company being under administration ................................... 96 [5.160] No share transfers .............................................................................. 96 [5.170] Protection of company property ..................................................... 96 [5.180] Powers of an administrator ......................................................................... 96 [5.190] Duties of an administrator .......................................................................... 97 [5.200] Liability of an administrator ....................................................................... 98 [5.210] Process of the administration: first creditors’ meeting .......................... 99 [5.220] Process of the administration: second creditors’ meeting ..................... 99 [5.230] Process: deed of company arrangement ................................................. 100 [5.240] Process: resolution to enter liquidation .................................................. 101 [5.260] Process: court involvement ....................................................................... 101 [5.260] Technical breaches ............................................................................ 101 [5.270] Other court orders ........................................................................... 101 [5.280] Court supervision of the administration ..................................... 101 [5.290] Termination of a deed of company arrangement ...................... 102

[5.300]

Liquidation ................................................................................................ 102 [5.310] Who can apply to wind up a company? ................................................ 102 [5.320] The process of applying to wind up a company .................................. 103 [5.330] The court hearing ........................................................................................ 103 [5.340] Winding up: the appointment of a liquidator ....................................... 104 [5.360] Powers and duties of a liquidator ........................................................... 105 [5.360] Powers ................................................................................................ 105 [5.370] Duties ................................................................................................. 106 [5.380] Court involvement ........................................................................... 107 89

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[5.400] During a winding up ................................................................................. 107 [5.400] Name of company ........................................................................... 107 [5.410] Suspension of directors’ powers and functions ......................... 107 [5.420] Suspension of litigation and enforcement of judgment debts ................................................................................. 107 [5.430] Company property .......................................................................... 108 [5.440] Transfers of company property ..................................................... 108 [5.450] Examinations ..................................................................................... 108 [5.460] Court powers in relation to company officers ....................................... 109 [5.470] Investors’ liability in a winding up ......................................................... 109

[5.480]

Voidable transactions ............................................................................... 110 [5.490] Definitions ..................................................................................................... 111 [5.500] Insolvent transactions ................................................................................. 112 [5.510] Unreasonable director-related transactions ................................. 112 [5.520] Unfair loan ......................................................................................... 113 [5.530] Defences ........................................................................................................ 113

[5.550]

Insolvent trading....................................................................................... 114 [5.550] [5.560] [5.570]

[5.600]

Liability of directors ................................................................................... 114 Defences applicable to directors ............................................................... 114 Liability of a holding company ................................................................ 115

Creditors’ claims ....................................................................................... 115 [5.600] Types of debts .............................................................................................. 115 [5.600] Provable debts ................................................................................... 115 [5.610] Unprovable debts ............................................................................. 115 [5.620] Calculating the debt .................................................................................... 116 [5.630] Secured creditors ......................................................................................... 116 [5.650] Priorities ........................................................................................................ 117 [5.650] The general rule of pari passu ....................................................... 117 [5.660] Exceptions to pari passu ................................................................. 117 [5.670] Claims by employees ....................................................................... 117 [5.680] Claims by members ......................................................................... 118

[5.700]

Deregistration ............................................................................................ 120 [5.700] [5.710] [5.720]

Release of liquidator ................................................................................... 120 Deregistration .............................................................................................. 120 Reinstatement of registration .................................................................... 121

INTRODUCTION [5.10] This chapter discusses the consequences when a company suffers financial difficulties. For an investor, the effects of such an event can be enormous. As well as suffering loss in the value of their investment due to shares in the company becoming worthless as it becomes obvious that the company has no prospect of emerging from its difficulties and producing future profits, an investor who holds partly-paid shares in the company may become liable to contribute towards the company’s debts. 90 [5.10]

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There are other, less obvious consequences. For example, any person doing business with any company needs to be aware of the implications of an insolvency on their ability to recover debt owed by the company. Likewise, any person doing business with any company needs to be aware of the potential for transactions with that company to become voidable at the liquidator’s option if that company enters into liquidation even ten years after the transaction occurred. Therefore, it is most important that anyone doing business with a company is aware of the ways in which that transaction may be protected in the event of a company insolvency. A person investing in particularly small companies may also have accepted a directorship as a consequence of the investment, or may control a company through ownership of a holding company. Thus, directors’ and holding companies’ personal liability for the debts of a company may also become relevant to the investor. Finally, it is important to note that winding up and the consequent deregistration of a company represent the end of a company’s existence as a separate legal entity. After deregistration, the company cannot issue shares, enter into contracts, incur liability, or sue or be sued. It is therefore important that members and creditors of a company under administration or winding up act in a timely manner to ensure that they are not deprived of legal rights through failure to act and the elapsing of time.

Key points [5.20] This chapter will provide a greater understanding of: • the concept of “insolvency” and when a company is (or is deemed to be) insolvent; • the process of claiming payment of a debt by means of a statutory demand; • the effect and consequences of a company entering voluntary administration; • the effect and consequences of a company entering into liquidation; • the circumstances which cause directors’ and holding companies’ liability for insolvent trading;

• the types of transactions that can be voidable in a liquidation; and • the consequences of deregistration of a company.

Key terms [5.30] The key terms in this chapter are: • Solvency • Insolvency • Liquidation • Liquidator • Administration • Administrator • Voidable transactions [5.30] 91

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SOLVENCY Definition in s 95A [5.50] A company is solvent if it is able to pay all debts as and when they become due and payable: Corporations Act 2001 (Cth) s 95A(1). A company who cannot do this is insolvent: s 95A(2). Contingent or prospective liabilities are also relevant when determining whether a company is insolvent: s 459D(1). The test is the cash flow test, but the company’s situation must be considered in its entirety as a temporary lack of liquidity does not necessarily mean that a company is insolvent. 1 The relevant principles applied to the question of whether a company is solvent are as follows: • The solvency of a company is a question of fact to be ascertained from a consideration of its financial position taken as a whole.

• In considering the amount of resources available to the company to meet its liabilities, the court must have regard to commercial realities, including whether non-cash resources are realisable by sale or borrowing upon security and, if so, when.

• The court must attempt to distinguish between surmountable temporary illiquidity and insurmountable endemic illiquidity resulting in insolvency. In deciding which describes a company’s finances, the court can consider the commercial reality that, in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade.

• The commercial reality that creditors will normally allow some latitude in time for payment does not, in itself, warrant a conclusion that the debts are not payable at the times contractually stipulated and have become debts payable only upon demand.

• The court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the court’s satisfaction, that there has been an express or implied agreement for an extension of the time for payment, or the course of conduct between the company and the creditor gives rise to an estoppel, preventing the creditor from relying upon the stipulated time for payment, or there has been a well-established and recognised course of conduct in the industry or between the company and its creditors whereby debts are payable at a time other than that stipulated, or are payable only on demand. The burden of proof lies on the person asserting that the stipulated time does not apply to the company. 2

Presumption of insolvency [5.60] Unless the contrary is proven by evidence, 3 a court must presume that a company is insolvent for the purposes of an application to wind up the company if any of the following events occurred in the three months before an application is made (s 459C): 1

2 3

Sandell v Porter (1966) 115 CLR 666.

Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation (2001) 53 NSWLR 213; 19 ACLC 1513. This presumption may be rebutted or disproved by evidence that the company is solvent: Corporations Act 2001 (Cth) s 459C(3).

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• the company has failed 4 to comply with a statutory demand for payment; • the company has failed, wholly or partially, to satisfy a judgment debt; • a receiver has been appointed over company property, or an order was made for the appointment of a receiver under a floating charge or a person has taken possession or control of company property as a result of enforcing a floating charge; or

• a person was appointed to enter into possession or assume control of property of the company.

A court must also presume insolvency under s 588E of the Corporations Act 2001 (unless there is evidence to the contrary (s 588E(9)) if: • the company is being wound up and it is proved (or because of s 588E(4) or (8) it is presumed) that the company is insolvent at a particular time during the 12 months ending on the relation-back day: s 588E(3); or

• the company has failed to keep financial records as required by s 286: s 588E(4); or • a matter of a specified kind has been established in another recovery proceeding in relation to the company: s 588E(8).

Statutory demands When a statutory demand can be served [5.80] A creditor of a company can serve a statutory demand on the company in relation to any overdue debt of at least $2,000: s 459E. 5 The demand can also be served by an assignee of the debt: s 459E(4). Formalities do apply, and the debt can be set aside by a court if it does not exactly conform to those formalities or is improperly served on the company. Some recipients of a statutory demand claim that they never received it – perhaps due to post redirection problems, postal or postbox theft or even the recent and unknown change of address of their accountant or lawyer. The creditor will not be able to enforce a statutory demand unless proper service can be proven, so it is important for a person serving a demand to keep accurate and immediate records of service, and to reattempt service at alternative addresses (eg directors’ addresses) if, for example, the company’s address appears to be wrong or no one is present during normal business hours.

Formalities [5.90] The relevant form is Form 509H (located in Sch 2 of the Corporations Regulations 2001 (Cth)), and the demand must specify specific details relating to the debt and the company to whom it is addressed. It must demand that the company pay the debt(s) (or to secure payment for that amount to the creditor’s reasonable satisfaction) within 21 days after the demand is served on the company: s 459E(2)(c). It must also be signed by or on behalf of the creditor: s 459E(2)(d) and (e). If the debt is not a judgment debt (that is, resulting from a 4

5

Defined in Corporations Act 2001 (Cth) s 459F.

$2,000 was the statutory minimum as at April 2016. [5.90] 93

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court affidavit), it must also be accompanied by an affidavit, dated before the demand, which verifies the debt: s 459E(3). 6 It is important that the affidavit not only states the amount of the debt, but why the person giving the affidavit (the “deponent”) believes that the debt is due and payable and not in genuine dispute – and the deponent needs reasonable grounds for this belief.

When a company can apply to the court to set aside the demand [5.100] If a genuine dispute exists about the existence of the debt specified in a statutory demand served on a company, the company can apply to the court for an order setting aside a statutory demand: ss 459G(1) and 459H (eg date for payment; offsetting claim). If the company is successful, the court may order the company’s costs to be paid: s 459N. Creditors who attempt to use the statutory demand procedure when there is a genuine dispute, risk a court order to pay increased costs if the statutory demand was inappropriate due to the existence of a genuine dispute. An example of a this occurred in the case of Rite Flow Pty Ltd v Nahas Constructions (NSW) Pty Limited [2012] NSWSC 553, where the court found that a genuine dispute about the debt existed. In this case, the purported “debt” was claimed to result from contractual clauses making the subcontractor liable for defective building works. The subcontractor adduced evidence that indicated that they had not been responsible for the defect; and other evidence proving that the claimed remedial work had not been performed. These two factors were sufficient for the court to conclude that the demand related to a claim for liquidated damages, not a genuinely-existing debt, and as such, was not suitable for the statutory demand procedure under the Corporations Act 2001 (Cth). A court can also set aside the demand if there is a genuine defect in the demand which would cause substantial injustice unless the demand is set aside: s 459J(1). But a “mere defect”, without injustice, will not provide a valid ground for the demand to be set aside: s 459J(2). For example, defects that would have caused injustice in Khadine Pty Ltd v Giant Bicycle Co Pty Ltd 7 were that the amount demanded was very inaccurate and included excessive interest (without setting out the basis for the calculation of interest) and did not credit partial payments already made by the company. One example of a such a defect, which rendered a demand invalid, was an obscured postcode in a posted demand in Deputy Commissioner of Taxation v ABW Design and Construction Pty Ltd [2012] FCA 346. In that case, given that actual receipt of the demand was denied, the fact that the postcode was obscured on the actual posted letter was a sufficient defect to render the demand invalid. However, use of an outdated form, which still included all of the necessary elements required by the Corporations Act 2001 but referred to legislation superseded by the Act, has been held to substantially comply with the legislative 6 7

If an affidavit is required and not attached, the demand is ineffective: Technology Licensing Ltd v Climit Pty Ltd [2002] 1 Qd R 566; (2001) 19 ACLC 808. Khadine Pty Ltd v Giant Bicycle Co Pty Ltd (1995) 16 ACSR 421.

94 [5.100]

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requirements and did not cause injustice. 8 A demand that is in a foreign currency does not necessarily cause injustice; 9 but it can do so if there is no obvious mechanism for the calculation of the appropriate exchange rate. 10 If a company has unsuccessfully applied to the court to have a statutory demand set aside, it cannot later oppose a winding up on the same grounds unless the court allows: s 459S.

VOLUNTARY ADMINISTRATION [5.110] When a company is in voluntary administration, it is said to be “under administration”. It is controlled by a person known as the “voluntary administrator” or “administrator”. The administrator is normally appointed by the directors by board resolution, 11 but can only be appointed if the directors consider that the company is insolvent or likely to become insolvent in the future. 12 If the company was previously in liquidation, the liquidator can also place a company into administration. (A liquidator can also become the administrator if the court allows or if the company’s creditors pass a resolution approving the appointment: s 436B(2) or, if a secured party who is entitled to enforce a perfected security interest in all or substantially all of the company’s property, appoints an administrator under s 436C).

Significance of placing a company into administration Sign of insolvency [5.130] The fact that the directors of a company have placed the company into voluntary administration is a signal to investors who have shares in the company, and to every person dealing with the company (eg entering into contracts with the company), as well as to the company’s creditors, that the company is in serious financial difficulty and that the directors suspect that the company is, or may become, insolvent.

Protecting directors from liability [5.140] The main reason directors place a company into voluntary administration is that they are very concerned about their own personal liability for the company’s debts under s 588G of the Corporations Act 2001 if they allow the company to continue to incur debts when it may be insolvent.

8

9 10 11 12

Quitstar Pty Ltd v Cooline Pacific Pty Ltd (2003) 22 ACLC 15.

Vehicle Wash Systems Pty Ltd v Mark VII Equipment Inc (1997) 80 FCR 571; 16 ACLC 223. Jtec Pty Ltd v Industrial Development Agency (Ireland) [2003] NSWSC 10. Corporations Act 2001 (Cth) s 436A. Shirlaw v Graham [2001] NSWSC 612.

[5.140] 95

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Effect of a company being under administration No share transfers [5.160] Most importantly for the investor, any share transfer during the period the company is “under administration” will be void unless the court orders otherwise. Thus, once administration occurs, the investor is unable at law to divest the investor’s shares in the company unless the administrator unconditionally consents (and can only do this if the administrator is satisfied that the transfer is in the best interests of the company’s creditors as a whole) or if a court order is obtained: s 437F. This also affects other alterations in the status of members – for example, the conversion of equity securities to debt securities would not be permitted.

Protection of company property [5.170] The company’s property is protected during the administration: ss 440A – 440J. For example, property that is used, occupied or possessed by the company during administration cannot be seized or claimed by the owner, unless a court order is obtained or the administrator consents: s 440C. Further, existing court proceedings (including the enforcement of judgment debts) 13 are suspended and new proceedings cannot be commenced: s 440C(1). Such debts cannot be recovered under directors’ guarantees of the company’s debts unless the court allows: s 440J. However, an exemption now exists for property subject to a security interest held by an ADI (authorised deposit-taking institution) or the operator of a clearing and settlement facility: s 440JA. While the company is in administration, it cannot be voluntarily wound up by its members, 14 nor placed in provisional liquidation: s 440A(3). A chargee cannot enforce 15 a charge against the company unless it covers perishable property, 16 or the administrator consents, or the court so orders, 17 or if the charge covers all or substantially all of the company’s assets and enforcement occurs within the first ten days of the administration: s 441A.

Powers of an administrator [5.180] In effect, the administrator takes control of the company’s affairs and is deemed to be an agent of the company: ss 437A and 437B. The administrator’s powers include the power to: • take control of the company’s business, property and affairs; • require any person to deliver the company’s books to the administrator: s 438C; • carry on the business and manage the property and its affairs; 13

14 15 16 17

Corporations Act 2001 (Cth) ss 440G(2) and 440F.

Corporations Act 2001 (Cth) s 440A; but see the exceptions in s 446. Corporations Act 2001 (Cth) s 441B(1) defines “enforcement”. Corporations Act 2001 (Cth) s 441C. Corporations Act 2001 (Cth) s 440B.

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• terminate or dispose of all or part of the business, and dispose of any of the property; • perform any function, and exercise any power, that the company or any of its officers could perform or exercise if the company were not under administration;

• remove and appoint directors; • execute documents, conduct litigation, or do anything in the company’s name and on its behalf; and

• do anything else necessary for the purposes of the administration. 18 While a company is under administration, the directors’ powers are suspended and the directors are specifically prohibited from performing or exercising their functions and powers without the administrator’s consent: s 437C(1). Likewise, only the administrator can deal with the company’s property and so any transaction or dealing affecting the company’s property is void unless entered into by the administrator or with the administrator’s written consent or the consent of the court: s 437D. However, an administrator is not allowed to dispose of company property which is encumbered by a charge or is owned or leased by another person, 19 unless this is in the ordinary course of the company’s business or with the consent of the chargee, owner, lessor, or the court: s 442C(2). The court will only allow this if arrangements have been made to adequately protect the interests of the chargee, owner or lessor: s 442C(3). The administrator receives remuneration from the company, 20 and payment of this remuneration (as well as an indemnity for liabilities properly incurred by the administrator as a consequence of the administration) 21 takes priority over claims by all other unsecured creditors: s 443E(1)(a).

Duties of an administrator [5.190] The administrator is obliged to investigate the company’s business, property, affairs and financial circumstances and form an opinion about whether it would be in the creditors’ interests for the company to execute a deed of company arrangement, or for the administration to end, or for the company to be wound up (ie enter into liquidation): s 438A. Directors are obliged to assist the administrator by delivering company books (or telling the administrator where to find them), 22 giving a written statement about the company’s business, property, affairs and financial circumstances, normally within five days after the start of the administration (s 438B(2)), and 18 19 20

Corporations Act 2001 (Cth) ss 437A and 442A. The administrator also has other powers under ss 437A(1) and 442A. Corporations Act 2001 (Cth) s 442C(1). Corporations Act 2001 (Cth) s 449E.

22

Corporations Act 2001 (Cth) s 438B(1).

21

In Cresvale Far East Ltd (in liq) v Cresvale Securities Ltd [No 2] (2001) 39 ACSR 622, the indemnity was refused by a court because the administrator had not acted properly and reasonably.

[5.190] 97

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giving such further information as the administrator may require: s 438B(3). Failure to do so is a criminal offence, unless the director has a “reasonable excuse”: s 438B(4) and (6). The administrator receives various claims from creditors and determines the amount owed to each, 23 and can reject claims the administrator reasonably considers not to be valid. 24 The administrator must also report to the Australian Securities and Investments Commission (ASIC) in relation to any offence the administrator considers may have been committed by any past or present officer or member, or any person who took part in the formation, promotion, administration, management or winding up of the company, including any offence relating to misapplication or wrongful retention of company money or property, and any negligence, breach of duty, default or breach of trust relating to the company: s 438D(1). The administrator must also pay the Commissioner of Taxation each amount payable under a remittance provision because of deductions made by the administrator, 25 even if the amount becomes payable after the administration: s 443BA(1). The administrator must also call and preside over various creditors’ meetings (discussed below), which decide the fate of the company.

Liability of an administrator [5.200] The administrator will be liable for any debts for services rendered to the company or goods bought on behalf of the company or property hired, leased, used or occupied by the company, and repayment of money borrowed, together with interest and borrowing costs: s 443A(1). However, the administrator retains any rights he or she has to sue the company or any other person in relation to these debts, and so could claim indemnity from the company – if the company has sufficient assets to fund this expense: s 443A(2). If the company uses or occupies property prior to the administration, the administrator becomes responsible for the company’s liability for the use or occupation (eg rent), except for any amount attributable to the first five days of the administration: s 443B(2). This allows the administrator time to terminate such agreements within five days after the commencement of the administration and thus avoid personal liability, 26 although termination will not affect the company’s liability: s 443B(4). The administrator will not be liable if a chargee or receiver takes possession or control of the premises: s 443B(7). The company must indemnify an administrator for company debts for which the administrator becomes liable, together with the administrator’s liabilities under remittance provisions, and the administrator’s remuneration. This right of 23 24 25

26

Vincent, White & Associates Pty Ltd v Vouris (1998) 16 ACLC 974. Selim v McGrath (2003) 177 FLR 85. Corporations Act 2001 (Cth) s 443BA. Corporations Act 2001 (Cth) s 443B(3).

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indemnity generally has priority over all of the unsecured debts of the company, 27 and may have priority over debts secured by a floating charge over company property: s 443E(1)(b) and (2) – (4). Priority of company debts is governed by s 556 and is discussed below.

Process of the administration: first creditors' meeting [5.210] Within five business days of being appointed, the administrator calls and convenes a meeting of the company’s creditors. The aim of this meeting is to determine whether to appoint a committee of creditors: s 436E(1). Accordingly, the administrator publishes a notice of the meeting in a newspaper with a circulation in the State or Territory where the company has its registered office or carries on its business: s 436E(3). Only creditors and their agents can be members of the committee: s 436G. The committee consults with the administrator, 28 and the administrator reports to the committee about matters relating to the administration, as requested by the committee: s 436F(3). The committee cannot normally give directions to the administrator except in limited circumstances: s 436F(2).

Process of the administration: second creditors' meeting [5.220] A second meeting must be called after the “convening period”, which is generally the first 21 days of administration, although there is some scope to lengthen this period over Christmas or Easter, or if the court makes an order extending the period: s 439A(1). A good reason is required for such an order: s 439A(6). 29 The administrator must convene a second meeting of the company’s creditors within five business days of the convening period: s 439A(2). Creditors are notified of the meeting by advertisements, which must appear at least five business days before the meeting in specified newspapers: s 439A(3)(a) and (b). A creditor may also expect individual notice if they appear in the company’s books as a creditor. 30 When convening the meeting, the administrator must report on the company’s business, property, affairs and financial circumstances, whether the administrator considers it would be in the creditors’ interests to execute a deed of company arrangement, or for the administration to end and the company to be placed into liquidation. Reasons must be given and if a deed is proposed, a detailed summary of its contents must be attached: s 439A(4). The administrator 27

28 29

30

Corporations Act 2001 (Cth) s 443E(1)(a).

Corporations Act 2001 (Cth) s 436F(1). For example, a court might make the order if this would improve the return to creditors, or if the company’s affairs are too complex for the administrators to be able to prepare the necessary reports within the convening period. An example of this would be the Ansett administration. For judicial discussion of the various extensions granted and refused in the Ansett administration, see Mentha v Sydney Airports Corporation (2002) 120 FCR 310; [2002] FCA 530. Corporations Regulations 2001 (Cth) reg 5.6.11(2).

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attends and presides at the meeting, 31 which can, if necessary, be adjourned for up to 45 business days: s 439B(2). At the meeting, creditors decide whether to wind up the company, end the administration, or to execute the deed of company arrangement: s 439C.

Process: deed of company arrangement [5.230] If the creditors resolve that the company should execute a deed of company arrangement, the administrator of the company becomes the administrator of the deed, unless the creditors pass a resolution appointing another person: s 444A. The administrator of the deed prepares the deed itself, which sets out (s 444A(4)): • the name of the administrator of the deed; • the company property available to pay creditors’ claims; • the nature and duration of any moratorium period for which the deed provides; • to what extent the company is released from its debts; • any conditions that apply before the deed takes effect and the circumstances in which it terminates;

• the order in which company property will be distributed among creditors; and • the date after which no further claims will be admitted under the deed. The deed is then executed by the company and the administrator: s 444B. The deed binds all members, creditors, 32 the administrator and the company, 33 even before it is executed, 34 until the deed terminates according to its terms: s 444E(2). Thus, a creditor who is bound to the deed cannot separately commence legal proceedings or enforce a debt against the company unless a court allows: s 444E(3). The court can also restrain a secured creditor from dealing with company property that is security for a secured debt owed to the creditor if the court considers that this might adversely affect the purposes of the deed and the creditors’ interests will be adequately protected: s 444F(3). The deed of company arrangement releases the company from a debt only insofar as the deed provides for the release: s 444H. The deed can be varied by a resolution passed at a creditors’ meeting. If such a resolution is passed, a creditor can apply to the court for an order cancelling the variation: s 445B(1). The court has wide powers to vary, cancel or confirm the variation: s 445B(2). Creditors can also pass a resolution terminating the deed, and can instead resolve to put the company into liquidation: s 445E. For creditors to vary or terminate a deed, a meeting is required. Such a meeting can be convened by the administrator at any time, but must be convened by the administrator if required 31 32 33

34

Corporations Act 2001 (Cth) s 439B(1). Corporations Act 2001 (Cth) s 444D. Corporations Act 2001 (Cth) s 444G. Corporations Act 2001 (Cth) s 444C.

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by creditors who are owed 10% or more of the company’s debts: s 445F. The administrator must give written notice of the meeting to as many of the company’s creditors as is reasonably practicable, and advertise the meeting in specified newspapers at least five business days before the meeting: s 445F(2). The administrator presides at the meeting, which can be adjourned if required: s 445F(5). The termination of a deed of company arrangement does not affect acts already done under the deed: s 445H.

Process: resolution to enter liquidation [5.240] The administrator of a company, or of a deed of company arrangement, becomes the liquidator 35 if the creditors pass a resolution that the company be wound up or the company contravenes s 444B(2). The effect of this is that the company is deemed to have passed a special resolution that it be wound up voluntarily. 36 If this occurs, the liquidator must notify ASIC within five days and creditors (by advertisements in specified newspapers) within 15 days: s 446(5).

Process: court involvement Technical breaches [5.260] The court can excuse technical breaches of the above legislative provisions if satisfied that substantial compliance was achieved and that injustice will not result: s 445G(3). Other breaches may result in criminal or civil prosecution.

Other court orders [5.270] The company, any creditor, the administrator, ASIC and any other interested person all have the right, during an administration, to apply to the court for an order governing the administration or any part of it: s 447A(4). The court has the power to make any order it considers appropriate, 37 including conditional orders: s 447A(3). Such orders can be used to clarify doubt about the validity or legality of a proceeding, solve a vacancy left by a deceased administrator, 38 or be used by the administrator as authority (or directions) about any matter arising in connection with the administration of the company or a deed of company arrangement: s 447D(2).

Court supervision of the administration [5.280] The court can also supervise an administration if it considers that the administrator’s administration is or may be prejudicial to the interests of some or all of the company’s creditors or members: s 447C(1). 35 36 37

38

Corporations Act 2001 (Cth) s 446A. See Corporations Act 2001 (Cth) s 491. The company is also deemed to have lodged a declaration under s 494. It is also deemed to have complied with s 497 in relation to the winding up: s 446(3). Corporations Act 2001 (Cth) s 447A(1). Corporations Act 2001 (Cth) s 447C(2).

[5.280] 101

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Termination of a deed of company arrangement [5.290] A court can also terminate a deed of company arrangement if it considers that one of the following applies (s 445D): • information about the company’s business, property, affairs or financial circumstances that was false or misleading and would have been reasonably material to creditors when deciding whether to approve execution of the deed, was given to the administrator or to creditors; or

• there was an omission from a report or statement to the administrator or creditors and the omission can reasonably be expected to have been material to such creditors in so deciding; or

• there has been a material contravention of the deed by a person bound by the deed; or • effect cannot be given to the deed without injustice or undue delay; or • the deed (or part of it, or any actual or proposed act or omission under it) is or would be oppressive or unfairly prejudicial to, or unfairly discriminatory against, one or more creditors or would be contrary to the interests of the company’s creditors as a whole; or

• the court considers that the deed should be terminated for some other reason.

LIQUIDATION [5.300] “Liquidation” is the process of ending a company’s life, ie of “winding up” the company. The person who takes control of a liquidation is known as a “liquidator”. There are many paths to liquidation. As discussed above, creditors in a company administration can resolve to place the company into liquidation. Members can also resolve to voluntarily wind up the company, and a court can order the company to be wound up, if the company is insolvent, 39 or if any of the following apply (s 461): • the company passes a special resolution resolving that it be wound up by the court; • the company did not commence business within one year of incorporation or it has suspended its business or has no members;

• the directors have acted in their own interests or been unfair to other members; • there has been oppressive or discriminatory conduct; • ASIC considers the company should be wound up because it cannot pay its debts or because it is in the public interest or the interest of creditors that the company be wound up; or

• the court considers that it is just and equitable that the company be wound up.

Who can apply to wind up a company? [5.310] The following people can apply to wind up a company either on the ground of insolvency or on any of the other grounds listed above (s 459P): • the company itself; • any creditor, whether actual, contingent or prospective; 39

Corporations Act 2001 (Cth) s 459A or s 459B.

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• any liquidator or provisional liquidator of the company; • ASIC or the Australian Prudential Regulation Authority (APRA); and • any member of the company. Unless the application is made by an actual creditor, 40 the company or a liquidator or provisional liquidator, the court also needs to be satisfied that, on the evidence, there is a prima facie case that the company is insolvent: s 459P(2) and (3).

The process of applying to wind up a company [5.320] When a person applies to the court for the winding up of the company, they must also notify ASIC of the application, 41 serve a copy of the notice on the company within 14 days, 42 and place newspaper advertisements advising of the application: s 465A(c). Once one creditor has applied to wind up the company, another creditor cannot take over the proceedings unless the court considers that there is prejudice, delay or some other good reason: s 465B(1). The applicant must bear the costs of the proceedings until a liquidator is appointed, but these costs can be reimbursed from company funds unless a court orders otherwise: s 466. Any person (including the company or an investor in the company) is entitled to oppose the application, but they must file a notice with the court (and serve it on the person applying for the winding up) with an affidavit, setting out reasonable grounds for the opposition: s 465C. After an application has been made, a provisional liquidator can be appointed to take control of the company until the court hearing: s 472(2). The provisional liquidator carries on the company’s business subject to the court’s supervision: s 472(4) and (6). The court determines the amount of remuneration given to the provisional liquidator. 43 A liquidator is entitled to $5,000, unless the committee of inspection or creditors’ resolution or the court approves a larger amount: s 473(3) and (4A).

The court hearing [5.330] Even if one or more of the above grounds are proven in court, the court does not need to wind up the company. Traditionally, courts are reluctant to wind up a company, preferring to do so only as a last resort. 44 The court may choose to dismiss the application with or without costs, or make any other order that it thinks fit: s 467(1). The court is not entitled to refuse the order merely 40 41

42 43

44

That is, not a provisional or contingent creditor.

Corporations Act 2001 (Cth) s 465A(a). The relevant form is Form 519, available at http://asic.gov.au/ regulatory-resources/forms/forms-folder/519-notification-of-court-action-relating-to-winding-up/ (accessed 3 May 2016). Corporations Act 2001 (Cth) s 465A(b). Corporations Act 2001 (Cth) s 473(2). Re Saltdean Estate Co Ltd [1968] 1 WLR 1844.

[5.330] 103

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because the company has no assets or insufficient assets for distribution, 45 but is entitled to refuse the application if an alternative remedy exists and winding up the company is unreasonable in all the circumstances: s 467(4). The existence of a defect in a statutory demand can constitute sufficient grounds for the court to refuse to wind up the company if the defect or irregularity would cause or has caused substantial injustice that cannot otherwise be remedied: s 467A. Alternatively, the court can decide to grant the order, which commences the process of winding up the company: s 513A. The order operates for the benefit of all the company’s members and creditors as if it had been made upon a joint application by all of them: s 471.

Winding up: the appointment of a liquidator [5.340] If the court orders the winding up of the company, the court can appoint an official liquidator to be the liquidator of the company: s 472(1). The court also has the power to remove a liquidator 46 and appoint another liquidator: s 473(7). As with directors, 47 a defect in the appointment of a liquidator does not affect the validity of the liquidator’s acts: s 473(9). To be a liquidator, a person must (s 532): • not be an insolvent under administration: s 532(7); • be registered as an official liquidator: s 532(8); 48 • have given written consent to the particular appointment: s 532(9); • be a member of the Institute of Chartered Accountants, CPA Australia or some other prescribed body; or

• have tertiary qualifications in accountancy and commercial law, or other qualifications or experience which ASIC considers to be equivalent: s 1282(2);

• have experience in winding up companies, be capable of performing the duties of a liquidator and be a fit and proper person; 49

• have lodged a bond with ASIC, as security for performance of their duties: s 1286. A liquidator must not have a conflict of interest and, accordingly, must not act as liquidator without court approval if he or she (s 532): 45

46 47 48

49

Corporations Act 2001 (Cth) s 467(2) and (5).

Corporations Act 2001 (Cth) s 473(1). See Corporations Act 2001 (Cth) s 201M. This refers to the official register of liquidators, maintained by ASIC pursuant to Corporations Act 2001 (Cth) s 1286. A person can also be registered as a liquidator of a particular company: s 1282(3). Registration is not necessary if the particular liquidation is a members’ voluntary winding up of a proprietary company: s 532(1). Note: Australian residency is required (s 1282(5)); and the person must not be banned from managing corporations: s 1282(4). Registration can also be cancelled or suspended if the liquidator fails to adequately perform the duties of a liquidator, including the lodgment of necessary reports, or is no longer a “fit and proper person”: ss 1290 – 1298. These matters must be proven to ASIC’s satisfaction. ASIC has said that it will normally require at least five years’ experience, being at least three years’ corporate insolvency experience under the supervision of an official liquidator and at least two years’ supervision of corporate insolvency matters.

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• (or a company in which he or she has a substantial holding) owes more than $5,000 to the company or a related body corporate;

• is a creditor of the company or of a related body corporate in an amount exceeding $5,000 (debts as liquidator are excluded); or

• has been an officer or auditor of the company, or has a specified relationship with that officer or auditor.

The liquidator is entitled to claim from the company any expenses incurred in relation to the winding up of a company: s 545(1). If there is insufficient company property, a creditor or member can apply to the court or ASIC for an order that the liquidator incur a particular expense on condition that the creditor or member indemnifies the liquidator for this expense. Security may be required: s 545(2).

Powers and duties of a liquidator Powers [5.360] The Corporations Act 2001 (Cth) gives liquidators broad powers. A liquidator may (s 477): • carry on the company’s business as necessary for the beneficial disposal or winding up of that business;

• make a compromise or arrangement with creditors (but compromise of a debt over $20,000 requires court or creditor approval): s 477(2A);

• compromise any calls or claims between the company and members; • bring or defend any legal proceeding on behalf of the company and appoint a solicitor if desired; and

• sell or otherwise dispose of some or all of the company’s property. In addition, a liquidator is entitled to inspect any books of the company at any reasonable time. Refusal to allow this is an offence: s 477(3). The liquidator will normally take possession of company books, and inspect and make copies of books relating to the company that are in the possession of a creditor: s 530B. Company directors must assist the liquidator by providing a report on the company’s affairs as at the date of winding up (or any other date specified by the liquidator): s 475. In addition, every person who is, or has been, an “officer” of the company, is required to assist the liquidator (or provisional liquidator) as required: s 530A. For example, officers must: • deliver all books relating to the company that are in the officer’s possession; • tell the liquidator where any other books are, if the officer knows of other books relating to the company;

• do whatever the liquidator or provisional liquidator reasonably requires the officer to do to help in the winding up;

• attend on the liquidator at such times as may be reasonably required; • give all information about the company’s business, property, affairs and financial circumstances as is reasonably required; [5.360] 105

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• attend meetings of the company’s creditors or members as the liquidator reasonably requires: s 530A(2); and

• keep the liquidator informed about the officer’s residential and work or business addresses, and any changes during the winding up.

The liquidator may convene creditors’ and members’ meetings for the purpose of ascertaining their wishes: s 479(2). The liquidator can only distribute surplus assets with the court’s special leave: s 488(2).

Duties [5.370] Within two months of the liquidator’s appointment, 50 the liquidator must lodge a “preliminary report” with ASIC, as to (s 476): • the amount of the company’s issued, subscribed, and paid up capital; • the estimated amounts of assets and liabilities of the company; • whether the company has failed, the causes of the failure; and • whether, in the liquidator’s opinion, further investigation should be made as to the company’s promotion, formation, or insolvency or the conduct of its business.

Under s 533, a liquidator must also report to ASIC if the liquidator considers that: • any past or present employee, officer or member may have committed an offence; • any person who has taken part in the formation, promotion, administration, management or winding up of the company, may have misapplied or be accountable for any company money or property; or

• the company may be unable to pay its unsecured creditors more than 50 cents for every dollar owed.

The liquidator is obliged to keep records and proper books, and to allow creditors and members to inspect them: s 531. These records and books can be used as evidence, 51 and so must be retained for five years, after which they can be destroyed 52 (subject to the requirements of the Income Tax Assessment Act 1936 (Cth)). The liquidator must have regard to any directions given by creditors, members or the committee of inspection: s 479(1). If directed by creditors or members, the liquidator must convene meetings of creditors or members: s 479(2). 50 51 52

This period can, however, be extended by ASIC. Corporations Act 2001 (Cth) s 542(1).

Corporations Act 2001 (Cth) s 542(2). The liquidator may choose to obtain court authorisation for the destruction under s 542(3). In a members’ voluntary winding up, the company can resolve to destroy the books. In a creditors’ voluntary winding up, the creditors can (by the committee or by creditors’ resolution) direct that the books be destroyed: s 542(3). However, in a members’ or creditors’ voluntary winding up, the liquidator is not entitled to destroy the books unless ASIC has also consented: s 542(4).

106 [5.370]

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Court involvement [5.380] If a court is satisfied that a person has concealed or removed company property, the court can issue a warrant to search for and seize the company’s books or property: s 530C. This can include authorisation to break open a building: s 530C(3). ASIC has the power to report to the court any suspected misfeasance, neglect or omission on the part of the liquidator. If a court considers that a liquidator is not faithfully performing their duties, the court is entitled to supervise the liquidation, including the power to inquire into the matter and take such action as it thinks fit: s 536(1). For example, the court may (s 536): • order the liquidator to make good any loss that the company has sustained; • require a liquidator to answer any inquiry, on oath, in relation to the winding up of a company; and

• direct an investigation into the books of the liquidator. The liquidator can apply to the court for directions, 53 but otherwise must use his or her own discretion in the management of the affairs and property of the company and the distribution of its property: s 479(4).

During a winding up Name of company [5.400] Every “public document” and “negotiable instrument” must include the words “in liquidation” after the name of the company: s 541(1). This acts as a warning to persons doing business with the company that the company is in liquidation and under the control of a liquidator.

Suspension of directors' powers and functions [5.410] During the winding up, directors’ powers and functions are suspended – no person is able to act as a director or officer of the company. There is an exemption for acts done by a liquidator or administrator or with the approval of the liquidator or the court: s 471A. The prohibition will not affect company employees or the appointment of or actions by a receiver and manager of company property: s 471A(4).

Suspension of litigation and enforcement of judgment debts [5.420] During the winding up, legal proceedings against the company cannot be continued or commenced. All enforcement of judgment debts is also suspended, unless the court grants leave to proceed with enforcement: s 471B. This provision will not affect a secured creditor’s right to realise or deal with the secured property: s 471C. 53

Corporations Act 2001 (Cth) s 479(3). [5.420] 107

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Company property [5.430] If the company is being wound up in insolvency or by the court, or a provisional liquidator has been appointed, the liquidator must take all company property into the liquidator’s custody or control and, as soon as practicable, apply those assets in discharging the company’s liabilities: s 478. If necessary, the court can grant orders to allow a liquidator to recover company property from, eg a trustee, receiver, banker, agent or officer of the company, even if the company’s entitlement is only “prima facie”: s 483. 54 The liquidator has the power to invest company funds in any manner authorised for trustee investments, but interest remains company property: s 543(1). The manner of investment can be subject to directions by the committee of inspection. The committee of inspection or the liquidator can also sell such investments: s 543(2). The liquidator (and provisional liquidator) must account for company property, 55 and lodge accounts every six months: s 539(1) and (1A). 56 These can be audited by ASIC: s 539(2).

Transfers of company property [5.440] After winding up commences, any attempt to dispose of company property is void unless the court orders otherwise, 57 or the disposition falls into one of the following categories of “exempt disposition” (s 468): • a disposition made by the provisional liquidator; • a disposition made in good faith by, or with the consent of, an administrator; or • a disposition under a deed of company arrangement executed by the company. The court has the power to validate a disposition of company property which was made in the period between the application and any resultant winding up order: s 468(3). Similarly, any attempt to enforce execution of a judgment debt against company property after the winding up order, is void: s 468(4).

Examinations [5.450] During the winding up, or up to two years afterwards, the court can require any person associated with the company to participate in an “examination” to provide information 58 and assistance in the winding up, 59 to facilitate the recovery of company property, to examine officers’ conduct and to investigate possible legal action. A summons for such an examination can be set 54 55 56 57 58 59

“Prima facie” means that the entitlement appears to exist. However, this entitlement may be disputed and disproven after the hearing of evidence. For the regulation of this process, see Corporations Act 2001 (Cth) s 538; and Corporations Regulations 2001 (Cth) regs 5.6.06 – 5.6.10. The requisite form is Form 524, with Form 911 used to verify the accounts. Corporations Act 2001 (Cth) s 468(1). Corporations Act 2001 (Cth) s 596D – this includes company books.

Corporations Act 2001 (Cth) ss 596A and 596B.

108 [5.430]

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aside on the grounds that the person does not have information that would assist the liquidator. 60 The examination is normally public, 61 and questions are answered on oath. It is an offence to make false or misleading statements. 62 Advance notice of the questions is not given, 63 and questions must be answered even if they incriminate the examined person: s 597(12). However, if the examined person invokes the privilege against self-incrimination, the answers cannot be used in subsequent criminal proceedings: s 597(12A).

Court powers in relation to company officers [5.460] A liquidator can apply to the court for an order prohibiting an officer or related entity from leaving Australia, or from taking or sending company property out of Australia. Such an order can require the officer to surrender his passport, 64 but can only be made if the court is satisfied that (s 486A): • at least a prima facie case exists that the officer or related entity is or will become liable to pay money to the company, or to account for company property;

• there is substantial evidence that the officer or related entity has concealed or removed money or other property or has sought to leave the relevant State or Territory or Australia in order to avoid any liability; and

• it is necessary or desirable to make the order to protect the company’s rights against the officer or related entity.

Upon application by a liquidator, the court can also issue a warrant against a person who may avoid his or her obligations in connection with a winding up: s 486B. The court may also issue a warrant if satisfied that the person is about to leave Australia to avoid paying money to the company or examination of the company’s affairs or some other obligation, or if they have concealed or removed company property or company books (or are about to do so): s 486B. The court can arrest a contributory if they have reasonable cause to believe that they are about to leave Australia to avoid paying a call or participating in an examination: s 487.

Investors' liability in a winding up [5.470] One of the assets of the company is the company’s right to make calls on partly-paid shares. This right is not only exercisable in a winding up, but an investor can be certain that a company in financial difficulties will sooner or later call in the unpaid balance of the subscription price of its partly-paid shares. Payment of the call is required as, once made, it is a debt enforceable by the 60 61 62 63

64

Ex parte Merrett (1997) 140 FLR 412. In this case, Deloitte’s newly-appointed managing partner avoided the summons on the grounds that, due to the recency of the appointment, the partner did not have relevant information that would assist. Corporations Act 2001 (Cth) s 597(4). Corporations Act 2001 (Cth) s 597(11). Re Stolliar (2003) 21 ACLC 869.

Corporations Act 2001 (Cth) s 486A(1). [5.470] 109

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company. However, if the company is a no-liability company, the investor can exit the investment without paying the call, but will forfeit the shares: s 254Q. Section 515 obliges members to contribute to the company property an amount sufficient to pay the company’s debts and liabilities and the costs, charges and expenses of the winding up. However, most importantly, a member of a company limited by shares is not obliged to contribute more than the amount (if any) unpaid on the shares in respect of which the member is liable as a present or past member: s 516. If the shares held by a member were all fully paid, then on a winding up, a member would not have to contribute any money to the winding up of the company. Likewise, in a company limited by guarantee, a member need not contribute more than the amount the member has undertaken to contribute to the company’s property if the company is wound up: s 517. 65 A past member need not contribute towards company debts contracted after membership ceased 66 or if the ex-member was not a member at any time during the year preceding the commencement of the winding up: s 521. A past member also need not contribute unless the court considers that the existing members are unable to satisfy the contributions they are liable to make. In a liquidation of a company other than a no-liability company, the liquidator considers whether to settle a list of “contributories”. This must be done if members or past members will be required to contribute to the company’s property (eg by paying calls) or are likely to be participating in distribution of surplus assets (if the company has sufficient assets to distribute to its members).

VOIDABLE TRANSACTIONS [5.480] The liquidator has the power to “reverse” certain transactions involving the company if the liquidator considers that this would be in the company’s best interests. The transactions that can be reversed are known as “voidable transactions” and are described in s 588FE. To be voidable, the transaction must be one of the types of transaction set out in s 588FE, and also either the transaction must have occurred during the period applicable to that transaction type, or an act or omission giving effect to the transaction must have occurred during that period (the periods vary according to the type of transaction), and no defence must apply. Section 588FF(1) allows the liquidator to apply to the court for orders relating to a voidable transaction. The application must normally be made in the first three years after the relation-back day, but there is provision for the court to extend this time during this period: s 588FF(3).

65

66

See also Corporations Act 2001 (Cth) s 518. Corporations Act 2001 (Cth) s 520.

110 [5.480]

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Definitions [5.490] The following transactions are voidable under s 588FE: Voidable transactions Type of transaction Relevant period An “unfair preference” that is an insolvent During the six months before “relation-back transaction. day”. An “unfair preference” is defined in s 588FA as a transaction beween the company and an unsecured creditor which results in the creditor receiving from the company more than the creditor would receive if the transaction were set aside and the creditor proved the debt in a winding up of the company. An “insolvent transaction” is defined in s 588FC as a transaction which is: • either an uncommercial transaction or an unfair preference, and • the company is insolvent when the transaction occurs or when an act or omission is done for the purpose of the transaction, or the company becomes insolvent as a result of any of these occurring. An “uncommercial transaction” that is an During the two years before the “relation-back insolvent transaction (note the definition above). day”. An “uncommercial transaction” is defined in s 588FB as a transaction that a reasonable company would not have entered into, having regard to the benefits and detriments of the transaction. Insolvent transaction (note the definition above) During the four years before the “relation-back day”. to which a related entity of the company is a party. Insolvent transaction and the company became During the ten years before the “relation-back day”. a party to it for the purpose (or purposes including the purpose) of defeating, delaying or interfering with the rights of any or all of its creditors on a winding up of the company At any time – no time limits apply. An unfair loan to the company – defined by s 588FD as a loan where the interest or charges was/were or has/have become “extortionate” given the amount of the risk, value of security provided, amount and term of the loan, schedule of repayments and any other relevant matter. During the four years before the “relation-back An unreasonable director-related transaction – defined in s 588FDA as a payment made by the day”. company, or property transfer, or security issue, or incurring a debt to a director or close associate, and a reasonable person in the company’s circumstances would not, having regard to the benefits and detriment to the company, have entered that transaction

The “relation-back day” is defined in s 9 of the Corporations Act 2001 (Cth) and essentially refers to the date on which the company’s winding up was ordered, or any earlier entry into voluntary administration, or the appointment of either a liquidator or a provisional liquidator. [5.490] 111

Law of Investments and Financial Markets

Insolvent transactions [5.500] Under s 588FC, a transaction is an “insolvent transaction” of the company if, and only if, it is either an “unfair preference” given by the company, or an “uncommercial transaction” of the company, which is entered into, or given effect to by an act or omission, when the company is insolvent, or if the company becomes insolvent as a result of the company entering into the transaction or a person doing any act or making any omission for the purpose of giving effect to the transaction. A court can rely on presumptions of insolvency, discussed above. “Unfair preference” is defined in s 588FA as a transaction which includes the company and an unsecured creditor as parties to the transaction, and the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company. The definition also applies to the amount of a secured debt which is not reflected in the value of the security; and to a series of transactions as part of a continuing business relationship which results in increases and reductions in the company’s net indebtedness to the creditor, as if that series of transactions were a single transaction. An “uncommercial transaction” is a transaction where it is to be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to the benefits and detriment to the company of entering into the transaction, the benefits to other parties, and any other relevant matter: s 588FB. For example, selling company property at an undervalue is likely to be an uncommercial transaction, 67 as is waiver of a company debt for no benefit to the company. 68

Unreasonable director-related transactions [5.510] Under s 588FDA, a transaction is an “unreasonable director-related transaction” of the company if, and only if: • it is a payment made by the company, an issue of securities made by the company, or a transfer of company property by the company, or the incurring of an obligation (even a contingent obligation) to do any of these;

• it is made to a director of the company, or close associate of a director, or to another person on behalf of a director or a close associate of a director; and

• having regard to the benefits and detriments to the company, the benefits to other parties, and anything else relevant in existence at the time of the transaction, a reasonable person in the company’s circumstances would not have entered into the transaction.

The transaction can still constitute an “unreasonable director-related transaction” even if ordered by a court or required by a government agency. 67

68

Demondrille Nominees Pty Ltd v Shirlaw (1997) 15 ACLC 1716.

Lewis v Cook (2000) 18 ACLC 490.

112 [5.500]

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Unfair loan [5.520] Under s 588FD, a loan is an “unfair loan” only if the interest was extortionate when the loan was made, or has since become extortionate because of a variation, or if the charges in relation to the loan were extortionate when the loan was made, or have since become extortionate because of a variation. It is irrelevant that the interest is, or the charges are, no longer extortionate. The court will consider the following factors when determining whether the interest or charges were extortionate: • the risk to which the lender was exposed and the value of any security in respect of the loan;

• the amount and term of the loan; and • the schedule for payments of interest and charges and for repayments of principal.

Defences [5.530] The court cannot make an order under s 588FF in relation to a voidable transaction if the order would materially prejudice a person who was not a party to the transaction: • who has received no benefit from the transaction: s 588FG(1)(a); or • who received a benefit in good faith and, but at the time the person received the benefit, there were no reasonable grounds for suspecting that the company was or would become insolvent: s 588FG(1)(b).

The court also cannot make an order under s 588FF in relation to a voidable transaction if the order would materially prejudice a person who was a party to the transaction if: • the transaction is not an unfair loan or unreasonable director-related transaction; and • the person became a party to the transaction in good faith, at a time when they had no reasonable grounds for suspecting that the company was or would become insolvent (and nor would a reasonable person have suspected that); and

• the person provided valuable consideration or has changed position in reliance on the transaction: s 588FG(2).

The “good faith” requirement refers to the creditor’s knowledge of the company’s solvency. The onus is on the creditor to prove that it had no reasonable grounds to suspect insolvency. 69 This is a subjective test, and so business conducted in an “atmosphere of irregularity”, such as the acceptance of post-dated cheques, can be used in court as evidence of reasonable grounds to suspect insolvency. 70 Payments received after a running account has been closed may not be received in good faith. 71 69 70

71

Cook’s Construction Pty Ltd v Brown (2004) 49 ACSR 62. Mann v Sangria Pty Ltd (2001) 19 ACLC 696. Panasonic Australia Pty Ltd v Wily (1997) 15 ACLC 613.

[5.530] 113

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INSOLVENT TRADING Liability of directors [5.550] Directors who allow the company to incur a debt while the company is insolvent, or which causes the company to become insolvent, will become personally liable for that debt. The company’s entitlement to recover this amount from the directors represents an asset of the company, which is recoverable by the company’s liquidator. Section 588G(1) applies if: • a person was a director of a company at the time the company incurred a debt; • the company was insolvent at the time the debt was incurred or became insolvent by incurring the debt; and

• at the time of incurring the debt there were reasonable grounds for suspecting that the company was insolvent or would become insolvent because of the debt or because of other debts incurred at the time.

The director will be personally liable if: • the director was aware, at the time of incurring the debt, that there were reasonable grounds for suspecting the company was insolvent: s 588G(1); or

• a reasonable person in a similar position in another company in the same circumstances would be aware that there were reasonable grounds for suspecting that the company was insolvent: s 588G(2).

It is an offence if the director acted dishonestly and suspected at the time of the debt that the company was insolvent: s 588G(3). Either the liquidator or a creditor may pursue the director for recovery of these losses: s 588M. The director can be ordered to compensate creditors who have suffered loss as a result of the director’s insolvent trading: s 588J(1). (Of course, such conduct may also trigger a liability for a pecuniary penalty order 72 and/or an order disqualifying the director from managing corporations: s 206C.)

Defences applicable to directors [5.560] It is a defence to liability under s 588G if the director can prove that: • the director had reasonable grounds, at the time the debt was incurred, to expect that the company was and would remain solvent: s 588H(2);

• at the time the debt was incurred, the director had reasonable grounds to rely on, and did in fact rely on, information regarding the company’s solvency which was supplied by a competent and reliable person: s 588H(3);

• for reasons of illness or some other good reason, the director did not participate in the company’s management at the time the debt was incurred: s 588H(4); or

• the director took all reasonable steps to avoid the company incurring the debt: s 588H(5). 72

See Corporations Act 2001 (Cth) s 1317G.

114 [5.550]

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Liability of a holding company [5.570] A holding company also incurs liability under s 588W for its subsidiary company’s insolvent trading (defined in s 588V and phrased very similarly to directors’ liability under s 588G, discussed above). Similar defences also apply to holding companies. Under s 588X, the holding company will not be liable if: • the holding company had reasonable grounds to believe, and did believe, that a competent and reliable person was responsible for providing adequate information about the company’s solvency, and that the person was fulfilling that responsibility, and expected on the basis of that information that the company was solvent and would remain so, even if it incurred that debt and other concurrent debts: s 588X(3);

• the holding company took all reasonable steps to avoid the company incurring the debt: s 588X(5); or

• the holding company was relying on a particular director who, for reasons of illness or some other good reason, did not participate in the holding company’s management at the time the debt was incurred: s 588X(4).

CREDITORS' CLAIMS Types of debts Provable debts [5.600] To obtain payment of their debt by the liquidator, creditors need to “prove” their claim for the debt as the liquidator will only pay debts which have been admitted “to proof” against the company under s 553(1). The process is set out in s 553D and generally the same rules apply as for a personal bankruptcy: s 553E. This requirement applies to all debts, whether contingent, present, future, and whether the amount has been ascertained or not.

Unprovable debts [5.610] Debts owed to a member, whether by way of dividends, profits or otherwise, are not admissible to proof against the company unless the person has paid to the company or the liquidator all amounts that the person is liable to pay as a member of the company: s 553A. 73 The selling shareholder in a share buy-back is not entitled to a distribution of money or property unless the shareholder has discharged the shareholder’s obligations to give documents in connection with the buy-back. The selling shareholder’s claim ranks after those of non-member creditors and before those of other member creditors: s 553AA. Penalties or fines imposed by a court in respect of an offence against a law are not admissible to proof against an insolvent company, unless they amount to a pecuniary penalty order under the Proceeds of Crime Act 1987 (Cth): s 553B. 73

For example, calls on partly paid shares. [5.610] 115

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Calculating the debt [5.620] Section 554 determines the calculations, including interest, as at the relevant date. If the amount cannot be quantified, it must be estimated by the liquidator, and the estimate can be reviewed by the court: s 554A. If the debt is payable after the relevant date, it can be discounted to take account of this: s 554B. If the amount of the debt is calculated in a foreign currency, this can be converted into Australian dollars under s 554C. Mutual dealings, including credits, must be included in the calculations: s 553C(1). Importantly, a contingent liability (eg damages, the amount of which is not yet quantifiable) may be set off against a debt, provided that the claim exists at that date, 74 and at the time there was no notice of the company’s insolvency: s 553C(2). Set-off will also not be allowed in respect of debts which are separate and not intertwined. 75 Interest is payable on debts at the prescribed rate, calculated from the “relevant date” until the date on which payment is made: s 563B(1). However, payment is postponed until all other creditors’ debts have been paid: s 554B.

Secured creditors [5.630] The proof of a secured debt is governed wholly by s 554E. It must be in writing and include particulars of the security and the creditor’s estimate of its value. The creditor has a choice whether to (s 554G): • turn the assets covered by the security over to the liquidator for the benefit of all creditors and claim the entire amount owed;

• properly realise the security in good faith and prove for any extra amount of the debt not covered by the security; or

• take possession of the security, estimate its value, and prove for the balance of the debt which is owed and not covered by the security. This estimate can be revised if necessary.

If the secured creditor lodges a proof of debt to claim the balance due after deducting the creditor’s estimate of the value of the security, the liquidator may, at any time, redeem the security on payment to the creditor of the amount of the creditor’s estimate of its value: s 554F. The creditor can force the liquidator’s hand by requiring the liquidator to choose whether to exercise this power within three months. If this power is then not exercised within that time, the liquidator cannot redeem the security. The liquidator can require the property to be offered for sale: s 554F. If sold by public auction, both the creditor and the liquidator are entitled to bid for, and purchase, the property. If the amount that the asset realises is more than the amount the creditor is entitled to, the creditor must repay the excess to the liquidator: s 554H. 74 75

Gye v McIntyre (1991) 171 CLR 609.

Lloyds Bank NZA Ltd v National Safety Council of Australia (Vic) (in liq) [1993] 2 VR 506.

116 [5.620]

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Priorities The general rule of pari passu [5.650] The fundamental principle, known as “pari passu”, is that all debts and claims which have been “proved”, rank equally and so if the company’s property is insufficient to pay all proven claims in full, the claims must be paid on a pro rata basis: s 555. The same principle of “pari passu” applies within each “class” of claims: s 559.

Exceptions to pari passu [5.660] Secured creditors rank above unsecured creditors: s 561. Entitlement to priority payment is available for (ss 561 – 564): • liquidator’s expenses, including the expenses of recovering company property; • liquidator’s remuneration; • the costs of the application for the winding up of the company; and • certain employee entitlements.

Claims by employees [5.670] Persons who were employed by the company immediately prior to the winding up date are entitled to payment as if the company had terminated their employment on that date: s 558(1). If the liquidator continues to employ that person, they are still deemed to have been employed by the company. Claims for long service leave and extended leave and retrenchment payments are deemed to be costs of the winding up. Payment of employees’ claims can be made out of property that is subject to a circulating security interest in priority to the debt secured by that circulating security interest: s 561. It is an offence to enter into an agreement or transaction with the intention of defeating employee entitlements: s 596A. In recent years, the Australian Government has set up schemes to provide a safety net for the protection of employees’ entitlements for unpaid wages, accrued annual leave, long service leave, pay in lieu of notice, and redundancy entitlements of up to eight weeks’ wages, if their employer became or becomes becomes insolvent. The previous scheme, the General Employee and Redundancy Scheme (GEERS), applied to insolvency events occurring prior to 5 December 2012, and applied to entitlements based on legislation, an industrial award, a statutory agreement or a written employment contract. Payments were discretionary and without legal obligation, and did not allow double recovery.

[5.670] 117

Law of Investments and Financial Markets

This scheme has now been replaced by the “Fair Entitlements Guarantee”, which applies to insolvency events on or after 5 December 2012. 76 This scheme allows employees to claim up to 13 weeks of unpaid wages, their unpaid annual leave and long service leave, payment of up to 5 weeks in lieu of notice, and redundancy pay of up to 4 weeks per full year of service. (Unpaid superannuation guarantee contributions are not covered by the scheme). Claims must be lodged within 12 months and will also apply to those who lost their jobs up to 6 months prior to the insolvency events.

Claims by members [5.680] Previously, s 563A used to provide that payment of a debt owed by a company to a member of the company, whether by way of dividends, profits or otherwise, is to be postponed until all debts owed to, or claims made by, persons otherwise than as members of the company have been satisfied. This does not postpone claims for services, which were paid for but never provided, or for loans or other debts incurred in a capacity other than as members. Doubt was thrown on the correct interpretation of this section in the Federal Court decision of Gwalia 77 and for a time, the law was officially “confused” 78 in relation to the circumstances in which a shareholder, claiming loss resulting from the acquisition of shares in a company, could claim that amount as a debt as a creditor (with the priority of a creditor), and not as a member of the company (who was generally accepted, prior to this decision, to rank behind creditors in the priorities of a winding up). The original rationale for s 563A was that once an investor has subscribed capital to the company, that capital should be available to satisfy the company’s creditors. The company cannot reduce its capital except in accordance with Ch 2J of the Corporations Act 2001 (Cth) (and under the common law, all capital reductions were prohibited). 79 To preserve the capital of the company so that creditors’ claims can be paid, members were and are only allowed to liquidate their equity after all debts of the company have been paid. The decision in Gwalia was difficult because a member may have two claims: one for a return of capital as a member, and another against the company for misrepresentation or misleading and deceptive conduct which resulted in the member acquiring the shares. The member could argue that subscription would not have occurred without the misrepresentation or misleading conduct, and that a claim for damages for misleading and deceptive conduct allows the member to compete in the winding up as an unsecured creditor ranking equally with other creditors, instead of having the member’s claim postponed until after all creditors’ payments have been made. The problem is that creditors are 76 77 78

79

See https://www.employment.gov.au/fair-entitlements-guarantee-feg (accessed 3 May 2016). Sons of Gwalia Ltd v Margaretic (2005) 55 ACSR 365; [2005] FCA 1305.

The law on this topic “is, to say the least, confused”: Johnston v McGrath (2005) 195 FLR 101; [2005] NSWSC 1183 at [46] per Gzell J. This is in accordance with the rule in Trevor v Whitworth (1887) App Cas 409.

118 [5.680]

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naturally against the idea that members can claim as creditors, because this reduces the proportion of the company’s assets that other unsecured creditors will receive. On appeal, the High Court 80 upheld the Federal Court decision 81 that a shareholder’s claim for compensation for loss suffered as a result of acquiring worthless shares in the company at a time when the company was engaging in misleading and deceptive conduct, 82 was a claim in the shareholder’s capacity as a creditor, and not as a shareholder. The claim was therefore not postponed under s 563A (which applied to the company, although it was not in liquidation, because it had been included in a deed of company arrangement) until debts owed to, or claims made by, persons otherwise than as members had been satisfied. The company had gone into voluntary administration soon after Margaretic had purchased shares in the company on the stock exchange. Margaretic also claimed that his loss was the result of the company’s breach of its obligation to disclose all information that a reasonable person would expect to have a material effect on the price and value of the company’s shares. The administrators argued that Margaretic’s claim was in the capacity of a member and not a creditor and should therefore be postponed under s 563A until all non-members’ debts and claims had been paid. They argued that Margaretic was denied the right to claim as a creditor. However, the court distinguished an earlier case as not applicable to Margaretic because Margaretic had acquired the shares on the Australian Securities Exchange (ASX) and not directly from the company, and decided that Margaretic’s claim was not in his capacity as a shareholder. Even if the claim was a debt (which was assumed), the court held that the debt arose as a result of the operation of consumer protection provisions, which prohibited misleading and deceptive conduct, and not in Margaretic’s capacity as a shareholder. Thus, s 563A did not postpone Margaretic’s claims. Moreover, Margaretic was entitled to attend and vote at creditors’ meetings. This decision triggered consternation amongst many in the industry, who feared that the cost of reorganising insolvent companies would increase, and complained that it was not the company’s role to underwrite shareholders’ losses. The Treasurer referred these issues to the Corporations and Markets Advisory Committee (CAMAC) for consideration with a view to law reform, and subsequently s 563A has been amended so as to clarify that shareholders’ “subordinate claims” are now ranked lower in priority than creditor claims. Section 563A now provides: 80 81 82

Sons of Gwalia Ltd v Margaretic (2007) 81 ALJR 525; [2007] HCA 1. Sons of Gwalia Ltd v Margaretic (2005) 55 ACSR 365; [2005] FCA 1305.

The claim was for compensation for loss suffered as a result of an alleged breach (admitted by the company for the purposes of these proceedings only) of s 52 of the Trade Practices Act 1974 (Cth), s 1041H of the Corporations Act 2001 (Cth), and of s 12DA of the Australian Securities and Investments Commission Act 2001 (Cth). The shareholder also claimed that the company was in breach of its obligation to disclose all information that a reasonable person would expect to have a material effect on the price and value of the company’s shares: Corporations Act 2001 (Cth) s 674. [5.680] 119

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Postponing subordinate claims (1)

The payment of a subordinate claim against a company is to be postponed until all other debts payable by, and claims against, the company are satisfied.

(2)

In this section: “claim” means a claim that is admissible to proof against the company (within the meaning of section 553). “debt” means a debt that is admissible to proof against the company (within the meaning of section 553). “subordinate claim” means: (a)

a claim for a debt owed by the company to a person in the person’s capacity as a member of the company (whether by way of dividends, profits or otherwise); or

(b)

any other claim that arises from buying, holding, selling or otherwise dealing in shares in the company.

The effect of this amendment is to negate the effect of the High Court’s decision in Gwalia.

DEREGISTRATION Release of liquidator [5.700] An “order of release” discharges a liquidator from all liability for the administration of the company’s affairs, but can be revoked if obtained by fraud or by suppression or concealment of material facts. A liquidator can ask for an “order of release” if the liquidator has (s 480): • realised all the company property (or as much as can be reasonably realised); • distributed a final dividend (if any) to the creditors; • adjusted the rights of the members among themselves and made a final return (if any) to the contributories; or

• resigned or been removed from office. If a court is satisfied that a liquidator has been guilty of negligence, breach of trust or breach of duty, the court can order the liquidator to compensate the company for any loss suffered: s 481(2).

Deregistration [5.710] The company’s existence as a separate legal entity ends when the company is deregistered by ASIC. In a voluntary winding up, ASIC deregisters the company three months after the request was lodged, but the court can order earlier deregistration: s 509. Where a court orders deregistration of a company

120 [5.700]

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following reconstruction or amalgamation, 83 release of the liquidator, 84 or final report of a liquidator’s return at the end of a winding up, 85 ASIC must deregister the company: s 601AC(1).

Reinstatement of registration [5.720] If a company’s registration is reinstated, it is deemed to have continued in existence as if it had not been deregistered: s 601AH(5). The court can order the reinstatement of the registration of a company if it is satisfied that it is just that the company’s registration be reinstated: s 601AH(2). ASIC can reinstate the registration of a company if it is satisfied that the company should not have been deregistered: s 601AH(1). The court will not order reinstatement for the purposes of collecting a debt if the reinstated company would have insufficient funds to repay that debt, since such an order would be futile. 86 The person seeking the order may be required to indemnify a liquidator for expenses incurred as a result of the reinstatement. 87

83 84 85

86 87

Corporations Act 2001 (Cth) s 413(1)(d). Corporations Act 2001 (Cth) s 481(5)(b). Corporations Act 2001 (Cth) s 509(6).

Australian Competition and Consumer Commission v Australian Securities and Investments Commission (2000) 174 ALR 688. Promnitz v Australian Securities and Investments Commission (2004) 22 ACLC 108.

[5.720] 121

CHAPTER 6 Managed Investment Schemes [6.10]

Introduction ............................................................................................... 124 [6.20] Key points ...................................................................................................... 125 [6.30] Key terms ....................................................................................................... 125

[6.40]

What is a managed investment scheme? ............................................. 125 [6.50] Exclusions from the definition of managed investment scheme ......... 127 [6.60] Listed and unlisted managed investment schemes ................................ 128

[6.70]

Registration of managed investment schemes.................................... 128 [6.70] Requirements for registration ..................................................................... 128 [6.80] How to register .............................................................................................. 129

[6.90]

Responsible entity .................................................................................... 129 [6.100]

Statutory duties of the responsible entity .............................................. 130

[6.110]

Scheme property .......................................................................................... 132

[6.114]

Responsible entities and product disclosure statements ...................... 133

[6.117] Simple managed investment schemes and product disclosure statements .......................................................................................................... 134

[6.120]

Scheme constitution ................................................................................. 134 [6.130]

[6.140]

[6.170] [6.180]

[6.340]

Contents of the constitution ...................................................................... 135

Compliance plan....................................................................................... 136 [6.150]

Contents of the compliance plan ............................................................. 137

[6.160]

Audit of compliance plan .......................................................................... 137

Compliance committee ............................................................................ 137 Protection of scheme members .............................................................. 138 [6.185]

Civil liability of responsible entity to members .................................... 138

[6.210]

Voidable contracts ....................................................................................... 139

[6.310]

Members’ rights to withdraw from a scheme ....................................... 140

[6.320]

Withdrawal from non-liquid schemes ..................................................... 141

[6.330]

Winding up and deregistration ................................................................ 144

Managed investment industry ............................................................... 144 [6.340]

Managed funds industry ........................................................................... 144

[6.350]

Serviced strata schemes ............................................................................. 145

[6.355]

Scheme property in serviced strata schemes ......................................... 146

[6.360]

Indications and examples of serviced strata schemes .......................... 146

[6.370] Real estate agents, financial advice and managed investment schemes .............................................................................................................. 147 [6.380]

Mortgage investment schemes ................................................................. 148

[6.390]

Investor directed portfolio services ......................................................... 150

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INTRODUCTION [6.10] Managed investments are often referred to as collective investments or managed funds – in other words, they are funds where investors pool their money together with others to invest together in common investments. A trustee is appointed to hold and manage the money on behalf of all the investors and invest the money for their benefit. The underlying business structure is usually a public unit trust with investors holding the units within the trust. Managed investment schemes invest the pooled money in property, equities, primary production schemes, time-sharing arrangements and property and mortgage schemes. In general, these are investments which are not subject to direct prudential regulation or direct investor control as the investors are not shareholders. Therefore, usually the capital invested is at greater risk and investors do not have day-to-day management or control of the investment. Managed funds in Australia amount to $1.1 trillion, 1 although a large portion of this is attributed to compulsory superannuation funds. Managed investment schemes are defined in s 9 of the Corporations Act 2001 (Cth) and those schemes that need to be registered with the Australian Securities and Investments Commission (ASIC) are defined in Ch 5C s 601EB of the Act. For the purposes of Ch 7 of the Corporations Act 2001, the operation of a managed investment scheme is a “financial service”, while interests in managed investment schemes are “financial products”. In relation to disclosure documents for interests in managed investment schemes, Pt 7.9, and not Ch 6D, fundraising provisions apply. This means in general that a product disclosure statement (PDS) will be required. Unlike Ch 6D disclosure documents, there is no expiry date on a PDS. Thus, product offer documents will only need to change when the products change to prevent the PDS from being out of date, misleading or deceptive. Section 1021B describes a defective PDS, and s 1012J establishes the role of a Supplementary PDS. 2 Chapter 5C of the Corporations Act 2001 (Cth) was introduced in 1998. The primary purpose of Ch 5C is the regulation of managed investments and the provision of investor protection for investors in these schemes. A single licensed responsible entity which operates the scheme and holds scheme property on trust for scheme members replaced the former two-tiered trustee/fund manager structure for collective investments. The changes also required a scheme constitution, compliance plan and, if necessary, a compliance committee, together with direct statutory obligations for the responsible entity. The introduction of the single responsible entity was designed to determine the issue of liability in the event of scheme failure and, hence, avoid the exercises in blame shifting arising under the trustee/manager structure. The failure of the 1 2

Australian Bureau of Statistics (ABS) data (September 2009). Corporations Act 2001 (Cth) s 1012J: “The information in a Product Disclosure Statement must be up to date as at the time when it is given, a Supplementary Product Disclosure Statement containing updated information may be given with a Product Disclosure Statement that has become out of date. The updated information is taken to be included in the Product Disclosure Statement.”

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unlisted property trust, Estate Mortgage, in the early 1990s illustrated the need for two important features of the managed investments legislation: • replacement of the dual responsibility structure by the responsible entity to avoid confusion of roles and legal liability of the trustee and the manager; and

• restructuring of the investors’ rights to redeem their investment, distinguishing between liquid and non-liquid schemes.

Key points [6.20] This chapter will provide a greater understanding of: • the specific classification of a managed investment scheme and the investment vehicles included under this classification;

• the statutory obligations connected to the operation of managed investment schemes; • the “responsible entity” concept of overseeing a managed investment scheme; • how compliance plans and committees are formulated and regulated; and • what protection and rights are afforded members of managed investment schemes.

Key terms [6.30] The key terms in this chapter are: • Trust • Trustee • Managed investment scheme • Constitution • Responsible entity • Compliance plan • Buy-backs

WHAT IS A “MANAGED INVESTMENT SCHEME”? [6.40] According to s 9 of the Corporations Act 2001 (Cth), a “managed investment scheme” has the following features: • people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not);

• any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders);

• the members do not have day to day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions); or

• a time-sharing scheme.

[6.40] 125

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It follows from the above list that a managed investment scheme has three “key elements”: 1.

the investor contributes money or money’s worth; 3

2.

there is generation or intended generation of a financial return or benefit. This takes account of the possibility of an investment giving rise to a loss. While the intention should be to generate a financial benefit, this may not always be the outcome; and

3.

the investor has no day-to-day control over the use of the money to generate the return.

The word “scheme” has been discussed in many cases. In Australian Securities & Investments Commission v Takaran Pty Ltd 4 Barrett J said: The essence of a “scheme” is a coherent and defined purpose, in the form of a “programme” or “plan of action”, coupled with a series of steps or course of conduct to effectuate the purpose and pursue the programme or plan. In some cases, the scope of the scheme will readily be gathered from some constitutive document in the nature of a blueprint setting out all relevant matters. 5

and It must also be emphasised that a scheme having the characteristics bringing it within the s 9 definition of “managed investment scheme” will not necessarily possess those characteristics alone. …. A managed investment scheme, … may involve elements beyond the core attributes that give it its essential character. Elements which lie beyond those attributes but contribute to the coherence and completeness which make a “programme” or “plan of action” must form part of that “scheme”. Every programme or plan of action must be taken to include the logical incidents of and consequences of and sequels to its acknowledged components. 6

In Australian Securities & Investments Commission v Primelife Corporation Limited Goldberg J described a scheme as “a network of contractual rights and contractual obligations”. 7 In National Australia Bank Ltd v Norman, 8 decided in the Full Court of the Federal Court, Graham J said: In my opinion a finding could not be made that people contributed money or money’s worth “as consideration to acquire rights to benefits produced by” a 3 4 5 6 7 8

Crocombe v Pine Forests of Australia Pty Ltd [2005] NSWSC 151 parties who contributed their interest in land rather than cash still contributed “money’s worth”. Australian Securities & Investments Commission v Takaran Pty Ltd (2002) 43 ACSR 46; [2002] NSWSC 834. Australian Securities & Investments Commission v Takaran Pty Ltd (2002) 43 ACSR 46; [2002] NSWSC 834 at [15]. Australian Securities & Investments Commission v Takaran Pty Ltd (2002) 43 ACSR 46; [2002] NSWSC 834 at [16].

Australian Securities & Investments Commission v Primelife Corporation Limited [2006] FCA 1072 at [33]. National Australia Bank Ltd v Norman [2009] FCAFC 152.

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scheme unless they were seized of the nature of the scheme, the benefits that may be produced by the scheme and the nature of the rights to those benefits which they were acquiring. … 81 If the scheme was one under which some or all of the contributions were “to be pooled, or used in a common enterprise, to produce … benefits … for the people [holding] interests in the scheme” it was essential that at the time of making the contributions the contributors knew that some or all of the contributions were to be pooled or used in a common enterprise. The words “to be” cannot be overlooked.

Exclusions from the definition of “managed investment scheme” [6.50] The broad definition of “managed investment scheme” in s 9 of the Corporations Act 2001 is followed by a list of specific exclusions: • a partnership that has more than 20 members but does not need to be incorporated or formed under an Australian law;

• a body corporate (other than a body corporate that operates as a time-sharing scheme); • a scheme in which all the members are bodies corporate that are related to each other and to the body corporate that promotes the scheme;

• a franchise; • a statutory fund maintained under the Life Insurance Act 1995 (Cth); • a regulated superannuation fund, an approved deposit fund, a pooled superannuation trust, or a public sector superannuation scheme, within the meaning of the Superannuation Industry (Supervision) Act 1993 (Cth);

• a scheme operated by an Australian authorised deposit-taking institution (ADI) in the ordinary course of its banking business;

• the issue of debentures or convertible notes by a body corporate; • a barter scheme under which each participant may obtain goods or services from another participant for consideration that is wholly or substantially in kind rather than in cash;

• a retirement village scheme; • a scheme that is operated by a co-operative company registered under Pt VI of the Companies (Co-operative) Act 1943 (WA) or under a previous law of Western Australia that corresponds to that Part;

• a contribution plan; and • a scheme of a kind declared by the regulations not to be a managed investment scheme.

Recent cases show that managed investment schemes can be found in the most unlikely scenarios. In Brookfield Multiplex Ltd v International Litigation Funding Partners Pte Ltd (No 3), 9 the Full Court of the Federal Court decided that a litigation funding arrangement whereby members of the class action seeking to recover damages, who entered a funding agreement with litigation specialists, were deemed to be part of a managed investment scheme. 9

Brookfield Multiplex Ltd v International Litigation Funding Partners Pte Ltd (No 3) (2009) FCA 450; 256 ALR 427. [6.50] 127

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Any scheme involving a programme or plan for the misappropriation of investors’ funds could not involve contributions being pooled or used in a common enterprise to produce financial benefits “for the people … who hold interests in the scheme”, as required by the second limb of the definition of “managed investment scheme”. 10

Listed and unlisted managed investment schemes [6.60] Managed funds can be listed on the Australian Securities Exchange (ASX) thus providing investors with access to a professionally managed and diversified portfolio of assets. These may include Australian shares, international shares, fixed income securities, unlisted private companies and specialist sectors. Importantly managed funds can be bought and sold on the ASX in the same way as any other share. Investors own a proportion of the investment portfolio equal to the size of their investment, and are entitled to any profits and distributions (dividends), but are also subject to losses if the value of the portfolio declines. 11 The ASX website provides information concerning investing in listed managed investment schemes.

REGISTRATION OF MANAGED INVESTMENT SCHEMES Requirements for registration [6.70] A managed investment scheme must be registered under s 601EB of the Corporations Act 2001 if (s 601ED(1)): • it has more than 20 members; or • it was promoted by a person, or an associate of a person, who was, when the scheme was promoted, in the business of promoting managed investment schemes; or

• ASIC has determined in writing pursuant to s 601ED(3) that a number of managed investment schemes are closely related and that each of them has to be registered at any time when the total number of members of all the schemes exceeds 20. ASIC must give written notice of the determination to the operator of each of the schemes.

The importance of registration, where required, is seen in the discussion of s 601MB below. A person must not operate a managed investment scheme that this section requires to be registered under s 601EB unless the scheme is so registered: s 601ED(5). Otherwise ASIC, the person operating the scheme or a member of the scheme may apply to the court to have the scheme wound up and the court may make any orders it considers appropriate for the winding up of the scheme: s 601EE. Only small unregistered schemes which are not professionally managed will fall outside the definition of “financial product” for the purposes of Ch 7 of the Corporations Act 2001. 10

11

National Australia Bank Ltd v Norman [2009] FCAFC 152 at [185] per Gilmour J.

See http://www.asx.com.au under the tab products/managed funds (accessed 26 April 2016).

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How to register [6.80] To register a managed investment scheme, s 601EA requires lodgment of an application with ASIC. The application should state and be in accordance with the following: • the name and the address of the registered office of the proposed responsible entity; • the name and address of a person who has consented to be the auditor of the compliance plan; and

• the applicant must have the auditor’s consent when the application is lodged. After the scheme is registered, the applicant must give the consent to the responsible entity. The responsible entity must keep the consent.

The following must be lodged with the application (s 601EA(4)): • a copy of the scheme’s constitution; • a copy of the scheme’s compliance plan signed by the directors of the responsible entity as required by s 601HC; and

• a statement signed by the directors of the proposed responsible entity that the scheme’s constitution complies with ss 601GA and 601GB and the scheme’s compliance plan complies with s 601HA.

Within 14 days of lodgment of the application, ASIC must register the scheme unless it appears to ASIC that (s 601EB(1)): • the application does not comply with s 601EA; or • the proposed responsible entity does not meet the requirements of s 601FA; or • the scheme’s constitution does not meet the requirements of ss 601GA and 601GB; or • the scheme’s compliance plan does not meet the requirements of s 601HA; or • the copy of the compliance plan lodged with the application is not signed as required by s 601HC; or

• arrangements are not in place that will satisfy the requirements of s 601HG in relation to audit of compliance with the plan.

If ASIC registers the scheme, ASIC must give it an Australian Registered Scheme Number (ARSN) (s 601EB(2)) and must keep a record of the registration of the scheme: s 601EB(3).

RESPONSIBLE ENTITY [6.90] The responsible entity (RE) operates the scheme, is liable for any loss or damage resulting from contravention of Ch 5C and holds the scheme property on trust. The RE of a registered scheme must be a public company that holds an Australian financial services licence, authorising it to operate a managed investment scheme: s 601FA. The licence will authorise the RE to operate a scheme of a particular category, eg real property, which includes property trusts and syndicates and serviced strata schemes, financial assets such as shares and bonds, derivatives, primary production schemes and time-sharing schemes. There is no exemption from this licensing requirement under Ch 7 if the financial [6.90] 129

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service involves the operation of a managed investment scheme. The RE must have available adequate resources (including financial, technological and human resources) to provide the financial services covered by the licence and to carry out supervisory arrangements: s 912A(1)(d). In the case of One RE Services Ltd v Australian Securities and Investments Commission [2012] AATA 294; (2012) 30 ACLC 12-021, the AAT considered ASIC’s decision to refuse a licence application for authority to manage schemes of a particular “kind”, that is, not limited to a single named scheme, but instead to operate multiple schemes without further approval from ASIC. The reason for ASIC’s refusal was that ASIC was not satisfied that the newly-created company had the necessary level of organisational competence and capacity to comply with s 912A. The AAT upheld ASIC’s decision, given that the responsible entity was relatively small, staffed primarily by its two directors, and had limited relevant prior experience managing active schemes. Section 601FB provides that the RE of a registered scheme is to operate the scheme and perform the functions conferred on it by the scheme’s constitution and the Corporations Act 2001. The RE can appoint an agent or engage a person to do anything the RE is authorised to do in connection with the managed investment scheme. However, in determining whether there is liability to investors or that the RE has properly performed its duties, the RE is taken to have done (or failed to do) anything that the agent or person has done (or failed to do) because of the appointment or engagement. This is so even if the agent or other person were acting fraudulently or outside the scope of their authority or engagement: s 601FB(2). It should be noted that a scheme’s constitution may provide for the RE to be indemnified for liabilities, but s 601GA(2) requires that a right of indemnity must be specified in the scheme’s constitution and is to be available only where the RE properly performs its duties. Where the RE appoints a custodian to hold scheme property on its behalf, as is commonly the case, and the agent is liable to indemnify the RE against any loss or damage that the RE suffers as a result of a wrongful or negligent act or omission of the agent and relates to a failure by the RE to perform its duties in relation to the scheme, any amount recovered under that indemnity forms part of the scheme property: s 601FB(4).

Statutory duties of the responsible entity [6.100] The statutory duties of the RE arise primarily out of the requirement that it operate the scheme and hold scheme property on trust for the scheme members. The obligations of the RE are in part similar to the fiduciary duties owed by an adviser to an investor at common law and are contained in s 601FC of the Corporations Act 2001. Section 601FC provides that, in exercising its powers and carrying out its duties, the RE of a registered scheme must (s 601FC(1)): 130 [6.100]

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• act honestly; • exercise the degree of care and diligence that a reasonable person would exercise if they were in the RE’s position;

• act in the best interests of the members and, if there is a conflict between the members’ interests and its own interests, give priority to the members’ interests;

• treat the members who hold interests of the same class equally and members who hold interests of different classes fairly;

• not make use of information acquired through being the responsible entity in order to gain an improper advantage for itself or another person or cause detriment to the members of the scheme;

• ensure that the scheme’s constitution meets the requirements of s 601GA (contents of the constitution) and s 601GB (legally enforceable constitution as between members and the RE);

• ensure that the scheme’s compliance plan meets the requirements of s 601HA (contents of the compliance plan);

• comply with the scheme’s compliance plan; • ensure that scheme property is clearly identified as scheme property and held separately from property of the responsible entity and property of any other scheme;

• ensure that the scheme property is valued at regular intervals appropriate to the nature of the property;

• ensure that all payments out of the scheme property are made in accordance with the scheme’s constitution and the Corporations Act 2001;

• report to ASIC any breach of the Corporations Act 2001 that relates to the scheme and has had, or is likely to have, a materially adverse effect on the interests of members, as soon as practicable after it becomes aware of the breach; and

• carry out or comply with any other duty, not inconsistent with the Corporations Act 2001, that is conferred on the responsible entity by the scheme’s constitution.

The officers and employees of the RE have similar duties placed on them under ss 601FD and 601FE, respectively. Officers of the RE have a statutory non-delegable duty placed on them to take all steps that a reasonable person would take, if they were in the officer’s position, to ensure compliance of the RE with (s 601FD(1)): • the Corporations Act 2001; • any conditions imposed on the responsible entity’s Australian financial services licence; and

• the scheme’s constitution and compliance plan. A RE who contravenes the above duties, and any person who is involved in a RE’s contravention of the s 601FC(1) duties, is subject to the civil penalty provisions of the Corporations Act 2001 (s 601FC(5)), while s 601FC(6) provides that a person must not intentionally or recklessly be involved in a RE’s breach of its duties. A recent example of ASIC enforcing these statutory duties can be found in the action it has commenced against Octaviar Ltd: [6.100] 131

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ASIC has commenced civil proceedings in the Supreme Court of Queensland against three subsidiary companies of the formerly listed MFS Ltd (now known as Octaviar Ltd (in Liquidation) and four former officers and one manager of MFS Investment Management Ltd. The proceedings relate to the use of $147.5 million in funds of the Premium Income Fund (PIF), for which MFS Investment Management Ltd (“MFSIM”, now known as Management Investments Ltd) was the responsible entity at the relevant time. In taking this action, ASIC is addressing the core obligations of a responsible entity and its directors and officers to operate the fund with care and diligence, and in the best interest of the fund’s members. 12

Scheme property [6.110] The RE holds scheme property on trust for scheme members: s 601FC(2). Normally, however, a third party custodian is appointed by the RE as agent to hold scheme property separately from other property. Regulatory Guide 133 covers scheme property arrangements in managed investment schemes. The introduction to RG 133 states: Underlying principles RG 133.4 The Law highlights the importance which is placed on the arrangements that the responsible entity will put in place to ensure proper standards for the safe keeping of scheme property. We believe that members’ interests will be better protected if the scheme property is held only by entities which meet minimum standards.

The RE may only invest scheme property, or keep scheme property invested in another managed investment scheme if that other scheme is registered under Ch 5C: s 601FC(4). In Australian Securities and Investments Commission v Wellington Capital Limited [2013] FCAFC 52, the full Federal Court considered s 601FC(2) in the context of the responsible entity of a managed investment scheme transferring scheme assets to an unlisted public company in return for share capital in that company, then distributing those shares to members of the scheme in proportion to the value of their investment in the scheme. (The issue arose in court as ASIC objected to the transferring, arguing that the transfer – which occurred without the consent of scheme members – was contrary to the obligation of trust set out in s 601FC(2)). The full Federal court held that the principles of trust law applied, and would limit the powers given to a responsible entity under the scheme constitution. The Federal Court held that neither the scheme constitution, nor s 124 (which lists a wide range of powers of companies), entitled the responsible entity to distribute scheme property directly to the scheme members. This decision was upheld by the High Court. 13 12

13

See http://www.asx.com.au, under the tab Publications/09-214AD ASIC commences civil proceedings against former officers of MFS Group 2 November 2009. Also referred to in “Responding to the global financial crisis: the ASIC story” a speech by Tony D’Aloisio, Chairman, Australian Securities and Investments Commission, Trans-Tasman Business Circle, 30 November 2010. See Wellington Capital Ltd v Australian Securities and Investments Commission [2014] HCA 43.

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If the responsible entity changes, the rights, obligations and liabilities of the former responsible entity in relation to the scheme become the rights, obligations and liabilities of the new responsible entity: s 601FS(1). This provision was tested in the case of Willmott Forests Ltd (in liq) v Primary Securities Ltd (2013) 31 ACLC 13-068. That scheme involved investors contributing money to the scheme, which was then used by the responsible entity to purchase land, then to lease that land back to the investors for 25 years for the purpose of growing the investors’ timber on that land leased to them by the responsible entity. The former responsible entity claimed that the land itself was owned by the responsible entity and did not constitute scheme property and therefore did not need to transfer the land to the new responsible entity. The Supreme Court of Victoria held that in this case, according to scheme documents including leases of the land, the title to the land itself did not form part of scheme property. The scheme’s members had the rights to use the land during the life of the scheme, but the title to the land did not fall within scheme property. In deciding this, the court relied on the fact that the lease documents were entered into by the company in its own personal capacity, not in its capacity as responsible entity of the scheme. In contrast, in Re Gunns Finance Limited (in liq) (recs & mgrs apptd) (No 2) [2013] VSC 365; (2013) 281 FLR 121, another case involving “woodlot” schemes whereby the investors entered into leases with the responsible entity, allowing the investors to grow forests on that land. The responsible entity, Gunns Plantations Limited (GPL), was entitled to receive fees from growers’ sales of wood grown on land covered by the leases, and had loaned funds to growers, secured by their investment in the scheme. The scheme became insolvent, and a restructure proposal which would reduce or eliminate certain leases, was opposed by the receivers. The Supreme Court of Victoria held that the s 9 definition of “scheme property” included non-monetary contributions of “money’s worth” and that this included the contribution of rights over property, and thus GPL’s contribution of rights over leasehold to the scheme, formed part of scheme property and thus were held on trust by GPL for the benefit of scheme members and the new responsible entity would inherit this obligation, and the new entity could not escape the obligations to pay future rents on scheme leases. The documentation about the proposal provided to members was accordingly misleading.

Responsible entities and product disclosure statements [6.114] Managed investment schemes are financial products under s 763B of the Corporations Act 2001 14 and therefore PDSs are required by Pt 7.9 of the Corporations Act 2001. Details of disclosure documents are set out in RG 168. 15 Following growing concern in recent years about the information contained in 14 15

Note the discussion of financial products at [11.270]. Available at: http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-168disclosure-product-disclosure-statements-and-other-disclosure-obligations (accessed 7 May 2016). [6.114] 133

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some PDSs used by managed investment schemes, which was also reflected in a number of collapses, ASIC issued a regulatory guide geared specifically towards the sector: Regulatory Guide 232 Agribusiness Managed Investment Schemes. 16

Simple managed investment schemes and product disclosure statements [6.117] Recent amendments to the Corporations Regulations 2001 (Cth) 17 require shorter and simpler PDSs for simple managed investment schemes. A simple managed investment scheme is one that invests at least 80% of their assets in an account or a deposit with a bank where the money is able to be withdrawn immediately during the bank’s normal business hours, or at the end of a fixed period that is no longer than three months, or under one or more arrangements by which the responsible entity can reasonably expect to realise the investment within 10 days at market value. The new regulations do not apply to registered managed investment schemes that are or are intended to be quoted on a financial market; are part of a stapled security; are property, mortgage or agricultural schemes; or are platforms. These PDSs must: • be a maximum page length of eight pages (for superannuation and managed investment scheme PDSs) and four pages (for margin loan PDSs);

• be a prescribed minimum font size; • have prescribed section headings to make it easier for consumers to find important information in the PDS and compare across products, and key content requirements, to ensure that consumers are provided with the key information they need to make an investment decision;

• have provision for other material to be located outside the PDS document itself, but form part of the PDS through incorporation by reference; and

• have provision for inclusion of additional information within the PDS, provided the prescribed length is not exceeded. 18

SCHEME CONSTITUTION [6.120] The scheme constitution determines the relationship between the RE (product issuer) and the member/investor. Under the previous prescribed interests regime, trust deeds or syndicate deeds contractually bound the manager, trustee and investors in the scheme and, given the nature of the previous governing documents, it would be expected that most scheme constitutions would not diverge much from a trust deed format. To be registered, a managed investment scheme must have a constitution (s 601EA(4)) and the 16 17 18

Available at: http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-232agribusiness-managed-investment-schemes-improving-disclosure-for-retail-investors (accessed 7 May 2016). Corporations Amendment Regulations 2010 (No 5) (Cth). Corporations Regulations 2001 (Cth) Sch 10E.

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constitution of a registered scheme must be contained in a document that is legally enforceable as between the members and the RE: s 601GB.

Contents of the constitution [6.130] The constitution of a registered scheme must make adequate provision for (s 601GA(1)): • the consideration that is to be paid to acquire an interest in the scheme; • the powers of the responsible entity in relation to making investments of, or otherwise dealing with, scheme property;

• the method by which complaints made by members in relation to the scheme are to be dealt with; and

• winding up the scheme. If the RE is to have any rights to be paid fees out of scheme property, or to be indemnified out of scheme property for liabilities or expenses incurred in relation to the performance of its duties, those rights (s 601GA(2)): (a)

must be specified in the scheme’s constitution; and

(b) must be available only in relation to the proper performance of those duties; and any other agreement or arrangement has no effect to the extent that it purports to confer such a right.

If the RE is to have any powers to borrow or raise money for the purposes of the scheme, those powers must be specified in the scheme’s constitution. Any other agreement or arrangement has no effect to the extent that it purports to confer such a power: s 601GA(3). Regulatory Guide 134, Managed investments: Constitutions, provides further guidance on the contents of scheme constitutions: [134.8] We cannot register a scheme if its constitution does not appear to meet ss 601GA and 601GB. … [U]nder ss 601GA and 601GB a constitution must: (a)

adequately cover some specified matters which are important to the relationship between the members and the responsible entity; and

(b)

be a document which is legally enforceable between the members and the responsible entity.

Regulatory Guide 134 further states: [134.14] … A constitution must deal adequately with key matters set out at ss 601GA and 601GB governing your rights and obligations as well as those of the members. These are: (a)

the consideration to acquire interests in the scheme;

(b)

investment and borrowing powers of the responsible entity;

(c)

member complaints handling;

(d)

winding up the scheme;

(e)

your rights to be paid or indemnified from the scheme property; and

(f)

the withdrawal rights of the members and the exit price for interests in the scheme. [6.130] 135

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The constitution of a registered scheme can be changed by special resolution of the members of the scheme or by the RE if the RE reasonably considers the change will not adversely affect members’ rights: s 601GC(1). One recent case which considers this issue is Re Elders Forestry Management Ltd (2012) 30 ACLC 12-032, [2012] VSC 287. This scheme involved forestry growing interests, and was suffering from the financial difficulties common across the forestry industry. It was not yet insolvent, due to funding from its parent company, but this was not likely to continue and other funding sources were not available. To solve the problem, the responsible entity, proposed extinguishing certain member rights to mature forest leaseholds through amendments to its constitution, selling some scheme property and distributing net proceeds to members, and applied to the court for judicial approval. Before making this proposal, the responsible entity had sought independent expert advice as to whether it was in the best interests of growers (and the expert concluded, with one exception, it was) as well as independent legal advice as to whether the effect on member rights would be adverse (and the lawyers concluded the effect would not be adverse). The lawyers made this conclusion on the basis that the members affected held interests in projects that were soon due to be harvested, and the effect of the proposals was that they would receive more money than they would otherwise receive after harvesting, and would receive it sooner. The court agreed, allowing the responsible entity to make these changes without putting them to a vote of growers. (The responsible entity put the proposed relinquishment of immature forests (which were not soon due for harvest) to a members’ vote). Another case which considers the status of the scheme constitution, is 360 Capital Re Ltd v Watts (2012) 30 ACLC 12-051, [2012] VSCA 234, where the Victorian Court of Appeal held that a member’s rights to have a managed fund managed and administered in accordance with its constitution were “members’ rights” within the meaning of s 601GC(1)(b) and were actually the most important right of membership as, without it, all other membership rights would be at the responsible entity’s whim. In this case, the board did not act unreasonably, but they were incorrect, and the court had jurisdiction to examine the board’s decision.

COMPLIANCE PLAN [6.140] A major feature of the managed investments legislation is the requirement for a formal compliance plan and the implementation of a compliance monitoring system. The compliance plan of a registered scheme must set out adequate measures that the RE is to apply in operating the scheme to ensure compliance with the Corporations Act 2001 and the scheme’s constitution: s 601HA(1). The RE must ensure the scheme’s compliance plan meets the minimum requirements of s 601HA (s 601FC(1)(g)) and is in accordance with the compliance plan: s 601FC(1)(h). 136 [6.140]

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Regulatory Guide 132, Managed investments: Compliance plans, provides guidance on how to prepare a compliance plan for a managed investment scheme.

Contents of the compliance plan [6.150] The compliance plan must include the arrangements for (s 601HA(1)): • ensuring that all scheme property is clearly identified as scheme property and held separately from property of the RE and property of any other scheme as required by s 601FC(1)(i);

• in circumstances where the scheme is required to have a compliance committee, ensuring that the compliance committee functions properly;

• ensuring that the scheme property is valued at regular intervals appropriate to the nature of the property;

• ensuring that compliance with the plan is audited as required by s 601HG; • ensuring adequate records of the scheme’s operations are kept; and • any other matter prescribed by the regulations. The RE may change the compliance plan or ASIC may direct it to modify the compliance plan to ensure it is consistent with s 601HA: s 601HE.

Audit of compliance plan [6.160] The RE of a registered scheme must ensure at all times that a registered company auditor is engaged to audit compliance with the scheme’s compliance plan: s 601HG(1). The function of the compliance plan auditor is set out in s 601HG(3). The auditor of the compliance plan must notify ASIC as soon as possible if the auditor has reasonable grounds to suspect that a contravention of the Corporations Act 2001 has occurred and the auditor believes that the contravention has not been or will not be adequately dealt with by commenting on it in the s 601HG(3) auditor’s report given to the RE or bringing it the attention of the RE: s 601HG(4).

COMPLIANCE COMMITTEE [6.170] The RE of a registered scheme must establish a compliance committee if less than half of its directors are external directors who are independent: s 601JA(1). A scheme’s compliance committee must have at least three members, and a majority of them must be independent external members: s 601JB(1). The functions of a scheme’s compliance committee are to (s 601JC(1)): • monitor to what extent the RE complies with the scheme’s compliance plan and to report on its findings to the RE;

• report to the RE any breach of the Corporations Act 2001 involving the scheme; or any breach of the provisions included in the scheme’s constitution in accordance with s 601GA of which the committee becomes aware or that it suspects;

• report to ASIC if the committee is of the view that the RE has not taken, or does not propose to take, appropriate action to deal with a matter reported to it as above; [6.170] 137

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• assess at regular intervals whether the compliance plan is adequate; and • report to the RE on the assessment and to make recommendations to the RE about any changes that it considers should be made to the plan.

In carrying out its functions, the compliance committee may commission independent legal, accounting or other professional advice or assistance, at the reasonable expense of the RE: s 601JC(2). A member of a scheme’s compliance committee must (s 601JD(1)): • act honestly; • exercise the degree of care and diligence that a reasonable person would exercise if they were in the member’s position;

• not make use of information acquired through being a member of the committee in order to gain an improper advantage for the member or another person; or cause detriment to the members of the scheme;

• not make improper use of their position as a member of the committee to gain, directly or indirectly, an advantage for themselves or for any other person or to cause detriment to the members of the scheme.

Under s 601FF, ASIC may from time to time perform surveillance checks to determine whether the RE is complying with the scheme’s constitution and compliance plan and the Corporations Act 2001. The RE and its officers and members of the compliance committee, pursuant to ss 601FF(2) and 601JD(2) respectively, must take all reasonable steps to assist ASIC in carrying out surveillance checks. A person who contravenes, or is involved in a contravention of, the above duties, is subject to the civil penalty provisions of the Corporations Act 2001: s 601JD(3). Section 601JD(4) provides that a person must not intentionally or recklessly contravene or be involved in a compliance committee member’s breach of its duties.

PROTECTION OF SCHEME MEMBERS [6.180] The scheme constitution and the legislative provisions governing the duties of the RE are the main sources of protection for investors in managed investment schemes. While scheme members do not have day-to-day control over the operation of the scheme, members, unlike shareholders in companies, can directly enforce the fiduciary obligations imposed on the RE as trustee and operator of the scheme.

Civil liability of responsible entity to members [6.185] Section 601MA, which provides for the civil liability of the RE to members, and s 601MB, which covers voidable contracts where subscription offers and invitations contravene the Corporations Act 2001, are important investor protection provisions. Section 601MA gives individual investors a statutory right of action against the RE. This is so whether or not the RE has been convicted of an offence, or has had a civil penalty order made against it in 138 [6.180]

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respect of the contravention. This emphasises the concept of a single RE but is of little comfort to investors if the RE is ultimately insolvent. Chapter 5C does not provide an avenue by which compensation may be awarded to a person who suffers loss or damage by reason of a breach by an officer of one of the duties imposed on him by s 601FD. A member’s ability to act against other persons involved in the operation of the scheme, such as directors, compliance committee members or any third party custodian of the scheme property, arises out of the general law or s 1325. Section 1325 allows a court to impose liability upon any person involved in a contravention of Ch 5C or of the Pt 7.9 disclosure provisions. 19 Action against the RE is subject to a six-year limitation period: s 601MB(2). The liability that a person has under other provisions of the Corporations Act 2001 or other laws is unaffected by s 601MA: s 601MA(3).

Voidable contracts [6.210] A contract entered into by an investor to subscribe in a managed investment scheme where the scheme is being operated in contravention of s 601ED(5) or the Pt 7.9 product disclosure requirements, when offering an interest in a registered scheme, is voidable at the option of the investor: s 601MB. The significance of this provision is illustrated in Amadio Pty Ltd v Henderson, 20 a Full Federal Court decision involving property syndication interests. The conclusion that the arrangements came within the, then prescribed, interest provisions (and hence necessarily within the managed investment scheme definition) caused third party securities and a re-conveyance of the underlying proprietary interests. In the face of Amadio Pty Ltd threatening to foreclose on the mortgage and sue for damages, a number of the purchasers and guarantors commenced proceedings in the Federal Court against Amadio Pty Ltd and the firm of solicitors promoting the scheme. The main claim against Amadio was for a declaration that the scheme contravened the then prescribed interest provisions of the Companies (Victoria) Code. At first instance, it was held by Heerey J that the sale of the Coles Myer building by Amadio, coupled with the mortgage back to Amadio and the associated guarantees, contravened the prescribed interest provisions of the Companies Code (equivalent managed investment scheme). 21 The Full Federal Court (Northrop, Ryan and Merkel JJ) said: Thus, where separate interests in an investment are to be held by individuals and there are to be separate benefits and obligations on the part of the holder of each interest the separate and discrete interest offered to the participants may not be a prescribed interest. However, where investors hold title to an asset with no separate or discrete interest which they could use or employ for their own benefit and will 19 20 21

See Mercedes Holdings Pty Limited v Waters (No 2) [2010] FCA 472 at [48], [49] where Perram J said that Pt 9.4B, s 1325(2) might provide an avenue of action against officers of the managed investment scheme. Amadio Pty Ltd v Henderson (1998) 81 FCR 149. Henderson v Amadio Pty Ltd (No 1) (1995) 62 FCR 1 at 217.

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be obliged to use and mortgage their interest in common with the other investors if they wish to make a profit from it, the interest held is more likely to have the requisite interaction of rights, benefits and obligations and therefore constitute a prescribed interest …

The court found (at 183–184) that the facts fell into the latter category above because of the interdependency found between the investors: • the offer to the investors was of an interest in a partnership; • the interest “offered” involved use by the partnership of the co-owned property

interests in common for profit and also to obtain and secure the principal sum for which the partners were jointly and severally liable with rights of contribution as between all of the parties ie partners, sub-partners and guarantors and their respective interests; • each partner or sub-partner was not free to deal with his, her or its interest

which was encumbered by that partner’s obligations as a partner and the inter-related rights of contribution (and where applicable, of subrogation) of all other persons directly or indirectly liable for the whole of the principal sum and interest; • the interest was offered on the basis that investors who accepted the offer would

do so as the partners of the Coles Myer partnership and not as persons who were to hold separate or discrete and unrelated interests solely as tenants in common; and • accordingly, the partners’ respective interests in the building were to be held

subject to the obligations of the co-owners as partners and not separately or solely for the benefit or at the will or direction of the co-owners.

As the prescribed interest provisions were contravened, ie there was no prospectus as required, the appeal of Hudson Conway Ltd and Amadio Pty Ltd was dismissed in relation to this matter. The contract of sale, mortgage and associated guarantees, as transactions entered into by Amadio and the investors, as a consequence of the contravention were unenforceable. This decision has relevance to the effect of s 601MB of the Corporations Act 2001, which is discussed at [6.185].

Members' rights to withdraw from a scheme [6.310] The members of a registered managed investment scheme do not have an automatic right to “withdraw” from the scheme. If this right is to exist it must be written into the constitution: s 601GA(4). However, this does not prevent the investor transferring their interest to another party. If the managed investment scheme is listed on the ASX, then the units are sold at market price to other investors. Investors may have the right to withdraw in the scheme constitution, but there is no obligation for schemes to offer investors a buy-back facility. Withdrawal rights, if any, depend on the liquidity of the scheme. In the late 1980s and early 1990s a downturn in the Australian real estate market resulted in the inability of a number of unlisted property trusts, most notably Estate Mortgage, to meet their buy-back obligations under the trust deed covenants. This resulted in a loss in investor confidence and a run on funds. The 140 [6.310]

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outcome, given the nature of the underlying assets, was insufficient liquidity to meet calls on the fund. This problem does not arise in the case of unit trusts involving liquid investments. Under Ch 5C there may be a right to withdraw from schemes that are liquid but there are limits to buy-backs in the case of illiquid schemes. A scheme is liquid if liquid assets account for at least 80% of the value of scheme property: s 601KA. Liquid assets include money in an account or on deposit with a bank, bank accepted bills, marketable securities and any other property that the RE reasonably expects can be realised for its market value within the period specified in the constitution for satisfying withdrawal while the scheme is liquid: s 601KA(5) and (6). This definition of “liquid” is likely to exclude property and infrastructure managed investments which are therefore classed as non-liquid and must comply with the provisions of Ch 5C relating to buy-backs in non-liquid schemes. In these circumstances, all members are required to be given notice of a withdrawal offer, which must remain open for 21 days. This contrasts with on market share trades. Thus the withdrawal procedures under Pt 5C.6 depend on the distinction between liquid and non-liquid schemes. The right to withdraw, and any provisions in the constitution setting out procedures for making and dealing with withdrawal requests, must be fair to all members: s 601GA(4).

Withdrawal from non-liquid schemes [6.320] The provisions relating to non-liquid schemes aim to prevent liquidity pressures on schemes while protecting investors’ interests. In the case of non-liquid schemes, the constitution may make provision for withdrawal in accordance with the constitution and ss 601KB – 601KE: s 601KA(3)(b). Scheme members cannot withdraw on request – they must receive a withdrawal offer from the RE: s 601KB(1). The opportunity to withdraw from the scheme is only to the extent that particular assets are available and can be converted to money in time to satisfy withdrawal requests that members may make in response to the offer. The withdrawal offer must be in writing and be made in accordance with any procedures specified in the constitution or, if no procedures are specified, by giving a copy of the offer to all members of the scheme or to all members of a particular class: s 601KB(2). The offer must specify (s 601KB(3)): • the period during which the offer will remain open (this period must last for at least 21 days after the offer is made);

• the assets that will be used to satisfy withdrawal requests; • the amount of money that is expected to be available when those assets are converted to money; and

• the method for dealing with withdrawal requests if the money available is insufficient to satisfy all requests. This method must comply with s 601KD, which provides a statutory formula for calculating how payments are to be made in these circumstances. [6.320] 141

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The RE must lodge a copy of the offer with ASIC as soon as practicable after making the withdrawal offer: s 601KB(5). Only one withdrawal offer may be open at any time in relation to a particular interest in a registered scheme that is not liquid: s 601KC. Section 601KD states how payments are to be made to withdrawing members: • The responsible entity of a registered scheme that is not liquid must ensure that withdrawal requests made in response to a withdrawal offer are satisfied within 21 days after the offer closes.

• No request made under the withdrawal offer may be satisfied while the offer is still open.

• If an insufficient amount of money is available from the assets specified in the offer to satisfy all requests, the requests are to be satisfied proportionately in accordance with the formula: Amount of money available (A) x Amount member requested to withdraw (B)/Total of all amounts members request to withdraw (C) eg, A x B/C

The RE may cancel a withdrawal offer before it closes if the offer contains a material error and must cancel the offer before it closes if it is in the best interests of members to do so: s 601KE. Notice of the cancellation must be in accordance with any procedures specified in the constitution or otherwise by notice to the members to whom the offer was made (s 601KE(2)) and written notice of the cancellation must be lodged with ASIC: s 601KE(3). The inflexibility of the laws on buy-backs of listed non-liquid schemes resulted in a Class Order (CO 07/422) the purpose of which is to allow the responsible entity of a registered scheme listed on the ASX, that has no more than one class of interests, to carry out on-market buy-backs of interests on a similar basis as applies to buy-backs of shares in companies listed on the ASX. This Class Order modifies ss 601GA(4) and 606 for on-market buybacks of interests to allow the buy-back to be operated without contravening the Corporations Act 2001. The relief is available when all of the following requirements are satisfied: (a)

the scheme’s constitution gives the responsible entity power to buy-back interests in the scheme;

(b)

the buy-back does not materially prejudice the responsible entity’s ability to pay its creditors in relation to liabilities incurred by it as responsible entity of the scheme;

(c)

the buy-back is carried out in the ordinary course of trading on the financial markets of the ASX and not by way of a special crossing or priority crossing;

(d)

the responsible entity complies with the ASX Listing Rules (ASXLRs) in relation to the buy-back as if the scheme were a company listed on the ASX (including ASXLR 7.33 which requires that the buy-back price is not more than 5% above the average of the market price for interests);

(e)

the responsible entity does not dispose of the interests it buys-back;

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(f)

immediately after registration of the transfer to the responsible entity of interests bought-back, the interests are cancelled.

(g)

member approval is obtained where the buy-back exceeds the “10/12 limit”;

(h)

a buy-back within the “10/12 limit” is disclosed to the ASX; and

(i)

any discretions in relation to the setting of the buy-back price are exercised reasonably, and the exercise of any discretions is documented.

The “10/12 limit” for a responsible entity of a registered scheme proposing to make a buy-back is 10% of the smallest number, at any time during the last 12 months, of interests in the scheme. One relevant recent case in this regard, is the recent High Court decision MacarthurCook Fund Management Ltd v TFML Ltd 22. RFML Limited (RFML) was the responsible entity of a registered managed investment scheme. MCFM held units in the scheme, issued under agreements that required RFML to redeem the units out of proceeds of public offers and if this did not occur by specified dates, to personally purchase the units back from MCFM. The constitution did not provide for these rights, and indeed stated that members had no right to withdraw other than in accordance with specified procedures which were in line with the Corporations Act’s prohibitions on withdrawals in liquid schemes. This included s 601KA(3)(b), that a responsible entity must not allow a member to withdraw from a scheme if the scheme was not liquid otherwise than in accordance with the scheme’s constitution and ss 601KB – 601KE. The constitution also gave RFML the power to indefinitely suspend member withdrawals, which it did prior to redeeming MCFM’s units, which caused the scheme to become not liquid as defined in s 601KA(4). MCFM sued RFML and its replacement responsible entity, TFML, for breach of contract in failing to redeem the units. On appeal to the Court of Appeal, the court held that because the agreements at the time of issue had been subject to the constitution, and because the constitution required the responsible entity to comply with the Corporations Act, which did not permit redemption of these units in an illiquid scheme in these circumstances, the responsible entity had not breached those agreements. 23 On a further appeal to the High Court, MCFM argued that s 601KA(3)(b) did not apply to redemption of units – in other words, that redemption of units under the terms of their issue, was not “withdrawal” from the scheme for the purposes of Pt 5C.6. The High Court agreed, concluding that the meaning of “withdraw” for the purpose of Pt 5C.6, in combination with s 601GA(4), included the idea that there was some act of choice or volition on the part of the member, and was not limited to rights which had a correlative obligation. The meaning of “withdraw” from a scheme for this purpose would be if the member acted so as to result in the responsible entity returning the whole or some part of the member’s 22

23

MacarthurCook Fund Management Ltd v TFML Ltd (2014) 32 ACLC 14-023, [2014] HCA 17, 14 May 2014.

TFML Ltd v MacarthurCook Fund Management Ltd (2013) 31 ACLC 13-046.

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contribution. The responsible entity exercising a mandatory power to compulsorily redeem a member’s interest, whether under the constitution or the terms of issue, would not constitute withdrawal by the member, due to the lack of volition by the member.

Winding up and deregistration [6.330] The winding up of a registered scheme is dealt with in ss 601NA – 601ND. Generally, a managed investment scheme can only be wound up: • in accordance with conditions detailed in its constitution: s 601NA; • at the direction of its members: s 601NB; • where the scheme’s purpose is accomplished or cannot be accomplished: s 601NC; or • by order of a court: s 601ND. A registered scheme can only be deregistered when (s 601PA): • the scheme has 20 or less members, all the members agree to the deregistration of the scheme, and there is no other requirement for the scheme to remain registered;

• all the issues of interests in the scheme were excluded issues (ie a PDS was not required) and all the members agree to the deregistration of the scheme; or

• the scheme ceases to be a managed investment scheme.

MANAGED INVESTMENT INDUSTRY Managed funds industry [6.340] Small investors are attracted to the concept of investing money in a vehicle whereby professional fund managers invest on their behalf. Managed funds structured as unit trusts are the traditional non-corporate collective investment vehicle. The terms “managed fund”, “mutual fund”, “collective investment vehicle”, “pooled investment fund” and “pooled investment vehicle” are used interchangeably. All describe the aggregation of the consideration provided by individual investors into a pool that is managed by a fund manager for the purpose of generating financial returns for the investors. 24 As noted by Ali: 25 … managed funds, despite their disparate legal structures, all share two key attributes: • the investor has provided cash or in specie consideration (typically, securities) to

a fund manager which has undertaken to use that consideration to generate financial returns for the benefit of the investor • the investment assets purchased with that consideration are registered in the

name of a party other than the fund manager. 24 25

P Ali, G Stapledon and M Gold, Corporate Governance and Investment Fiduciaries (Lawbook Co, Sydney, 2003) p 11. P Ali, G Stapledon and M Gold, Corporate Governance and Investment Fiduciaries (Lawbook Co, Sydney, 2003) p 7, n 4.

144 [6.330]

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The following discussion considers serviced strata schemes, contributory mortgages and investor-directed portfolio services by reference to the relevant Regulatory Guides.

Serviced strata schemes [6.350] Operators of serviced strata schemes must comply with the managed investment and financial services provisions of the Corporations Act 2001. It is considered by ASIC that there is likely to be a serviced strata scheme when an investor’s right to a return depends (totally or partially) on either or both of the following two factors: • the use of other investors’ strata units; or • the use of their strata unit as part of a hotel, motel, resort or serviced apartment complex.

An investor who has an understanding with a promoter that they will receive the return is treated as having a right to that return: RG 140.4. The concept of interdependency between investors is an important aspect of a managed investment scheme. In the case of serviced strata schemes, the investor’s return may depend on an arrangement for pooling income or for fairly allocating tenants: RG 140.16. Again, ASIC considers there is likely to be a serviced strata scheme when an investor in a strata unit has a right (including by agreement or an understanding with the promoter) to a return which depends, in whole or in part, on an investor’s strata unit being used as part of a serviced strata arrangement. For example, the investor depends on the serviced strata arrangement to receive some kind of fixed or indexed return: RG 140.17. A serviced strata arrangement is likely to be a managed investment scheme even if one of the situations discussed above exists only after some period during which investors derive returns in some other way – such as fixed or indexed rent paid regardless of the success of the operation of a serviced strata arrangement: RG 140.18. A serviced strata scheme may exist although the interests in the scheme are sold as part of a pre-packaged resale of interests, eg where interests initially issued to a promoter or its associate are resold: RG 140.19. The pooling of amounts payable by investors to a body corporate of a strata title property relating to the use of common property, or under the by-laws of the strata title property, does not give rise to a managed investment scheme: RG 140.25. A serviced strata arrangement can be a managed investment scheme even though joining is voluntary for people who own units in a particular location. However, if joining the scheme is compulsory, this supports an inference that there is a common enterprise: RG 140.26. [6.350] 145

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Scheme property in serviced strata schemes [6.355] When the operator has a right to occupy the strata unit, the principal scheme property is the lease or licence. When the operator has the right as agent of the strata unit owner to enter leases or licences of the strata unit, the principal scheme property is generally that right. The investor retains the freehold, which is not scheme property: RG 140.20. The investor thus makes available rights to the strata unit as their contribution to acquire interests in the scheme. Managed investment schemes do not exist when there are ordinary sales of standard, completed strata units or “off-the-plan” sales. These are sales when the only money paid by the investor before settlement and possession of the completed strata unit is a deposit that is held by a stakeholder: RG 140.23.

Indications and examples of serviced strata schemes [6.360] In RG 140.34, ASIC states that a serviced strata scheme is more likely to be found if one or more of the following applies: • the strata units are not suitable for use other than as part of a hotel, motel, resort or serviced apartment complex (including whether or not there are zoning restrictions on the use of the strata units);

• nothing is stated about what will happen at the end of a period during which returns do not depend on the use of the units. This is particularly important for short term fixed or indexed return arrangements of up to five years;

• there is any agreement with each investor that other investors make similar contracts; • there is pooling of expenses relating to the use of the strata units in a serviced strata arrangement;

• there is an understanding that the strata units will be used for short term tenancies, eg less than three months; or

• the investor places a strong reliance on the activities of the management for the generation of the investor’s return.

An example of a serviced strata arrangement that ASIC considers a managed investment scheme is a fixed or index return arrangement, provided in RG 140.38: (a)

a person (buyer) is invited to buy a strata unit from a developer and to lease the strata unit to another person (operator). The operator intends to operate a serviced apartment arrangement using the strata unit and other property;

(b)

the lease is for 5 years (renewable at the option of the operator for 3 further periods of 5 years). The rent is promised at 7% (CPI indexed) of the price paid for the strata unit;

(c)

the operator must ensure the strata unit is given back in good condition at the end of the lease;

(d)

the operator and the buyer understand that the operator has day to day operating control of the serviced apartment arrangement;

(e)

the buyer has the right to terminate the lease on 30 days notice;

(f)

the buyer is told that the operator is a substantial company;

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(g)

the buyer is told that the operator will operate a serviced apartment arrangement. However, the operator has no legally enforceable obligation to operate a serviced apartment arrangement;

(h)

the likelihood of the rent being paid in its entirety will be materially affected by whether the operator operates the serviced apartment arrangement profitably; and

(i)

buyers come to an explicit (or implicit) understanding with the developer (through sellers acting on behalf of the developer) that the serviced apartment arrangement will be operated so as to assist the operator in paying the rent.

A further example is provided in RG 140.41. This is a managed rights scheme commonly encountered in Queensland: (a)

a person (buyer) is invited to buy a strata unit from a developer. They are told that they can give an on-site letting agent the right to let, or licence use of, the strata unit;

(b)

the buyer is told that the on-site letting agent will operate a serviced apartment arrangement using the strata unit and other strata units made available in a similar manner. The buyer is also given to understand that they will not be involved in the day to day operation of the arrangement;

(c)

the buyer is told that what they are paid by the on-site letting agent will be based on the rent and licence fees received after the on-site letting agent deducts their costs and fees;

(d)

the buyer may live in their strata unit or use their own off-site letting agent. Therefore, joining the on-site letting agent’s serviced apartment arrangement is voluntary;

(e)

the buyer has a right to terminate participation in the serviced strata arrangement on 90 days notice;

(f)

buyers come to an explicit (or implicit) understanding with the on-site letting agent about how strata units will be allocated to visitors looking for accommodation. They agree that the operator will allocate units on the basis of what the visitors prefer. However, they also agree that this will be done, as far as possible, in a way that fairly allocates income between the owners of the strata units who join the arrangement.

Real estate agents, financial advice and managed investment schemes [6.370] Real estate agents who promote negatively-geared property investment packages are providing retail financial advice but not financial product advice to retail clients – see Chapter 8, “Common Law Framework for Market Participants” – and hence do not come within the licensing, conduct and disclosure requirements of Ch 7 of the Corporations Act 2001. It is considered by ASIC that persons who deal in, or give advice on, interests in serviced strata schemes should be subject to the same requirements as apply to persons who deal in, or give advice on, interests in other managed investment schemes: RG 140.115. Consequently, a real estate agent who sells an interest in a serviced strata scheme for the vendor of a strata unit must be appropriately licensed or authorised. This applies when a person who buys the strata unit [6.370] 147

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automatically becomes a member of the scheme, eg because the strata unit is subject to a lease in such a scheme. This requirement would not apply where the real estate agent does not issue interests in serviced strata schemes, induces buyers to become members of a scheme, or gives advice about interests in a scheme.

Mortgage investment schemes [6.380] The pooling of contributions of investors into lending under one mortgage, as in contributory or nominee mortgages, is a mortgage investment scheme and comes within the managed investments legislation. Regulatory Guide 144.10 26 notes the following factors are relevant in determining whether Ch 5C applies to mortgage arrangements: (a)

the extent to which the legal or commercial character of the investment depends on the business or operations of the promoter. For example:

(b)

if discrete interests in contributory mortgages are pooled and money contributed by different investors is lent under one mortgage. This strongly indicates the characteristics of a managed investment scheme (unless the money is jointly managed or invested for reasons other than investment in the mortgage scheme);

(ii)

if mortgages are taken in the name of a nominee for one investor. This is less clear-cut, but may indicate the characteristics of a managed investment scheme, if it is done to facilitate management or transfer the investor’s interest;

(iii)

if the availability of borrowers, securities or particular terms depends on the scale and continuity of the mortgage business. This may also indicate the characteristics of a managed investment scheme;

the extent to which commercial decisions are taken by the operator or the promoter of the scheme, and not by investors. For example:

(c) 26

(i)

(i)

if the operator or promoter routinely make investment decisions under general authority, or decide whether to extend loans or enforce securities, without referring decisions to investors. This strongly indicates the characteristics of a managed investment scheme (contributory mortgages are generally managed in this way, but not all nominee mortgages are);

(ii)

if the operator or promoter are responsible for obtaining, or determining valuations and approving lending against those valuations, or administering a repayment system. This suggests a managed investment scheme;

(iii)

conversely, if a solicitor documents a security and settles an advance under the instructions of a person who makes their own bargain. This does not give the transaction the characteristics of a managed investment scheme;

whether the scheme attracts s 601ED, that is, it must be registered. Available at: http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-144mortgage-investment-schemes (accessed 8 May 2016).

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Regulatory Guide 45 27 sets out eight benchmarks for unlisted mortgage schemes that can help retail investors understand the risks, assess the rewards being offered and decide whether these investments are suitable for them. Responsible entities of unlisted mortgage schemes in which retail investors invest should address the benchmarks in their disclosures on an “if not, why not” basis. These benchmarks are: 1.

Liquidity

2.

Scheme borrowing

3.

Portfolio diversification: the scheme’s lending practices and portfolio risk

4.

Related party transactions: addresses the risks associated with related party lending, investments and transactions

5.

Valuation policy

6.

Lending principles – loan-to-valuation ratios

7.

Distribution practices

8.

Withdrawal arrangements

ASIC has also set standards for advertising of all mortgage schemes (whether listed or unlisted) to retail investors. Those involved with mortgage schemes (eg compliance committees, compliance plan auditors and valuers) should use the benchmarks and the “if not, why not” explanations in carrying out their responsibilities. Regulatory Guide 45, Table 2 sets out the advertising standards for mortgage schemes: Area Repayment of principal investment

Returns on investment and investment ratings

27

Summary of standard To avoid common misconceptions about the risk profile of mortgage schemes, advertisements should include a prominent statement to the effect that investors risk losing some or all of their money. Advertisements should only quote returns if the return is accompanied by prominent disclosure that there is a risk that the investment may achieve lower than expected returns. Advertisements should only quote investment ratings if the rating is properly explained and does not create a misleading impression about the scheme. The advertisement should state that investment ratings are only one factor that investors should consider when deciding whether to invest.

Available at: http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-45mortgage-schemes-improving-disclosure-for-retail-investors (accessed 8 May 2016). [6.380] 149

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Area Comparisons with bank deposits and ‘risk-free’ suggestions

Withdrawal periods, withdrawal rights and investment periods Fees

Suitability statements Consistency with PDS disclosure Telephone inquiries

Summary of standard Advertisements should state that a mortgage scheme is not a bank deposit. They should not suggest that: • a mortgage scheme is, or compares favourably to, a bank deposit; or • there is little or no risk of the investor losing their principal or not being repaid. Advertisements that refer to withdrawal periods, withdrawal rights or investment periods should include details of any restrictions on withdrawals that might apply. Advertisements that state the amount of a fee (or that a type of fee is not payable) should include details of any circumstances in which a higher fee applies (or in which the fee is payable). Advertisements should not state or imply that the scheme is suitable for a particular class of investor. Statements in advertisements should be consistent with the corresponding disclosures on that subject matter in the PDS. Statements made in response to inquiries are subject to the same regulation about misleading and deceptive conduct as the advertisements.

Responsible entities may also choose to update disclosures against the benchmarks in other materials (eg monthly or quarterly fund updates). Regulatory Guide 45 also sets out advertising standards for mortgage schemes whether they be listed or unlisted. Regulatory Guide 45 has undergone several changes since the last edition of this book, with the aim of improving investor confidence by improving the consistency and quality of disclosure by responsible entities of unlisted mortgage schemes and to enhance investor confidence. 28

Investor directed portfolio services [6.390] Investor directed portfolio services (IDPS) are services for acquiring and holding investments that involve arrangements for the custody of assets and consolidated reporting. There will generally be a menu of investment opportunities associated with an IDPS. Arrangements typically marketed as master funds and wrap accounts are likely to be an IDPS. An important feature of an IDPS is that the investor makes all the investment decisions, although the operator can give effect to directions previously given by the client: RG 148.7. This arrangement is treated by ASIC as a service rather than as an investment 28

See ASIC’s consultation paper: Mortgage schemes: Strengthening the disclosure benchmarks Consultation Paper 141 (October 2010) Part B. Available at http://asic.gov.au/regulatory-resources/ find-a-document/consultation-papers/cp-141-mortgage-schemes-strengthening-the-disclosurebenchmarks (accessed 10 May 2016).

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product. The IDPS are managed investment schemes as they involve the expectation of cost savings (eg through netting of transactions or pooling of funds for the purposes of making acquisitions) or access to investments that are not otherwise available: RG 148.6. In this regard, ASIC believes that to the extent operators are performing similar functions to responsible entities of managed investment schemes, equivalent regulation should apply in relation to those functions. While the functions of an operator of an IDPS are more limited than those of a RE, ASIC still wants to ensure that a proposed licensee has the relevant expertise and capacity to manage investors’ assets. Regulatory Guide 148.12 provides that an IDPS is a managed investment scheme having the following features (noting however, that an IDPS with these features has no requirement to register that managed investment scheme: RG 148.8): (a)

A custodian (which may or may not be an IDPS operator) holds assets through the IDPS.

(b)

The investor has the sole discretion to decide what (but not necessarily when) assets will be acquired or disposed of through the IDPS, with limited exceptions (eg, an IDPS operator may rely on standing instructions where they do not exercise any discretion, such as in the case of realising predefined assets to maintain a minimum agreed cash balance).

(c)

An investor may direct the IDPS operator to transfer assets in specie to them. This allows an investor to move in and out of the IDPS with minimum disruption to the underlying investments. Such transfers are: (i)

limited to circumstances where the investor is able to hold the assets in their own right. A transfer is not required where, for example, there is a minimum holding requirement that is greater than the interest that the investor would have after the transfer.

(ii)

An investor may direct the IDPS operator to realise assets held on account for them, unless this is not possible under the law or the contractual terms under which the assets were issued. The realisation of an investor’s assets may be made on the direction of another person to pay money owing by the investor to: (A)

pay fees associated with the IDPS where necessary; and

(B)

cater for provisions typically found in margin lending agreements that enable the lender to sell assets provided as security where the borrower fails to meet a margin call.

(iii)

Any discretion of the holder of assets held through the IDPS may be otherwise exercised only in accordance with the directions of the investor with limited exceptions (eg, an IDPS operator may rely on standing instructions where they do not exercise any discretion).

(iv)

Investors are led to expect, and are likely to receive, benefits from using the IDPS in the form of: (A)

access to investments they could not otherwise directly access; or

(B)

cost reductions through the pooling of investor funds (which allow the IDPS operator to make large investments that can be acquired on more favourable terms) or through the netting of transactions [6.390] 151

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(where investors’ directions to buy and sell assets are offset against each other and a transaction for the net amount is entered into).

The exception for the realisation of assets on the direction of another person to pay money owing by the client is to enable assets to be realised to pay fees associated with the IDPS where necessary, and cater for provisions typically found in margin lending agreements which enable the lender to sell assets provided as security where the borrower fails to meet a margin call.

152 [6.390]

CHAPTER 7 Introduction to Investments and the Law [7.10]

Introduction ............................................................................................... 153 [7.20] Key points ...................................................................................................... 154 [7.30] Key terms ....................................................................................................... 154

[7.40] [7.50] [7.60]

What are investments? ............................................................................ 154 Classification.............................................................................................. 154 Classes of investment .............................................................................. 156 [7.70] Fixed interest securities ................................................................................ 156 [7.80] Equities ............................................................................................................ 157 [7.90] Real property ................................................................................................. 157

[7.110] [7.130]

[7.170]

[7.200]

[7.100]

Derivatives ................................................................................................... 157

[7.105]

Margin lending ............................................................................................ 157

[7.107]

Case Study: Opes Prime ............................................................................ 158

Why regulate? ........................................................................................... 159 Who regulates?.......................................................................................... 159 [7.130]

Australian Securities and Investments Commission ............................ 159

[7.140]

Australian Prudential Regulation Authority .......................................... 160

[7.150]

Australian Securities Exchange ................................................................ 160

Sources of law ........................................................................................... 162 [7.170]

Common law ............................................................................................... 162

[7.180]

Statutory law ................................................................................................ 162

[7.190]

Administrative actions by the regulators ............................................... 163

Investment advisers – money laundering............................................ 164

INTRODUCTION [7.10] The word “investment” comes from the Latin investire, “to clothe”, which is suggestive of placing money or capital within a structure or set of arrangements. When asking the question why invest? the answer invariably involves an expectation of profit through income flows and capital growth and these two objectives remain the primary focus for the investor and investment adviser. This chapter provides an overall, yet brief, introduction to the investment arena and the many topics introduced in this chapter are covered in greater detail in later chapters.

[7.10] 153

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Key points [7.20] This chapter will provide a greater understanding of: • the primary classifications of investments; • how various sources of law apply to the investment industry; • the compliance issues to be adhered to by investment advisers for the protection of investors’ funds; and

• potential legal issues the well-informed investor should be aware of.

Key terms [7.30] Key terms used in this chapter are: • Financial product • Australian Securities and Investments Commission (ASIC) • Australian Prudential Regulation Authority (APRA) • Australian Securities Exchange (ASX) • Australian Transaction Reports and Analysis Centre (AUSTRAC)

WHAT ARE INVESTMENTS? [7.40] While there are formal economic definitions of “investment”, the type of investment discussed in this work may be described as “financial investment”. Financial investment involves the purchase of investment products, eg, shares, interests in public unit trusts or collective investments, in order to create an income stream in the form of interest, rent or dividends together with, hopefully, capital growth. The most obvious form of direct financial investment is real property and it provides a good example of the intersection of the function of investment income plus capital growth, and taxation considerations such as negative gearing, which involves the borrowing of money to make investments.

CLASSIFICATION [7.50] The common ground that all investment products have is their economic function, even though they may relate to differing legal interests and individual products may involve different legal structures as their underlying legal vehicle. In considering the legal nature of derivatives, as an example, it is reasonably clear that the underlying legal relationship is contractual and relates to the value of an underlying asset, rate, index or commodity. Furthermore, the nature of the derivative contract can generally be characterised as an option or a futures contract. Chapter 7 of the Corporations Act 2001 (Cth) considers derivatives as facilities through which, or through the acquisition of which, a person manages financial risk and therefore they fall under the umbrella definition of “financial product”. The general definition of “financial product”, which is subject to specific inclusions and exclusions, has been drafted to be flexible enough to bring any 154 [7.20]

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future innovations within its ambit. Section 763A provides that, for the purposes of Ch 7 of the Act, a financial product is a facility through which, or through the acquisition of which, a person: • makes a financial investment; • manages a financial risk; or • makes non-cash payments. Section 763B provides that an investor makes a financial investment if the investor gives money or money’s worth, the contribution, to another person and any of the following apply: • the other person uses the contribution to generate a financial return, or other benefit, for the investor;

• the investor intends that the other person will use the contribution to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated);

• the other person intends that the contribution will be used to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated); or

• the investor has no day-to-day control over the use of the contribution to generate the return or benefit.

The following examples of making a financial investment are provided in the legislation (s 763B): 1.

A person paying money to a company for the issue to the person of shares in the company. Here the company uses the money to generate dividends for the person and the person, as a shareholder, does not have control over the day-to-day affairs of the company.

2.

A person contributing money to acquire interests in a registered scheme from the responsible entity of the scheme. In this case the scheme uses the money to generate financial or other benefits for the person and the person, as a member of the scheme, does not have day-to-day control over the operation of the scheme.

Pursuant to s 763B, examples of actions that do not constitute making a financial investment are: 1.

A person purchasing real property or bullion (while the property or bullion may generate a return for the person, it is not a return generated by the use of the purchase money by another person); or

2.

A person giving money to a financial services licensee who is to use it to purchase shares for the person (while the purchase of the shares will be a financial investment made by the person, the mere act of giving the money to the licensee will not of itself constitute making a financial investment).

The fact that real property is not a financial product for the purposes of Ch 7 of the Corporations Act 2001, 1 and therefore not regulated by ASIC, is an important issue for investors and is discussed in the following chapters. 1

Corporations Act 2001 (Cth) s 763B note 2(a). [7.50] 155

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CLASSES OF INVESTMENT [7.60] Fundamental to any consideration of investment law is an understanding of the menu of investment products. This is represented by the range of investment or asset classes that are typically combined into a diversified portfolio where investments are spread across the asset classes in order to manage risk. The asset classes are usually categorised as: • fixed interest; • equities involving domestic or international shares; and • property and derivatives (such as options) and futures. Investments in asset classes may be direct, as in the case of equities or shares, or indirect, eg a collective investment which results in an interest in a managed investment scheme which is typically structured as a unit trust. In relation to cash money, the short-term money market is available to institutional investors when large transactions are involved. Indirect access is available to retail investors via cash management trusts which utilise a unit trust structure. The shift from volatile share markets into lower risk (and hence lower yield cash) mortgage funds and fixed interest investments raises the question of whether investors, through their investment adviser, will seek better returns from alternative asset classes such as hedge funds. The extent of this will be limited by adherence to traditional portfolio theory in relation to asset allocation and understanding and acceptance by both investor and investment adviser. The traditional method of fundraising by corporations was to raise capital by issuing equity to investors in the form of shares, but over the last decade listed income investments have outstripped equity as a corporate fundraising instrument. Listed income investments are debt or loan instruments (as opposed to equities), referred to as “hybrid securities”, which are essentially fixed interest securities. It is against this background of change in the range and allocation of various investments that are available to the public that the law relating to investments will be examined.

Fixed interest securities [7.70] With fixed interest securities the investor lends money expecting a return of principal plus interest at maturity. The issuer of the debt instrument is generally not required to buy back the instrument until maturity, if at all, but an investor may recoup the underlying principal by selling the security to another investor in the open market. The categories of fixed interest include “at call” money, short-term money market transactions involving the trading of instruments such as bank bills and promissory notes, term deposits, bonds and company debentures and unsecured notes. Most investors obtain fixed interest exposure via collective investment structures, such as unit trusts. Capital notes involve investors effectively lending money to the note issuer who pays an agreed interest rate, fixed or floating, based on a predetermined formula for a specified period through to maturity when the principal plus 156 [7.60]

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interest is paid. Income securities or floating rate notes are similar to capital notes. They pay interest at a margin, “resettable” quarterly over the 90-day bank bill rate. However, they are usually perpetual so the investor has to sell the security in the market to recoup the principal. Convertible notes are a combination of a debt instrument and an option to convert the notes to ordinary shares at predetermined dates and prices. If the option is not exercised by maturity, the note is redeemable for a preset capital amount. Convertible preference shares are a cross between debt and equity securities.

Equities [7.80] A company limited by shares has the ability to raise funds by either equity or debt. Equity is raised by issuing shares to investors. The liability of shareholders is limited to the amount, if any, unpaid on shares held. Shareholders are entitled to a proportionate share of the profit distributed by the company as dividends although a company is not obligated to pay a dividend even if it makes a profit. Companies typically fundraise by issuing ordinary shares, and other types of securities such as contributing shares, preference shares, company options and convertible notes. The Rules of the Australian Securities Exchange (ASX) will be discussed in relation to compliance issues for a listed company together with the remedies available to an investor who holds shares in a company.

Real property [7.90] Investment in real estate may be direct or indirect through a property trust – a collective investment. In particular, property trusts can give investors exposure to commercial property, which historically has higher returns. Property investment has features of equity – the investor owns the asset and fixed interest assets where an income stream is produced. An investor needs to consider that real estate is an illiquid asset and that direct property investments include high costs of purchase, such as stamp duty, and sale expenses such as an agent’s commission.

Derivatives [7.100] Derivatives are financial instruments whose value is derived from an underlying asset that may be a physical commodity or a financial instrument. Derivatives are financial products under Ch 7 of the Corporations Act 2001. Underlying all derivative arrangements is a contractual relationship involving either futures or options.

Margin lending [7.105] Margin lending occurs where an investor borrows the funds to invest elsewhere. If the investment is successful, the investor benefits from the [7.105] 157

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investment returns, less the cost of investment (eg, interest on the loan for the investment funds). Normally such a loan is secured by the investment itself. This type of investment benefits the investor who can invest more funds than would otherwise be the case. However, if the investment is not successful, the investor is left to pay the cost of the loaned funds. Such an investor can also be put at risk of “margin calls” (needing to pay the financier an additional payment) if the value of the investment falls below a certain percentage above the value of the loan (eg, loan-to-value ratio). Most margin lending agreements allow the financier to sell some/all of the underlying investments if a margin call is not met within a specified time. The Corporations Act 2001 was amended by the Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 (Cth) for the purpose of regulating certain financial products, including margin lending facilities. A margin lending facility is now defined in s 761EA of the Corporations Act 2001, and relates to the provision of credit wholly or partly to acquire one or more financial products (which is also defined in the Corporations Act 2001). The result of this amendment is that investor protection provisions of the Corporations Act 2001 and the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) apply to consumers of these products. These amendments were largely the result of products that were sold to customers in the Opes Prime matter.

Case Study: Opes Prime [7.107] Opes Prime was a small brokerage firm set up in 2003. It was willing to lend against speculative and illiquid stocks at higher ratios than other lenders, and gave specialised treatment to certain clients. Late in 2007, Opes Prime’s business was in trouble as a result of increased margin calls. The directors appointed administrators in late March 2008, and a major creditor, ANZ, also appointed receivers. The problem for the some 1200 investors was that the legal position was unclear in relation to who owned the securities they had purchased as a result of the margin loans. If Opes Prime owned the securities (which could be $100,000 worth of securities for a $9,000 loan), then the total value of securities was lost to the investor – who would nonetheless be liable as a creditor of Opes Prime to still repay the interest on the loan accrued as at the date of administration, as well as losing the securities themselves to the administrator. On a technical reading of the contractual documentation, the court concluded that the ownership of the securities would be transferred by the loan agreement; with the borrower having merely a right to require transfer of equivalent value securities when the loan was repaid. This caused the clients of Opes Prime to become creditors in the administration – creditors whose right to the return of equivalent value securities would never fully eventuate – due to the insolvency of Opes Prime and, the secured creditors (ANZ and Merrill Lynch) having priority rights over the assets of Opes Prime. 158 [7.107]

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| CH 7

WHY REGULATE? [7.110] Regulation is necessary because many financial products do not have an easily ascertainable value as compared with tangible property. The value of financial products depends on the financial position and prospects of the company, together with the markets assessment of the company. Therefore the following are required to protect prospective investors: • Public disclosure of information relevant to the prospective investor’s decision to invest. This enables the investor to make informed choices in regard to their investments.

• Supervision and maintenance of proper markets in financial products. • Licensing of those who provide financial services and products. • Investor protection legislation.

WHO REGULATES? Australian Securities and Investments Commission [7.130] The Australian Securities and Investments Commission (ASIC) is an independent Commonwealth Government body, operating under the direction of six full-time Commissioners appointed by the Governor-General on the nomination of the Treasurer. The Commission reports to the Commonwealth Parliament, the Treasurer and the Parliamentary Secretary to the Treasurer. The Australian Securities Commission (ASC) was the forerunner of ASIC, which was established by the Australian Securities Commission Act 1998 (Cth) on 1 July 1998. ASIC is responsible for consumer protection in superannuation, insurance, deposit-taking and credit and regulates Australian companies, financial markets, financial services organisations and professionals who deal and advise in those services. The stated role of ASIC is: ASIC is Australia’s corporate, markets and financial services regulator. We contribute to Australia’s economic reputation and wellbeing by ensuring that Australia’s financial markets are fair and transparent, supported by confident and informed investors and consumers. We are an independent Commonwealth Government body. We are set up under and administer the Australian Securities and Investments Commission Act (ASIC Act), and we carry out most of our work under the Corporations Act. The Australian Securities and Investments Commission Act 2001 requires us to: • maintain, facilitate and improve the performance of the financial system and

entities in it; • promote confident and informed participation by investors and consumers in the

financial system; • administer the law effectively and with minimal procedural requirements; • enforce and give effect to the law; • receive, process and store, efficiently and quickly, information that is given to us; [7.130] 159

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make information about companies and other bodies available to the public as soon as practicable. 2

The functions and powers of ASIC are outlined in s 12A of the ASIC Act. These include: … (2)

ASIC has the function of monitoring and promoting market integrity and consumer protection in relation to the Australian financial system.

(3)

ASIC has the function of monitoring and promoting market integrity and consumer protection in relation to the payments system by: (a)

promoting the adoption of approved industry standards and codes of practice; and

(b)

promoting the protection of consumer interests; and

(c)

promoting community awareness of payments system issues; and

(d)

promoting sound customer-banker relationships, including through: (i)

monitoring the operation of industry standards and codes of practice; and

(ii)

monitoring compliance with such standards and codes.

Australian Prudential Regulation Authority [7.140] The Australian Prudential Regulation Authority (APRA) was established on 1 July 1998. It is responsible for the prudential supervision of banks, insurers, building societies, credit unions, friendly societies and superannuation funds. The role of APRA is essentially the promotion of prudent management of financial institutions and this involves being proactive in the area of financial institution risk management. Further, APRA has powers requiring financial institutions to adhere to prudential standards regarding capitalisation, liquidity and governance, and to intervene if the interests of depositors, policyholders or members are at risk. From an investor’s perspective, APRA is responsible for ensuring that financial institutions will be able to honour their commitments when they fall due. However, investors should be aware that APRA does not guarantee the performance of financial institutions. It should also be noted that the Australian Taxation Office (ATO) is responsible for self-managed superannuation funds. APRA currently supervises institutions holding approximately $4.9 trillion in assets for Australian depositors, policyholders and superannuation fund members. 3

Australian Securities Exchange [7.150] The Australian Stock Exchange (ASX) was formed in 1987 as a result of the amalgamation of six separate exchanges operating in each capital city. In 2006, a further amalgamation occurred with the Sydney Futures Exchange (SFE). 2 3

See http://www.asic.gov.au/about-asic/what-we-do/our-role (accessed 10 May 2016). This information is available from the site map. APRA website: http://www.apra.gov.au/AboutAPRA/Pages/Default.aspx (accessed 10 May 2016).

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The Australian Securities Exchange launched a new brand structure on 1 August 2010, when it became known as the ASX Group. The ASX Group includes: • Australian Securities Exchange – which reflects ASX’s primary, secondary and derivative market services. It represents the markets known as ASX (formerly Australian Stock Exchange) and ASX 24 (formerly Sydney Futures Exchange).

• ASX Clearing Corporation – a new brand under which ASX’s clearing services will be promoted. It encompasses ASX Clear (formerly the Australian Clearing House) and ASX Clear (Futures) (formerly SFE Clearing Corporation).

• ASX Settlement Corporation – a new brand under which ASX’s settlement services will be promoted. It encompasses ASX Settlement (formerly ASX Settlement and Transfer Corporation) and Austraclear.

• ASX Compliance – ongoing monitoring and enforcement of compliance with the ASX operating rules. This entity replaces ASX Markets Supervision. 4

The ASX describes itself as: one of the world’s leading financial market exchanges … as the first major financial market open every day, ASX is a world leader in raising capital, consistently ranking among the top five exchanges globally … With a total market capitalization of around $1.5 trillion, ASX is home to some of the world’s leading resource, finance and technology companies. Our $47 trillion interest rate derivatives market is the larges in Asia and among the biggest in the world. 5

The ASX must comply with s 792A of the Corporations Act 2001 (Cth) in the supervision of its market: 792A General obligations A market licensee must: (a)

to the extent that it is reasonably practicable to do so, do all things necessary to ensure that the market is a fair, orderly and transparent market; …

and thus it supervises almost 2,200 entities listed on the ASX by obliging them to comply with the ASX Listing Rules: ASX is a multi-asset class, vertically integrated exchange group, and one of the world’s top exchange groups measured by market capitalisation. ASX’s activities span primary and secondary market services, central counterparty risk transfer, and securities settlement for both the equities and fixed income markets. It functions as a market operator, clearing house and payments system facilitator. It monitors and enforces compliance with its operating rules, promotes standards of corporate governance among Australia’s listed companies and helps to educate retail investors. ASX’s diverse domestic and international customer base includes issuers of securities and financial products, investment and trading banks, fund managers, hedge funds, commodity trading advisers, brokers and proprietary traders, market data vendors and retail investors. 6 4 5 6

ASX website: http://www.asx.com.au (accessed 10 May 2016). http://www.asx.com.au/about/corporate-overview.htm (accessed 22 April 2016). ASX website: http://www.asx.com.au (accessed 10 May 2016). [7.150] 161

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SOURCES OF LAW Common law [7.170] The laws of negligence, contract law, fiduciary duties and agency each have an impact on the legal relationship between investment advisers and their clients. Despite the implementation of both Ch 7 of the Corporations Act 2001 and the ASIC Act, the common law, or case law, remains relevant in relation to investments. Furthermore, many common law principles are found in the legislation. Common law principles developed through the cases provide an additional layer of potential liability in the advisory function. This is particularly important where statutory provisions do not cover the nature of the investment advice. For example, if the investment advice relates to the purchase of real property, which is not a financial product for the purposes of Ch 7 of the Corporations Act 2001, the investor protection remedies do not apply and the investor needs to resort to the common law for assistance. The legal nature of the adviser-investor relationship is contractual, fiduciary and a recognised duty situation. As in the banker-customer relationship, the investment adviser has an ultimate duty to obey the investor’s instructions. An adviser should always obtain proper instructions as to how to act. The duty to use reasonable diligence, care and skill permeates the investor protection regime and consumer protection law generally as seen by reference to the statutory implied terms. This duty variously evolves as an implied term arising out of the adviser-client contract, common law negligence and the statutory implied warranty of due care and skill.

Statutory law [7.180] Statutory law is the primary source of law for investments and there are two main statutes that provide the law relating to the protection of the investor and the obligations imposed on the investment adviser and investment product provider. These statutes are Commonwealth law and were passed by the Commonwealth Parliament of Australia: • Corporations Act 2001 (Cth). This Act includes the Financial Services Reform Act 2001 (Cth) (FSRA) that now comprises Ch 7 and which regulates financial products, financial service providers, investment product advice and financial markets and Ch 5C of the Corporations Act 2001, which regulates managed investments.

• Australian Securities and Investments Commission Act 2001 (Cth). This Act provides ASIC with functions and powers, 7 and establishes the Takeovers Panel. 8 The legislation directs ASIC to (s 1(2)): 7

8

ASIC Act s 1(1)(a).

ASIC Act s 1(1)(d). Details of the Takeovers Panel are set out in the ASIC Act Pt 10.

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(a)

maintain, facilitate and improve the performance of the financial system and the entities within that system in the interests of commercial certainty, reducing business costs, and the efficiency and development of the economy; and

(b)

promote the confident and informed participation of investors and consumers in the financial system; and

(d)

administer the laws that confer functions and powers on it effectively and with a minimum of procedural requirements; and

(e)

receive, process and store, efficiently and quickly, the information given to ASIC under the laws that confer functions and powers on it; and

(f)

ensure that information is available as soon as practicable for access by the public.

(g)

take whatever action it can take, and is necessary, in order to enforce and give effect to the laws of the Commonwealth that confer functions and powers on it.

Administrative actions by the regulators [7.190] The third source of law, considered to be “soft law”, 9 in relation to investors and investment advisers consists of the pronouncements by the administrative body charged with administering the law, ie ASIC. Although the law is not made by ASIC – that is the sole role of Parliament – it does provide its own interpretation of the statutory law as contained in the statutes under its administration. As stated above, 10 the laws administered by ASIC are designed to protect consumers, investors and creditors. The primary function of ASIC, as stated in s 1(2) of the ASIC Act is the promotion of confident and informed participation by investors and consumers in the financial system. The law directed at achieving this objective is the Corporations Act 2001 (Cth), in particular Chs 7, 6D and 5C. Comprehensive powers have been granted to ASIC to ensure financial market integrity, investor and consumer protection, regulation of corporations and financial products through industry codes of conduct, licensing, disclosure and statements setting out the view of the administrator in regard to how they will apply the statute law. Prior to July 2007, policy statements were issued as formal declarations of ASIC policies. They indicated how ASIC intended to administer the Corporations Act 2001 and other legislation for which it is responsible. In July 2007, ASIC replaced the term “policy statement” with “regulatory guide”. The following list, reproduced from the ASIC website, sets out the current terminology: 9 10

The term “soft law” is applied to administrative actions that compel members of the public to follow suggested courses of action. It is not law in the true sense because it is not made by parliament. See [7.130].

[7.190] 163

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Consultation papers (CP). These documents seek feedback from stakeholders on matters ASIC is considering, such as proposed relief or proposed regulatory guidance. Regulatory guides (RG). These documents give guidance to regulated entities by: • explaining when and how ASIC will exercise specific powers under legislation

(primarily the Corporations Act) • explaining how ASIC interprets the law • describing the principles underlying ASIC’s approach • giving practical guidance (for example describing the steps of a process such as

applying for a licence or giving practical examples of how regulated entities may decide to meet their obligations). Reports (REP). These documents describe ASIC compliance or relief activity or the results of a research project. Information sheets (INFO). These documents provide concise guidance on a specific process or compliance issue or an overview of detailed guidance. Instruments. Instruments are issued to: • exempt a person(s) from certain provisions of the Corporations Act 2001 or other

Acts administered by us • modify or clarify the operation of certain provisions • make declarations about a person(s) who is subject to a particular provision of

the legislation. Class orders. Class orders are one form of instrument and usually apply to a class of persons who carry out a particular activity in certain circumstances, eg timeshare scheme operators, corporations conducting market research, operators of managed investment schemes based on syndicate arrangements etc. Media Releases, Advisories and Consumer Alerts. ASIC issues Media Releases, Advisories and Consumer Alerts to advise the public and practitioners of current issues in the financial services industry. 11

INVESTMENT ADVISERS – MONEY LAUNDERING [7.200] The introduction of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) (AML/CTF Act) imposes obligations on financial service providers and other persons or businesses, such as lawyers and accountants, which provide designated services in the financial sector. Designated services include: • opening an account; • accepting deposits; • making a loan; • issuing, acquiring or disposing of a bill of exchange, a promissory note or a letter of credit;

• issuing a debit or stored value card; • issuing traveller’s cheques; and 11

ASIC website: http://www.asic.gov.au/asic/asic.nsf – Media Releases tab (accessed 22 April 2016).

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• sending and receiving electronic funds transfer instructions. Providers of these designated services are called “reporting entities”: AML/CTF Act s 6. These reporting entities obligations include: • customer identification and verification of identity • record-keeping • establishing and maintaining an AML/CTF program • ongoing customer due diligence and reporting (suspicious matters, threshold transactions and international funds transfer instructions).

The AML/CTF Act is being implemented in two tranches – the first tranche having been enacted by Parliament and the second tranche at a later time. 12 The first tranche “covers the financial and gambling sectors, bullion dealers and lawyers/accountants, but only to the extent that they provide financial services in direct competition with the financial sector”. 13 The Replacement Explanatory Memorandum to the AML/CTF Bill states that the “reforms are a major step in bringing Australia into line with international best practice to deter money laundering and terrorism financing that includes standards set by the Financial Action Task Force (FATF)”. 14 Hence the reason for its enactment. The Financial Transactions Reports Act 1988 (Cth), the original money laundering legislation, still applies to cash dealers who are not reporting entities under the more recent legislation but are required to report suspect transactions involving $10,000 or more or international funds transfers and the opening of bank accounts. The AML/CTF Act adopts a “risk based approach” to identifying customers who may be engaged in money laundering or terrorism financing and will apply to a very wide range of businesses, not just cash dealers. Among the responsibilities introduced by the AML/CTF Act, a reporting entity must now carry out a procedure to verify a customer’s identity before providing a designated service to the customer. Reporting entities must also report to the Australian Transaction Reports and Analysis Centre (AUSTRAC) suspicious transactions and transactions above a certain threshold, 15 some international funds transfers and cross-border movements of currency. Traditionally, money laundering legislation focused on proceeds of crime and tax evasion, and financial institutions were primarily responsible for reporting suspicious or significant transactions to AUSTRAC. However, this legislation recognises that money laundering is an issue that infects many areas of the financial sector and thus the legislation extends the group of reporting entities and the obligations imposed on those reporting entities are extensive. 12 13 14 15

The AML/CTF Act received Royal Assent on 12 December 2006. Replacement Explanatory Memorandum to the AML/CTF Bill, p 1. Replacement Explanatory Memorandum to the AML/CTF Bill, p 2. $10,000. [7.200] 165

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New procedures which require businesses engaged in providing “designated services” to report suspect customers and obtain proof of identification are the key measures being used by the law to detect suspicious matters. The definition of “designated services” is so broad that it will cover all businesses which provide trade credit, including all consumer credit transactions. There is also no limit to the money paid for a designated service (except a $1,000 limit for stored value cards). Generally, the Act requires a business to “identify” new customers before providing a service. Circumstances in which a customer can be identified after the service has been provided include: • if the prior identification would disrupt the ordinary course of business; • if the service is specified in the AML/CTF Rules, and if: • it is not provided face-to-face; or • it consists of acquiring or disposing of a security or derivative on behalf of a customer; or

• it consists of issuing or undertaking liability as the insurer under a life policy or a sinking fund policy.

• in some circumstances, the provision of certain low-risk services will not require client identification.

Lawyers, accountants and financial advisers are only under an obligation to report suspicious matters when providing “designated services”. Section 6 of the AML/CTF Act contains two tables – the first lists 63 designated services of a financial services nature with specific reference to Australian financial services licence holders (items 62 and 63 refer to buying and selling bullion). The second table refers to gambling services. Therefore, lawyers, accountants and financial advisers are a reporting entity to the extent that they provide designated services. For example, lawyers who acquire or dispose of securities on behalf of clients, create and deal with promissory notes and bills of exchange, or who arrange safe deposit box facilities are providing a designated service. Preparing a will is not a designated service. However, the purchase of real property and the provision of mortgage finance or the international transfer of funds are designated services because the transfer of real property and mortgage arrangements can be used to launder money. 16 Similarly, the creation of a trust or company structure to be used to move funds offshore or onshore will be a designated service. The following services are not regarded as being “designated services”: • preparation of a tax return; • providing advice on securities and derivatives; • establishing a superannuation fund and then advising on the investment of the funds; or

• advising on life insurance or a sinking fund insurance policy. 16

Australian Government, Attorney-General’s Department, Anti-Money Laundering Law Reform, Issues Paper 5, Legal Practitioners – Accountants – Company and Trust Service Providers (2003) p 5.

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The AML/CTF Act requires businesses that provide designated financial services to have a process to identify their customers. Professional advisers are referred to as “gatekeepers” in the Explanatory Memorandum due to those people involved in money laundering using the services of professionals to launder the money. The government has recognised that criminals use sophisticated structures, such as trusts, companies and managed investment schemes, to launder money. Under the AML/CTF Act, reporting entities have the responsibility of managing their own money laundering and terrorism financing risks. Section 81 states: (1)

A reporting entity must not commence to provide a designated service to a customer if the reporting entity: (a)

has not adopted; and

(b) does not maintain; an anti-money laundering and counter-terrorism financing program that applies to the reporting entity.

The AML/CTF program must contain a framework for identifying risks and contain procedures for customer identification. It must be designed to identify and materially mitigate the risk that the provision of a designated service might involve or facilitate a transaction connected with a money laundering offence or the financing of a terrorism offence. A customer due diligence program must be included in the AML/CTF program. The key elements of a customer due diligence program for a service provider are: • “know your customer” (KYC) information; • be aware of risk classification; and • ensure there is transaction monitoring. The AML/CTF Act provides a framework by which the businesses providing “designated services” will be classified as “reporting entities”, and thus obligations relating to monitoring and reporting of clients’ activities are imposed on the entity. The obligations will have a substantial impact on compliance requirements of financial advisers.

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CHAPTER 8 Common Law Framework for Market Participants [8.20]

Introduction ............................................................................................... 169 [8.20] Key points ...................................................................................................... 169 [8.30] Key terms ....................................................................................................... 169

[8.40]

What is common law? ............................................................................. 170 [8.50] Common law duties and liabilities in the market place ....................... 170 [8.60] Tortious liability ............................................................................................ 170 [8.70] Negligent advice ........................................................................................... 171 [8.75] Case example ................................................................................................. 173 [8.80] Contractual liability ...................................................................................... 175 [8.90] Fiduciary duties ............................................................................................. 176 [8.100]

Agency .......................................................................................................... 179

INTRODUCTION Key points [8.20] This chapter will provide a greater understanding of: • how common law applies to the financial services sector; • the common law rights and duties of participants in the financial services sector; • the laws of negligence, contract and fiduciary duties as they apply to financial services; and

• the common law duties of an agent and a trustee as they apply to the financial services sector.

Key terms [8.30] Key terms used in this chapter are: • Common Law • Tort • Negligent advice • Contract • Fiduciary • Agency • Trust

[8.30] 169

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WHAT IS “COMMON LAW”? [8.40] The “law” can be classified in many different ways; one method is to separate law into “enacted” or “Parliament” made law, and “unenacted” or “judge” made law. Laws made by judges in adjudicating disputes are often referred to as case law. Common law includes: 1.

decisions made by judges where no legislation applies; and

2.

judges’ interpretations of particular statutes and regulations.

The term “common law” has different meanings in different contexts but, for our purposes, “common law” means the law as it has developed through judicial decision-making – ie, case law.

Common law duties and liabilities in the market place [8.50] Relationships in the market place are subject to common law and applicable legislation. Financial advisers must be aware of their duties and liabilities in their relationship with clients, and should be familiar not only with their contractual obligations but also with the concept of “fiduciary” and the related common law duties and liabilities. This may involve a consideration of issues such as failure to maintain standards, economic loss caused by the client’s reliance on financial advice, and evidence of unconscionable behaviour. The main common law duties of a financial adviser are: • to provide contractual advice; • to take reasonable care in providing advice or information to clients; • to provide services with due skill and care; and • to avoid conflict of interest situations.

Tortious liability [8.60] The law of torts is concerned with the bases of civil liability that arise outside of contract law – eg, a negligence action for economic loss caused by negligently given financial advice or information. The basis of civil liability in tort of most concern is negligence. The basis of the modern law of negligence is to be found in the celebrated case concerning the snail in the opaque ginger beer bottle, Donoghue v Stevenson. 1 That case established manufacturer’s liability for defective products but, at the same time, established a more generally applicable proposition of law, namely the general duty of care. This is embodied in Lord Aitken’s “neighbour principle”: The rule that you are to love your neighbour becomes in law, you must not injure your neighbour; and the lawyer’s question “who is my neighbour?” receives a restricted reply. You must take reasonable care to avoid acts or omissions which you can reasonably foresee would be likely to injure your neighbour. Who, then, in law 1

Donoghue v Stevenson [1932] AC 562.

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is my neighbour? The answer seems to be – persons who are so closely and directly affected by my act that I ought reasonably to have them in contemplation as being so affected when I am directing my mind to the acts or omissions which are called in question. 2

This dictum contains two important concepts in negligence law: • reasonable foreseeability; and • sufficient proximity.

Negligent advice [8.70] In the case of Hedley Byrne v Heller & Co Ltd, 3 it was held that the rules of negligence as stated in Donoghue v Stevenson 4 were not limited to negligent actions but could also apply to negligent advice. This case, decided in 1964, has provided the precedent for many later cases of negligent advice. The general tests used to determine liability, which were developed by Hedley Byrne and later cases, are: 1. 2.

The speaker should have realised that he was trusted by the recipient.

3.

The speaker ought to have realised that the recipient intended to act on the information or advice.

4.

It was reasonable for the recipient to rely on the speaker.

Information was of a business or serious nature.

The terminology used in the law of negligence finds its way into recent cases of professional negligence involving liability under the legislation that preceded Ch 7 of the Corporations Act 2001 (Cth). Ali v Hartley Poynton Ltd 5 was a Victorian Supreme Court case, the facts of which arose prior to the introduction of the current Ch 7. In this case, the plaintiff was an elderly man, with no knowledge of investments. The defendant was a firm of stockbrokers, who were engaged to invest the plaintiff’s money and the investment strategy was to create a retirement fund. The plaintiff sued the defendant, alleging that the defendant was liable for breaches of the terms of the agreement between the defendant and the plaintiff, breaches of the duty of care owed to the plaintiff, misleading or deceptive representations, and breaches of the Trade Practices Act 1974 (Cth): I am satisfied that in making the representations, through Martin, which I have identified, the defendant owed a duty of care to the plaintiff in accordance with the Hedley Byrne principle (Hedley Byrne and Co Ltd v Heller and Partners Ltd [1964] AC 465). In particular, it knew or ought to have known that the plaintiff would rely upon the skill of Martin and the exercise of care by him in what he said. 6

2

3 4 5

6

Donoghue v Stevenson [1932] AC 562 at 580.

Hedley Byrne v Heller & Co Ltd [1964] AC 465. Donoghue v Stevenson [1932] AC 562. Ali v Hartley Poynton Ltd [2002] VSC 113.

Ali v Hartley Poynton Ltd [2002] VSC 113 at [270]. [8.70] 171

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In the case of Newman v Financial Wisdom Ltd, 7 claims were made against a financial adviser on the basis of negligent advice and breaches of the precursor to Ch 7, s 819 of the Corporations Law (Cth). Mandie J stated: I am therefore satisfied that Quarrell and Schimana, by recommending the investment, acted in breach of a duty of care which they owed to Mr Newman in the circumstances. In my opinion, the recommendation of the investment in itself constituted negligence. In addition, there was negligence in the failure to ensure that there were reasonable grounds for recommending the investment, in the failure to make any proper inquiries or investigations concerning the investment and the persons involved in it and in the failure to explain the risks involved and to ensure that they were within the risks which Mr Newman was prepared to accept. 8

In the case of Delmenico v Brannelly 9 the client suffered financial loss as a result of acting on advice from a firm of financial advisers. The client had approached the firm seeking information about financial products that the firm had advertised as being able to be acquired through the firm. The adviser supplied information about Westpoint products, some of which was incorrect. The Information Memorandum contained an explanation of the structure of the transaction and a diagram which showed the Westpoint Guarantor Group giving a guarantee to Bayshore, and a “charge” between Bayshore and the Bayshore Port Melbourne Trust under which was the development property. A synopsis of the promissory note offer contained the following entry: “Security – Guarantee from the Westpoint Guarantor Group … and a charge over the Trust.” 10 The appellants’ letter of 18 July 2005 contained two clearly false statements: … The appellants’ letter misstated the structure of the investment in a way which was apt to encourage in the respondent a favourable view of the security of the investment. The disclaimer … was in no way apt to convey to the respondent that the appellants’ description of the structure of the investment was not reliable. 11

However, the promissory notes were not guaranteed by the Westpoint Guarantor Group and were worthless, and Bayshore did not have a charge over the development property. The client lost all the money that he had invested with the financial advisers.The client had some investment experience and, as a result, the adviser argued that the client was negligent in not realising that there was a discrepancy in the information supplied to him, therefore contributing to his own losses. However, the court rejected this argument. It is also well-established by decisions of the High Court of which the most recent is I & L Securities Pty Ltd v HTW Valuers (Brisbane) Pty Ltd, [26] that the circumstance that a consumer, who is in fact induced to rely upon a statement which is objectively misleading, could have avoided the loss consequent upon that reliance

7

8 9 10 11

Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216.

Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216 at [410]. Delmenico v Brannelly [2008] QCA 74. Delmenico v Brannelly [2008] QCA 74 at [16] Delmenico v Brannelly [2008] QCA 74 at [38]

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by the exercise of reasonable care does not mean that the consumer did not act in reliance upon it so as to be entitled to recover damages by way of compensation for that loss. 12

In this case the covering letter from the adviser had stated that the information was not financial advice and was for information purposes only, however the letter used language which clearly indicated that the adviser was recommending particular financial products. The Appeal court upheld the trial judge’s decision in which the financial services provider and authorised representative were found liable for negligence and breaches of s 12DA of the Australian Securities and Investments Commission Act 2001 (Cth).

Case example [8.75] In Selig v Wealthsure Pty Ltd [2013] FCA 348, a financial services company (Wealthsure Pty Ltd) and its authorised representative (Bertram) had advised a then married couple (Mr and Mrs Selig) to invest in Neovest Ltd, in what was in effect a Ponzi scheme marketed by prospectus. The Seligs lost their investment when Neovest became insolvent, and also suffered consequential losses as a result, with losses totaling around $1.76 million. The holder of an Australian Financial Services Licence, Wealthsure, through its authorised representative Bertram, had provided oral recommendations and a written statement of advice to the Seligs, recommending this investment. They also supplied the Seligs with the prospectus, which the court later found to contain misleading statements. Following this advice, the Seligs had sold properties and incurred additional debt, to invest in Neovest. At the initial meeting, Bertram said that “Neovest would return 20% on investments” and was a tool for investors with cash and assets but with a poor income stream. He said that the investment “had been thoroughly researched by Wealthsure. They have done extensive research on it … It is on their approved product list”. No conditions or warnings were given. (Needless to say, it did not provide such a return; and was not a good investment etc). A later Statement of Advice was given, recommending the investment, but failing to disclose that dividends were discretionary, and there was a risk that the plaintiffs would not receive any dividends or repayment of capital. This case is a good example of how various threads of law intersect. The plaintiffs (who were unsophisticated) sued Wealthsure for breach of contract (because it was the party to the contract) and sued both Wealthsure and Bertram: (a)

under ss 953B, 1041H, 1041I and 1325 of the Corporations Act 2001 (Cth);

(b)

under ss 12DA and 12GF of the Australian Securities and Investments Commission Act 2001 (Cth);

(c)

for negligence; and

12

Delmenico v Brannelly [2008] QCA 74 at [36]. [8.75] 173

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(d)

for misrepresentation.

They also sued the four directors of Neovest, and were successful against two of them: Townley and Norton. No finding was made in respect of the other two directors, due to their liquidation and bankruptcy respectively. In addition to his directorship of Neovest, Townley had been a partner in a law firm (Nicol Robinson Halletts) at the time. The Seligs also sued the other partners in this firm, alleging that those partners were in partnership with Townley at the time; that Townley’s conduct fell within the scope of the law firm’s partnership and thus each partner in the law firm would be liable for Townley’s conduct under partnership law. (Under partnership law, each partner in a partnership is an agent for each other partner and thus liable for the conduct of other partners in that partnership. Agency is discussed below). However, the court dismissed the claims against the other partners in the law firm, finding that they were not responsible for Townley’s conduct in his directorship of Neovest, which was outside the scope of the law firm partnership). The Court found that Bertram had ascertained the plaintiffs’ relevant personal circumstances before giving advice, as required by s 945A of the Corporations Act, but failed to give advice that was reasonable in those personal circumstances, as was also required by s 945A. The plaintiffs had barely no income (no earning capacity and their only income was rental income of $380/week) and the court found they did not have the necessary income to enter into negative gearing arrangements and should not have been advised to enter into such an arrangement. 13 The investment was, in effect, a Ponzi scheme, marketed by prospectus. The Court also found that Bertram and Wealthsure should have warned the plaintiffs that the advice was misleading or inaccurate under s 945B, but failed to do so, contrary to their s 945B obligations. Because of the involvement of a professional indemnity insurer, the case was appealed several times 14 on various points of law, generating much interesting discussion on technical points of law, which are not particularly helpful to our more general discussion of negligence. For example: One High Court decision concerned the apportionment of liability between multiple liable defendants, particularly when the person insuring (an insurer) was responsible for some but not all of them. The court discussed the application of s 1041N and found that its application was limited to claims under ss 1041H and 1041I, but would not apply to claims under the ASIC Act or to common law claims such as negligence. These were not apportionable under the section. This case also considered who should pay the costs of the appeal: Selig v Wealthsure Pty Ltd [2015] HCA 18. 13 14

Selig v Wealthsure Pty Ltd [2013] FCA 348, at [308] – [309]. See eg Selig v Wealthsure Pty Ltd [2015] HCA 18; Selig v Wealthsure Pty Ltd [2015] HCATrans 54; Selig v Wealthsure Pty Ltd [2014] HCATrans 251 at 18; Wealthsure Pty Ltd v Selig [2014] FCAFC 76; Wealthsure Pty Ltd v Selig [2014] 221 FCR 1; Wealthsure Pty Ltd v Selig (No 2) [2013] FCA 770; Selig v Wealthsure Pty Ltd [2013] FCA 685; Wealthsure Pty Ltd v Selig [2013] FCA 628; Selig v Wealthsure Pty Ltd [2015] FCA 348.

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In the end, the persons held by the court to be liable for the economic losses suffered by the Seligs as a result of this failed investment, were Wealthsure, Bertram, and and the two non-insolvent directors of Neovest, Townley and Norton.

Contractual liability [8.80] Liability in contract in regard to professional advisers may arise from the contract of service that exists between the client and professional. A contract is an agreement between two parties whereby each party contributes to the agreement. In the case of professional advisers, the advice and services are provided by the professional and payment is provided by the client. Many rights and duties arise from this type of contract. Astley v Austrust Limited 15 was a case that involved a trustee company suing a firm of solicitors for breach of contract and for negligence in carrying out a retainer to give legal advice. The High Court said: The implied term of reasonable care in a contract for professional services arises by operation of law. It is one of those terms that the law attaches as an incident of contracts of that class. It is part of the consideration that the promisor pays in return for the express or implied agreement of the promisee to pay for the services of the person giving the promise. 16

Contractual obligations were also discussed in the following terms in Rahmat Ali v Hartley Poynton Ltd: 17 In addition, and of more immediate relevance, the defendant accepts there was an implied term of the retainer that the stockbroker would, in performing its obligations under the retainer, exercise such reasonable care, skill and diligence as might be expected of a reasonably competent stock broker. Plainly also stock brokers who provide professional services to clients owe a common law duty of care to their clients in respect of those services. … The duty to exercise reasonable care and the contractual obligation to exercise reasonable care apply to each of the professional activities undertaken for the client and extend to advice and recommendations for buying and selling stock on the share market and any decisions by the broker himself to buy and sell stock on the share market for the client in the exercise of his discretion.

In the Selig v Wealthsure Pty Ltd case 18 discussed above, the initial contract was a contract of service, between the clients (the Seligs) and their service provider (namely the person named in the financial services guide and on the statement of advice as the person giving the advice. This was Wealthsure Pty Ltd). That contract for the provision of the service of professional advice, in return for a fee, was a contract for the provision of services and thus under the common law it 15 16 17 18

Astley v Austrust Limited (1999) 197 CLR 1. Astley v Austrust Limited (1999) 197 CLR 1 at 47. Rahmat Ali v Hartley Poynton Ltd [2002] VSC 113 at [268]. Selig v Wealthsure Pty Ltd [2013] FCA 348, see [10.75].

[8.80] 175

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contained an implied condition that the services would be of reasonable quality. (There are also a number of legislative provisions that further set out obligations of financial advisers to their clients). There is a second contract raised by the facts in that case – namely the contract between the Seligs and the company, Neovest. When the Seligs applied for shares in Neovest, they entered into a contract with the company whereby the Seligs agreed to accept shares in Neovest and to pay the company for them, and the company agreed to issue those shares to the Seligs. This contract was formed on the basis of, and on the terms laid down in the prospectus which detailed the offer of shares in the company. Thus, this contract is able to be litigated under the common law – it is, after all, also a contract – however, because a prospectus is involved, there are a number of other duties and provisions and remedies laid down by Ch 6D of the Corporations Act, regarding defective disclosure documents (such as a prospectus), which could also aid the Seligs in their litigation regarding a defective prospectus.

Fiduciary duties [8.90] A fiduciary duty is a responsibility to act in good faith for the benefit of another. 19 The word “fiduciary” comes from the Latin word for “trust” – therefore, “a fiduciary” is a person who is trustworthy. The essence of this relationship is to exercise duties in the interests of the other, not in order to gain secret profits – there can be no conflict of interest. There is frequent debate about the nature and extent of fiduciary duties. This was recognised in the case of Hospital Products Ltd v United States Surgical Corporation: 20 The authorities contain much guidance as to the duties of one who is in a fiduciary relationship with another, but provide no comprehensive statement of the criteria by reference to which the existence of a fiduciary relationship may be established. The archetype of a fiduciary is of course the trustee, but it is recognized by the decisions of the courts that there are other classes of persons who normally stand in a fiduciary relationship to one another – eg, partners, principal and agent, director and company, master and servant, solicitor and client, tenant-for-life and remainderman. There is no reason to suppose that these categories are closed. However, the difficulty is to suggest a test by which it may be determined whether a relationship, not within one of the accepted categories, is a fiduciary one.

However, in Daly v Sydney Stock Exchange Ltd, 21 Gibbs CJ made it clear that fiduciary duties applied to financial advisers, stating that: It was right to say that Patrick Partners owed a fiduciary duty to Dr Daly and acted in breach of that duty. The firm, which held itself out as an adviser on matters of investment, undertook to advise Dr Daly, and Dr Daly relied on the advice which 19 20 21

The Parliamentary Joint Committee on Corporations and Financial Services recommended that the Corporations Act 2001 be amended to explicitly include a fiduciary duty for financial advisers operating under an AFSL, requiring them to place their clients’ interests ahead of their own. Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 at 68 per Mason J. Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371.

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the firm gave him. In those circumstances the firm had a duty to disclose to Dr Daly the information in its possession which would have revealed that the transaction was likely to be a most disadvantageous one from his point of view. Normally, the relation between a stockbroker and his client will be one of a fiduciary nature and such as to place on the broker an obligation to make to the client a full and accurate disclosure of the broker’s own interest in the transaction. 22

In the same case, Brennan J further stated (at 385) that: Whenever a stockbroker or other person who holds himself out as having expertise in advising on investments is approached for advice on investments and undertakes to give it, in giving that advice the adviser stands in a fiduciary relationship to the person whom he advises.

The 2001 High Court case of Pilmer v The Duke Group Ltd (in liq) 23 defined and discussed the nature and extent of fiduciary relationships and, in doing so, quoted from Norberg v Wynrib: 24 The foundation and ambit of the fiduciary obligation are conceptually distinct from the foundation and ambit of contract and tort. Sometimes the doctrines may overlap in their application, but that does not destroy their conceptual and functional uniqueness. In negligence and contract the parties are taken to be independent and equal actors, concerned primarily with their own self-interest. Consequently, the law seeks a balance between enforcing obligations by awarding compensation when those obligations are breached, and preserving optimum freedom for those involved in the relationship in question. The essence of a fiduciary relationship, by contrast, is that one party exercises power on behalf of another and pledges himself or herself to act in the best interests of the other.

In Adams v Perpetual Trustees Australia Ltd, 25 in the District Court of South Australia, the plaintiff, an elderly person, alleged that: defendants breached the terms of their retainer as financial advisors, which retainer included an implied term that the defendants would exercise all reasonable care, skill and diligence as might be expected of a reasonably competent financial advisor. The plaintiff asserts that the scope of the implied duty to carry out the retainer, obliged the defendants to fully inform the plaintiff as to the wisdom of, and the risks associated with any of her financial transactions on a direct basis; and further to ensure that the plaintiff was not unduly influenced by family members or others into making improvident advances; to monitor the plaintiff’s personal bank accounts and to ensure that the plaintiff’s investments were secured. She also alleges that such advice as she was given by the defendants, including that contained in investment reports prepared by them, was misleading and deceptive, contrary to the Trade Practices Act 1974 (Cwth) s 52; and the Fair Trading Act 1987. I appreciate that the defendants are financial advisers. They were not required to give legal advice. In my opinion however the defendants were not engaged simply to execute the plaintiff’s orders. … The defendants were engaged to advise the plaintiff as to her investments, to ensure that the investments were secure and that she received an income from 22 23 24 25

Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371 at 377. Pilmer v The Duke Group Ltd (in liq) (2001) 207 CLR 165; [2001] HCA 31. Norberg v Wynrib [1992] 2 SCR 226 at 272 per McLachlin J.

Adams v Perpetual Trustees Australia Ltd [2006] SADC 62.

[8.90] 177

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them. Money was entrusted by her to the defendants for the purposes of that investment. This case represents the clearest case of a vulnerable plaintiff both trusting and relying upon the defendants. In my opinion the duty extended to require the defendants to ensure that the plaintiff obtain independent legal advice from the time that they suspected that undue influence was being exercised over the plaintiff thereby putting her assets at risk. 26

However fiduciary duties are not to be presumed in every relationship between a financial services provider and a client. In Eric Preston Pty Ltd v Euroz Securities Limited, 27 the Federal Court of Australia decided that the retainer (partly oral and partly in writing) between a retail client and a stockbroker did not extend to the stockbroker undertaking to act as a financial adviser and, therefore, the stockbroker did not owe fiduciary obligations based on the financial adviser relationship to the client. In this instance the stockbroker did not have a licence to give financial advice generally: I also do not accept that by operation of law, an agreement to act as a stockbroker also gave rise to an agreement to act as a financial advisor, particularly in the circumstances where the right to act as a financial advisor is regulated by statute, and it is common cause that Euroz Securities did not have a licence to give financial advice generally, or in relation to financial products such as securities lending and borrowing agreements, in particular. 28

Gaudron and McHugh JJ in Breen v Williams said: 29 In this country fiduciary obligations arise because a person has come under an obligation to act in another’s interests. As a result, equity imposes on the fiduciary proscriptive obligations – not to obtain any unauthorized benefit from the relationship and not to be in a position of conflict. If these obligations are breached, the fiduciary must account for any profits and make good any losses arising from the breach. But the law of this country does not otherwise impose positive legal duties on the fiduciary to act in the interests of the person to whom the duty is owed.

In ASIC v Citigroup Global Markets Australia Pty Ltd (No 4), 30 ASIC alleged that Citigroup had breached fiduciary obligations by using confidential information for its own benefit. However, a mandate letter existed which said, “Citigroup had been retained solely as an adviser … as an independent contractor and ‘not in any other capacity including as a fiduciary’”. The Federal Court held that: but for the express terms of the mandate letter, the pre-contract dealings between Citigroup and Toll would have pointed strongly toward the existence of a fiduciary relationship in Citigroup’s role as an adviser. … it is difficult to see that the words of the mandate have anything but their plain meaning.

26 27 28 29

30

Adams v Perpetual Trustees Australia Ltd [2006] SADC 62 at [6].

Eric Preston Pty Ltd v Euroz Securities Limited [2010] FCA 97. Eric Preston Pty Ltd v Euroz Securities Limited [2010] FCA 97 at [203] per Siopis J. Breen v Williams (1996) 186 CLR 71.

ASIC v Citigroup Global Markets Australia Pty Ltd (No 4) [2007] FCA 963.

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Although breach of fiduciary duty was not pleaded in the actual case of Selig v Wealthsure Pty Ltd 31, when one considers the fact scenario in that case, fiduciary duties could arise in two respects: namely the duty owed by adviser (and representative) to the client; and the duty owed by directors of the company Neovest to the company (namely the members and future members of that company, considered as a whole rather than individually).

Agency [8.100] The agency relationship concerns the ability of an agent acting on behalf of a principal to bind the principal in arrangements or contracts with a third party. In these circumstances the agent has the same authority as the principal when dealing with third parties such as investors, and the principal cannot deny the authority of the agent. Furthermore, the principal will be liable for the negligence of the agent while the agent is acting. The relationship between the principal and agent is fiduciary and the legal issue most often arising in this area is the question of authority in regard to the agent. The fiduciary duties of an agent are primarily a matter of acting in the principal’s interests, and not divulging confidential information. The agency relationship involves three parties: the agent, the principal and the third party. According to s 916A(1) of the Corporations Act 2001 (Cth), a licensee may give a person a written authorisation to provide financial services on behalf of the licensee. Therefore, issues of agency law are relevant to the role of advisers who operate as representatives of investment advisers or securities dealers. 32 In the case of Newman v Financial Wisdom Ltd, 33 Mandie J said (at [230]): [I]t is clear that Mr Duncan believed that they were engaged in their relevant conduct on behalf of Pamacorp or Sentinel … in connection with a securities and investment advice business carried on by Pamacorp or Sentinel … I am satisfied that Mr Duncan acted (that is, accepted the various investment recommendations) because of his said belief, in the sense that one of the reasons for him accepting the recommendations was his belief that Quarrell and Schimana were acting on behalf of Pamacorp or Sentinel in connection with a securities or investment advice business … Mr Duncan’s said belief was reasonable.

It is worth noting that agency can arise in other respects – eg, through contract or partnership. It is a primary element of a partnership that each partner is an agent for each other partner in a partnership, as illustrated by the litigation claims in Selig v Wealthsure Pty Ltd 34 discussed above. 31

32

33

34

Selig v Wealthsure Pty Ltd [2013] FCA 348.

Note also RG 104.31: “If you outsource functions that relate to your AFS licence, you remain responsible for complying with your obligations as a licensee” and RG 104.32: “If a third party provides financial services to clients on your behalf, they will generally need to be your authorised representative or hold their own AFS licence.” Available at http://download.asic.gov.au/media/ 3278615/rg104-published-1-july-2015.pdf, accessed 7 May 2016. Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216. Selig v Wealthsure Pty Ltd [2013] FCA 348

[8.100] 179

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The common law duties discussed above are not superseded by the legislation that is discussed in the next chapters. Common law still has an important place in determining the responsibilities and liabilities of professionals in the financial services area, although in many situations an aggrieved client may be advised that the statutory protection provides a more straightforward avenue in which to seek redress for breaches of duty. The case example of Selig v Wealthsure Pty Ltd is a good illustration of this.

180 [8.100]

CHAPTER 9 Regulation of the Financial Services Industry: Corporations Act, Chapter 7 [9.10]

Introduction ............................................................................................... 182 [9.20] Key points ...................................................................................................... 182 [9.30] Key terms ....................................................................................................... 183

[9.40]

Licensing of financial services providers ............................................. 183 [9.50] The need for an Australian financial services licence ............................ 183 [9.60] Exemptions from the requirement to be licensed ................................... 184 [9.70] Obligations of licensees ................................................................................ 186 [9.75] Regulatory Guide 104 – Licensing: Meeting the general obligations .... 187 [9.76] Underlying principles ..................................................................... 187 [9.78] Risk management ............................................................................. 188 [9.80] Regulatory Guide 105 – Licensing: Organisational competence .......... 188 [9.90] Underlying principles ..................................................................... 188 [9.100] Applying for a licence ................................................................................ 189 [9.110] Suspension or cancellation of licences .................................................... 190 [9.120] Banning orders ............................................................................................ 190 [9.130] Disqualification by the Court ................................................................... 191 [9.140] Restrictions on the use of terminology ................................................... 191 [9.150] Restrictions on the use of terminology unless authorised in licence .... 191 [9.160] Unlicensed adviser – consequences ......................................................... 192 [9.170] Right to rescind ........................................................................................... 192 [9.180] Enforceability of agreement ...................................................................... 192 [9.190] Compensation arrangements .................................................................... 193

[9.200]

Authorised representatives ..................................................................... 193 [9.210] Providing financial services on behalf of a financial services business .............................................................................................................. 194 [9.220] Holding out .................................................................................................. 195 [9.230] Liability of licensees ................................................................................... 195 [9.240] Regulatory Guide 146 ................................................................................. 196

[9.250]

Financial product...................................................................................... 197 [9.260] [9.270] [9.280] [9.290] [9.300] [9.310] [9.320] [9.330]

What is a facility? ....................................................................................... 197 Making a financial investment ................................................................. 198 Managing financial risk ............................................................................. 198 Making non-cash payments ...................................................................... 199 Incidental financial products ..................................................................... 199 Specific inclusions as financial products ................................................ 199 Securities ....................................................................................................... 201 Derivatives ................................................................................................... 201 181

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[9.340]

[9.350]

[9.360] [9.370] [9.375] [9.380] [9.390] [9.400] [9.410] [9.420]

[9.430]

Specific exclusions from definition of financial product ..................... 203

Financial services...................................................................................... 203 What is a financial service? ....................................................................... 203 Financial product advice ........................................................................... 204 Electronic information ................................................................................ 204 Personal and general advice ..................................................................... 206 Dealing in a financial product .................................................................. 207 Making a market for a financial product ............................................... 208 What is a financial market? ....................................................................... 208 What is a clearing and settlement facility? ............................................ 208

Retail and wholesale clients ................................................................... 208 [9.440] General insurance products ...................................................................... 209 [9.450] Superannuation and retirement savings account products ................. 209 [9.460] Other types of financial product .............................................................. 209 [9.470] Packaging of general insurance products and other types of financial products ............................................................................................. 210

[9.480] [9.490]

Legal proceedings..................................................................................... 210 Recent law reform .................................................................................... 210

INTRODUCTION [9.10] The regulation of the financial services industry is primarily conducted through a national licensing system that is governed by Ch 7 of the Corporations Act 2001 (Cth) and administered by the Australian Securities and Investments Commission (ASIC). This licensing system regulates those who provide financial services in Australia. Part 7.6 of the Corporations Act 2001 requires financial service providers to be licensed. This is the foundation of the regulatory system for the provision of financial services. The key concepts governing the application of Ch 7 of the Corporations Act 2001 are “financial product” and “financial service”. If financial services are not being provided in relation to financial products, Ch 7 has no regulatory effect. Licensees should be responsible for the competency and conduct of their employees and agents (authorised representatives) while remaining legally responsible to their clients.

Key points [9.20] This chapter will provide a greater understanding of: • the extent of protection provided by the Australian Securities and Investments Commission (ASIC);

• the specific provisions and relevance of Ch 7 of the Corporations Act 2001 (Cth); • interpretations under financial services law of financial products in terms of investment, risk and exemptions of same; and

• licensing provisions and obligations of financial service providers. 182 [9.10]

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Key terms [9.30] The key terms in this chapter are: • Financial product • Financial product advice • Licensing obligations • Authorised representatives • Wholesale/retail clients • Exemptions from holding a licence • Suspensions and cancellations • Banning orders • AFSL – Australian Financial Services Licence

LICENSING OF FINANCIAL SERVICES PROVIDERS [9.40] Licensing of financial services providers represents an important aspect of investor protection and is a basic hurdle, which participants in the financial services industry must initially clear. A single licensing regime submits all participants in the financial services industry to the same initial scrutiny for licensing and ultimately ensures that all financial service providers are subject to consistent education, conduct and disclosure requirements. 1 Part 7.6 of the Corporations Act 2001 covers the licensing of financial services providers. This means that the same licensing regime regulates anyone undertaking sales, offering advice or dealing in financial products. The underlying objective of this is to achieve harmonisation – ie, different products are regulated in similar ways, with licensing as the starting point, supported by consistent conduct and disclosure requirements.

The need for an Australian financial services licence [9.50] In regard to licensing for an adviser, the basic principle is that where financial services are provided by a person carrying on a financial services business, the person must hold an Australian financial services licence (AFSL) or be the authorised representative of an AFSL holder: s 911A. The AFSL is issued 1

The Parliamentary Joint Committee on Corporations and Financial Services recommended the introduction of an industry-based professional standards board to oversee nomenclature and competency and conduct standards for financial advisers. This resulted in the government releasing a draft proposed Corporations Amendment (Professional Standards of Financial Advisers) Bill 2015, available at http://treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/ 2015/Raising%20professional%20standards%20of%20financial%20advisers/Key%20Documents/PDF/ ExplanatoryMemorandum.ashx (accessed 11 May 2016). Submissions on the draft legislation closed 4 January 2016. Proposed amendments included the introduction of an independent industryestablished standard setting body and a new education and training requirement for new advisers (with a transitional education pathway for existing advisers). At the time this book is being finalised, the government had not responded publicly to the submissions received, nor put the bill before Parliament. [9.50] 183

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by ASIC, which has the function of ensuring that financial services licensees have appropriate skills, financial resources and compliance systems. The licence must cover the services provided and this is reflected by conditions being placed on licences by ASIC. The obligations imposed on licensees by legislative provisions or licence conditions include the provision of dispute resolution mechanisms, compensation arrangements via professional indemnity insurance and a non-delegable duty to ensure adequate training and supervision of their authorised representatives. ASIC’s Regulatory Guide 146 covers the minimum training standards for advisers who provide financial product advice to retail clients as authorised representatives. 2 Examples of persons providing financial services includes insurance agents, stockbrokers, financial advisers, investment advisers, superannuation advisers, and responsibility entities (managed investments). Chapter 5D of the Corporations Act 2001 was inserted in 2009, 3 harmonising the laws relating to traditional “trustee companies” and requiring such companies to also hold AFSLs, which then in turn obliges these companies to comply with conduct, disclosure and dispute resolution procedures, ultimately providing better consumer protection. A trustee company is defined in s 601RAB(2A) as a company whose purposes include: providing services and functions of the kind referred to in s 601RAC(1)(b) and (c); and at least one other estate management function; s 601RAC defines traditional trustee company services as: (1)(a)

performing estate management functions (see subsection 3(2)); 4

(b)

preparing a will, a trust instrument, a power of attorney or an agency arrangement;

(c)

applying for probate of a will, applying for grant of letters of administration, or electing to administer a deceased estate;

(d)

establishing and operating common funds.

Exemptions from the requirement to be licensed [9.60] Whether or not a licence is required, is important because the obligation to be licenced carries with it significant and ongoing regulatory obligations. A person providing a financial service is exempt from the requirement to hold an Australian financial services licence in the following circumstances (see s 911A(2)): 2 3 4

Available at http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-146licensing-training-of-financial-product-advisers (accessed 11 May 2016). Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 (Cth). Corporations Act 2001 (Cth) s 601RAC: “(2) The following are estate management functions: (a) acting as a trustee of any kind, or otherwise administering or managing a trust; (b) acting as executor or administrator of a deceased estate; (c) acting as agent, attorney or nominee; (d) acting as receiver, controller or custodian of property; (e) otherwise acting as manager or administrator (including in the capacity as guardian) of the estate of an individual”.

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• the person provides the service as a representative of a second person who carries on a financial services business and who holds an Australian financial services licence (s 911A(2)(a) – but note the obligation to comply with s 911B);

• the service is the issue, variation or disposal of a financial product by the person (the product provider) pursuant to an arrangement (an intermediary authorisation) between the product provider and a financial services licensee under which the financial services licensee, or their authorised representatives, may make offers to people to arrange for the issue, variation or disposal of financial products by the product provider; and the product provider is to issue, vary or dispose of financial products in accordance with such offers if they are accepted, provided that the offer pursuant to which the issue, variation or disposal is made was covered by the financial services licensee’s Australian financial services licence (s 911A(2)(b));

• the service comprises entry into an intermediary authorisation, as above (s 911A(2)(ba)); • the service is the variation or disposal of a financial product by the same person who issued the financial product, and the service is provided at the direct request of the recipient (with no intermediary involved): (s 911A(2)(c));

• the service is, or is provided incidentally to, the operation of a licensed market, or a licensed CS facility, operated by the person (s 911A(2)(d));

• the service is the provision of general advice and the following apply: the advice is provided in a newspaper or the sole or principal purpose of the newspaper or periodical is not the provision of financial product advice (s 911A(2)(ea));

• the service is the provision of general advice and all of the following apply: the advice is provided in the course of, or by means of, transmissions that the person makes by means of an information service (a broadcasting service, an interactive or broadcast videotext or teletext service or a similar service); or an online database service or a similar service; or any other service identified in regulations (s 911A(6)); and the sole or principal purpose of the transmissions is not the provision of financial product advice (s 911A(2)(eb));

• the service is the provision of general advice and the following apply: the advice is provided in sound recordings, video recordings, or data recordings; the sole or principal purpose of the recordings is not the provision of financial product advice (s 911A(2)(ec));

• the provision of general advice by a person in connection with an offer of financial products under an eligible employee share scheme by the company issuing those products or an entity controlled by it (s 911A(2)(ee));

• the person provides the service while performing functions, or exercising powers, in any of the following capacities or circumstances: as an official receiver or trustee within the meaning of the Bankruptcy Act 1966 (Cth) or as a receiver, receiver and manager, or liquidator, administrator, trustee of a deed of company arrangement, a personal representative of a deceased person other than a deceased financial services licensee (s 911A(2)(f));

• the person is a body regulated by APRA; the service is one in relation to which APRA has regulatory or supervisory responsibilities; and the service is provided only to wholesale clients (s 911A(2)(g));

• the person is regulated by an overseas regulatory authority approved by ASIC; and the service is provided only to wholesale clients (s 911A(2)(h));

• the person provides the service only to related bodies corporate of the person (s 911A(2)(i)); [9.60] 185

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• the person provides the service in the capacity of trustee of a self-managed superannuation fund (s 911A(2)(j));

• the provision of the service is covered by an exemption prescribed in regulations (s 911A(2)(k)); and

• the provision of the service is covered by an exemption specified by ASIC (s 911A(2)(l)).

Obligations of licensees [9.70] The Corporations Act 2001 places general obligations on financial services licensees as well as specific licensing, conduct and disclosure requirements. Various aspects of these obligations, eg dispute resolution mechanisms, are discussed later in this book. The general obligations of financial services licensees are set out in s 912A(1), according to which a licensee must: (a)

do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly; and

(aa)

have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative; and

(b)

comply with the conditions on the licence; and

(c)

comply with the financial services laws; and

(ca)

take reasonable steps to ensure that its representatives comply with the financial services laws; and

(d)

unless the licensee is a body regulated by APRA – have available adequate resources (including financial, technological and human resources) to provide the financial services covered by the licence and to carry out supervisory arrangements; and

(e)

maintain the competence to provide those financial services; and

(f)

ensure that its representatives are adequately trained, and are competent, to provide those financial services; and

(g)

if those financial services are provided to persons as retail clients – have a dispute resolution system complying with subsection (2); and

(h)

unless the licensee is a body regulated by APRA – have adequate risk management systems; and

(j)

comply with any other obligations that are prescribed by regulations made for the purposes of this paragraph.

This section contains a mix of the traditional common law fiduciary duties and also provisions incorporating a more modern approach to investor protection. For example, s 912A(1)(aa) demands that the licensee have arrangements in place to identify and manage any conflict that may arise. Section 912A(1)(g) provides that licensees must have dispute resolution procedures and these procedures include both internal dispute resolution systems and membership of external dispute resolution bodies: s 912(A)(2). 186 [9.70]

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| CH 9

Regulatory Guide 104 – Licensing: Meeting the general obligations [9.75] A new version of Regulatory Guide 104 was released in July 2015. 5 It provides further detail of ASIC’s expectations of the licensee in relation to the statutory obligations in s 912A. Therefore, to understand the full implications of s 912A, the guide must also be considered. The Guide is also important for applicants seeking a licence as it sets out the information required by ASIC when assessing a licence. Failure to comply gives ASIC grounds to suspend or cancel the licence: RG 104.2: You must comply with the general obligations from the time your AFS licence is granted and on an ongoing basis. If we have reason to believe that you are not complying with your obligations, we may take administrative action, which could include suspending or cancelling your licence, or imposing additional licence conditions.

Underlying principles [9.76] Regulatory Guide 104 includes the following: RG 104.11: This guide aims to strike a balance between certainty and flexibility for licensees, while furthering the primary goals of the licensing regime and the general obligations. At the broadest level, these regulatory goals are to promote: (a)

consumer confidence in using financial services; and

(b)

the provision of efficient, honest and fair financial services by all licensees and their representatives. RG 104.37: Compliance with your obligations as a licensee is central to the protection of consumers and the promotion of market integrity. Having effective compliance measures is a way for you to ensure you comply with your obligations as a licensee, including identifying and appropriately dealing with instances of non-compliance. Compliance measures also help you demonstrate to us that you can comply and are complying with your obligations.

Regulatory Guide 104 also explains that licensees can outsource functions relating to the license either to external parties or related parties but that the licensee is still responsible for the outsourced functions. 6 The Regulatory Guide 104.30 gives some examples of functions that can be outsourced by the licensee, including: • information technology systems, especially for storage of records; • training and recruitment of representatives; • financial product research; • operating call centres; • compliance reviews of representatives; • unit pricing. 5 6

Available at http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-104licensing-meeting-the-general-obligations (accessed 23 April 2016). See paragraphs RG 104.30 – RG 105.34.

[9.76] 187

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The Guide focuses on compliance with the provisions of Ch 7 of the Corporations Act 2001, obligations in relation to authorised representatives, organisational issues and non-financial resources, such as technological and human resources.

Risk management [9.78] One of the key issues addressed in the latter part of Regulatory Guide 104 is risk management. The intention is for licensees to identify areas of their organisation where there is a risk factor in terms of complying with the licensee’s obligations under the Corporations Act 2001. The obligation is not only to have adequate risk management systems, but also measures in place to ensure that this obligation is complied with on an ongoing basis: RG 104.55. RG 104.58: The requirement for risk management systems ensures that you explicitly identify the risks you face and have measures in place to keep those risks to an acceptable minimum.

These risk management procedures are targeted at those risks that would materially affect consumers or “market integrity” objectives. 7 The licensee is expected to set out steps to be taken if there are breaches of law that may affect consumers or where market integrity is in jeopardy. Measures, processes and procedures must be in place to identify and address the risks. 8 The types of risk management systems will depend on the nature, scale and complexity of the business and the licensee’s risk profile (RG 104.60) and need to adapt over time (RG 104.61). Risk management includes managing financial risk – a topic on which further regulatory guidance is provided in Regulatory Guide 166 Licensing: Financial Requirements.

Regulatory Guide 105 – Licensing: Organisational competence [9.80] Regulatory Guide 105 provides further direction to the licensee in determining what ASIC is looking for when assessing compliance with the “organisational competence obligation” in s 912A(1)(e). 9

Underlying principles [9.90] Regulatory Guide 105 includes the following: RG 105.16: In setting out minimum expectations for demonstrating organisational competence, we aim to strike a balance between certainty and flexibility for licensees while promoting consumer protection and market integrity. RG 105.17: This guide focuses on the people in your business who are responsible for the quality of your financial services. In setting minimum expectations, we aim to ensure you have enough of these people with appropriate knowledge and skills so that you have the competence to provide all of your financial services efficiently, honestly and fairly. 7

8 9

RG 104.59(b).

RG 104.59(d).

Available at http://download.asic.gov.au/media/1240103/rg105-published-17-july-2014.pdf (accessed 23 April 2016).

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These principles are based around “responsible managers” appointed by the licensee. These managers must be nominated at the time the licensee applies for a license and ASIC must be notified if these responsible managers change. 10 These “responsible managers” must have the knowledge and skills for the financial services and products their role relates to; 11 and must be of “good fame and character”. 12 The Guide provides five options which are a combination of training, qualifications and experience for demonstrating that responsible managers have knowledge and skills appropriate to their role. 13

Applying for a licence [9.100] An Australian financial services licence is applied for by lodging an application with ASIC that includes the information and any documents required by the regulations (s 913A) and ASIC must grant an applicant an Australian financial services licence if (and must not grant such a licence unless): 14 (1)

… (a)

the application was made in accordance with section 913A; and

(b)

ASIC has no reason to believe that the applicant will not comply with the obligations …

(c)

the requirement … of this section applies is satisfied; and

(ca)

the applicant has provided ASIC with any additional information requested by ASIC …

(d)

the applicant meets any other requirements prescribed by …

(2)

If the applicant is a natural person, ASIC must be satisfied that there is no reason to believe that the applicant is not of good fame or character.

(3)

If the applicant is not a single natural person, ASIC must be satisfied: (a)

(4)

11

12

13

14

if the applicant is a body corporate – there is no reason to believe that any of the applicant’s responsible officers are not of good fame or character; or

(ii)

if the applicant is a partnership or the trustees of a trust – there is no reason to believe that any of the partners or trustees who would perform duties in connection with the holding of the licence are not of good fame or character; or

In considering whether there is reason to believe that a person is not of good fame or character, ASIC must (subject to Part VIIC of the Crimes Act 1914) have regard to: (a)

10

that: (i)

any conviction of the person, within 10 years before the application was made, for serious fraud; and

RG 105.14. RG 105.31.

RG 105.33.

RG 105.44, Table 1.

See Corporations Act 2001 (Cth) s 913B. [9.100] 189

Law of Investments and Financial Markets

(5)

(b)

whether the person has held an Australian financial services licence that was suspended or cancelled; and

(c)

whether a banning order or disqualification order under Division 8 has previously been made against the person; and

(d)

any other matter ASIC considers relevant.

However, ASIC may only refuse to grant a licence after giving the applicant an opportunity: (a)

to appear, or be represented, at a hearing before ASIC that takes place in private …

ASIC must not grant an Australian financial services licence to a person contrary to a banning order or disqualification order (see below).

Suspension or cancellation of licences [9.110] ASIC may suspend or cancel an Australian financial services licence held by a natural person, by giving written notice to the person, if the person (s 915B(1)): (a)

ceases to carry on the financial services business; or

(b)

becomes an insolvent under administration; or

(c)

is convicted of serious fraud; or

(d)

becomes incapable of managing their affairs because of mental or physical incapacity; or

(e)

lodges with ASIC an application for ASIC to do so, which is accompanied by the documents, if any, required by regulations made for the purposes of this paragraph.

There are also provisions to suspend or cancel an Australian financial services licence if it is discovered that the application for the licence was false in a material particular, or is materially misleading, or if there was an omission of a material matter from the application: s 915C(2). However, ASIC may only suspend or cancel an Australian financial services licence under s 915C after giving the licensee an opportunity to appear, or be represented, at a hearing before ASIC which takes place in private; and to make submissions to ASIC on the matter: s 915C(4).

Banning orders [9.120] A banning order is a written order that prohibits a person from providing any financial services or specified financial services in specified circumstances or capacities: s 920B(1). The order may prohibit a person from providing a financial service permanently or for a specified period: s 920B(2). By giving written notice to the person, ASIC may make a banning order against a person if, amongst other things (s 920A(1)): (a)

ASIC suspends or cancels an Australian financial services licence held by the person; or

(b)

the person has not complied with their obligations under section 912A; or

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(c)

ASIC has reason to believe that the person will not comply with their obligations under section 912A; or

(d)

the person becomes an insolvent under administration; or

(e)

the person is convicted of fraud; or

(f)

the person has not complied with a financial services law; or

(g)

ASIC has reason to believe that the person will not comply with a financial services law; or

(h)

the person has been involved in a contravention of a financial services law by another person; or ASIC has reason to believe that they are likely to be so involved.

A banning order can be immediate if the person has been convicted of serious crime or if there has otherwise been an immediate suspension or cancellation of their licence pursuant to s 915B: s 920A(3). In other cases the person must be offered a hearing, as with s 915C(4): s 920A. A person against whom a banning order is made cannot be granted an Australian financial services licence contrary to the banning order (s 920C(1)) and a person who engages in conduct that breaches a banning order contravenes s 920A(2) and commits an offence.

Disqualification by the Court [9.130] Under s 921A(1), ASIC can apply to the Court for a disqualification order in relation to a person if ASIC cancels an Australian financial services licence held by the person or makes a banning order against the person which is to operate permanently. The Court may make an order disqualifying the person, permanently or for a specified period, from providing any financial services or specified financial services, in specified circumstances or capacities, or any other order the Court considers appropriate: s 921A(2). A person against whom a disqualification order is made cannot be granted an Australian financial services licence contrary to the order: s 921A(4).

Restrictions on the use of terminology [9.140] Licensees and authorised representatives cannot use restricted words, such as “independent”, “impartial”, “unbiased” (or any other word or expression of similar meaning, alone or in combination with any other word or symbol), if they receive commissions or gifts from the issuers of financial products or remuneration calculated on the basis of volume of business placed with an issuer: s 923A.

Restrictions on the use of terminology unless authorised in licence [9.150] There is also a restriction on the use of certain words or expressions, unless authorised in licence conditions, referring to stockbroker or sharebroker, futures broker, insurance broker or insurance broking, general insurance broker or life insurance broker in s 923B unless authorised by the licensee. [9.150] 191

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Unlicensed adviser – consequences [9.160] Investors have a number of rights if they enter into an agreement that relates to the provision of a financial service with an unlicensed financial services provider – whether someone with no licence at all, or with someone who does not hold an AFSL covering the particular financial service rendered. These rights include rescission of the agreement, which renders the agreement unenforceable against the client, with the result that the non-licensee is unable to recover brokerage, commission or other fee and is liable to repay any moneys already paid to the adviser under the agreement. The consequences are the same regardless of whether the investor is a retail or wholesale client.

Right to rescind [9.170] In circumstances where a financial services provider should be licensed and is not, the client may, whether before or after completion of the agreement, give to the non-licensee a written notice stating that the client wishes to rescind the agreement: s 925A(1). The notice of rescission can only be given within a reasonable period after the client has become aware of the facts entitling him or her to give the notice: s 925A(2). The client is not entitled to give a notice under s 925A if he or she engages in conduct which would, if the entitlement to give a notice were a right to rescind the agreement for misrepresentation by the non-licensee, be taken to have affirmed the agreement: s 925A(3). Further, the client is not entitled to give a notice under this section if, within a reasonable period before the agreement was entered into, the non-licensee informed the client (whether or not in writing) that the non-licensee did not hold an Australian financial services licence: s 925A(4). If, at a time when an Australian financial services licence held by the non-licensee was suspended, the non-licensee informed the client that the licence was suspended, the non-licensee is to be taken to have informed the client at that time that the non-licensee did not hold the licence: s 925A(5). A notice given under s 925A rescinds the agreement unless that rescission would prejudice a right, or an estate in property, acquired by a person (other than the non-licensee) in good faith, for valuable consideration and without notice of the facts entitling the client to give the notice: s 925B. In these circumstances, the client may apply to the Court for partial rescission, ie, a variation of the agreement, such that third party rights are not affected and the client is restored as closely as possible to their original position: s 925C.

Enforceability of agreement [9.180] Where an investor is entitled to give a notice of rescission under s 925A, the non-licensee is not entitled, as against the client, to enforce the agreement; or to rely on the agreement whether by way of defence or otherwise: s 925E. A non-licensee is not entitled to recover any brokerage, commission or other fee for which the client may be liable under the agreement if the client is entitled 192 [9.160]

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to give a notice of rescission under s 925A or has given a notice of rescission, even if the notice does not result in rescission under s 925B: s 925F. If the client gives a notice under s 925A, the client may recover from the non-licensee any moneys already paid to the non-licensee under the agreement: s 925H. If it considers that it is in the public interest to do so, ASIC may also bring an action under s 925H(1) in the name of, and for the benefit of, the client: s 925H(2). On rescission under s 925B, the Court can make consequential orders similar to those available if the agreement were rescinded because of misrepresentation by the non-licensee: s 925D(1). However, the Court cannot make such an order if it would prejudice third party property rights: s 925D(2). According to s 925I, the client’s rights and remedies described above are additional to, and do not prejudice, any other right or remedy of the client.

Compensation arrangements [9.190] If a financial services licensee provides a financial service to persons as retail clients, the licensee must have arrangements in place for compensating those persons for loss or damage suffered because of breaches of the relevant obligations under Ch 7 of the Corporations Act 2001 (Cth) by the licensee or its representatives: s 912B(1). The arrangements must meet either regulations specifying requirements or be approved in writing by ASIC: s 912B(2). The most usual arrangements will be covered by appropriate professional indemnity insurance and a licence condition requiring lodgment of a security bond with ASIC. Before approving compensation arrangements, in accordance with s 912B(3) ASIC must consider: (a)

the financial services covered by the licence; and

(b)

whether the arrangements will continue to cover persons after the licensee ceases carrying on the business of providing financial services, and the length of time for which that cover will continue; and

(c)

any other matters that are prescribed by regulations.

AUTHORISED REPRESENTATIVES [9.200] A financial services licensee may give a person a written notice authorising the person, for the purposes of Ch 7, to provide a specified financial service or financial services on behalf of the licensee: s 916A(1). ASIC must be notified of this authorisation: s 916F. Authorised persons, or “representatives”, are, therefore, employees or agents of financial service providers. They do not need a licence themselves, but must be authorised on behalf of the licensed principal: s 916A. The financial services specified may be some or all of the financial services covered by the licensee’s licence: s 916A(2). The authorisation is void to the extent that it purports to authorise the representative to provide a financial service that is not covered by the licensee’s licence or is contrary to a banning order or disqualification order under s 916A(3). [9.200] 193

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An authorisation may be revoked at any time by the licensee giving written notice to the authorised representative: s 916A(4). In some jurisdictions, representatives are required to be licensed; however, the Ch 7 regime continues a similar system to that which existed prior to the current regulatory regime when the term used for an agent was “proper authority holder”.

Providing financial services on behalf of a financial services business [9.210] Section 911B sets out the parameters in which authorised representatives may operate. A financial services provider must only provide a financial service on behalf of another if one or more of the following paragraphs apply and the conditions are satisfied (s 911B(1) – emphasis added): (a)

(b)

(c)

194 [9.210]

… (i)

the principal holds an Australian financial services licence covering the provision of the service; and

(ii)

the provider is an employee or director of the principal or of a related body corporate of the principal; and

(iii)

the provider is not an employee or director, or authorised representative, of any other person who carries on a financial services business and who is not a related body corporate of the principal; and

(iv)

the provider is not an employee or director, or authorised representative, of a related body corporate of a person of the kind mentioned in subparagraph (iii);

… (i)

the principal holds an Australian financial services licence covering the provision of the service; and

(ii)

the provider is an authorised representative of the principal; and

(iii)

the authorisation covers the provision of the service by the provider; and

(iv)

in the case of a provider who is an employee or director of any other person (the second principal) who carries on a financial services business, or of a related body corporate of such a second principal – if the provider provides any financial services in this jurisdiction on behalf of the second principal, the provider does so as an authorised representative of the second principal;

… (i)

the principal holds an Australian financial services licence covering the provision of the service; and

(ii)

the provider is an employee of an authorised representative of the principal; and

(iii)

the authorisation covers the provision of the service by the authorised representative; and

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(iv)

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the service is the provision of a basic deposit product or of a facility for making non-cash payments (see section 763D) that is related to a basic deposit product, or is the provision of a financial product of a kind prescribed by regulations made for the purposes of this subparagraph;

the provider holds their own Australian financial services licence covering the provision of the service ….

Holding out [9.220] The term “holding out” refers to a person giving a false impression that they are agents of another party. In the context of the provision of financial services, the term refers to a person giving a false impression that they are a representative of an Australian financial services licensee. 911C Prohibition on holding out A person must not hold out: (a)

that the person has an Australian financial services licence; or

(b)

that a financial service provided by the person or by someone else is exempt from the requirement to hold an Australian financial services licence; or

(c)

that, in providing a financial service, the person acts on behalf of another person; or

(d)

that conduct, or proposed conduct, of the person is within authority (within the meaning of Division 6) in relation to a particular financial services licensee; if that is not the case. Note: Failure to comply with this section is an offence (see subsection 1311(1)).

Liability of licensees [9.230] Section 912A(1)(ca) and (f) state that the licensee must take reasonable steps to ensure that its representatives comply with the financial services laws and ensure that its representatives are adequately trained, and competent, to provide those financial services. This requirement is elaborated on in RG 104: 15 You must have measures for monitoring and supervising your representatives (ie the people who act on your behalf). We expect these measures will allow you to determine whether your representatives are complying with the financial services laws: see RG 104.67 – RG 104.72. You must also have measures to ensure that your representatives who provide financial services have, and maintain, the necessary knowledge and skills to competently provide those services: see RG 104.73 – RG 104.80.

According to the terms of s 917E, financial service providers are liable as principals to third parties for the conduct of their authorised representatives and are responsible for any loss or damage suffered by the client: The responsibility of a financial services licensee under this Division extends so as to make the licensee liable to the client in respect of any loss or damage suffered by the client as a result of the representative’s conduct. 15

At the start of Section E. [9.230] 195

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The case of Newman v Financial Wisdom Ltd 16 highlights the liability of the licensee to the client even when the representatives may have acted outside their general authority. The authorised representative is also responsible for losses that may occur as a result of their conduct in the provision of financial services (s 917F(1)): If a financial services licensee is responsible for the conduct of their representative under this Division, the client has the same remedies against the licensee that the client has against the representative.

Regulatory Guide 146 [9.240] Section 912A(1) provides that licensees must: (a)

do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly; and …

(c)

comply with the financial services laws; and

(ca)

take reasonable steps to ensure that its representatives comply with the financial services laws; and …

(e)

maintain the competence to provide those financial services; and

(f)

ensure that its representatives are adequately trained, and are competent, to provide those financial services …

These provisions recognise that financial service providers must have specialist skills and training both in the area of financial services generally and in the specialised areas of their licence. All advisers are required to have specialist knowledge about the specific products they advise on and the markets in which they operate. 17 Therefore, the focus is on the training and ongoing education of the licensee and authorised representatives. Details of ASIC’s requirements in relation to these matters are set out in Regulatory Guide 146. The Guide sets out minimum training standards for advisers who provide financial advice to retail clients as authorised representatives: [RG 146.4]: Subject to [RG 146.5], All natural persons who provide financial product advice to retail clients must meet the training standards. [RG 146.1]: We have set minimum standards for the training of advisers. By setting and enforcing these training standards, we aim to: (a)

protect consumers of financial advice by ensuring that those who provide the advice are competent to do so. Retail clients generally do not have the resources or expertise to assess whether their adviser has an appropriate level of competence to provide financial advice. [RG 146.8]: In general, advisers will meet the training standards by satisfactorily completing training courses listed on the ASIC Training Register relevant to their advisory activities..…

16 17

Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216. RG 146.50.

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Regulatory Guide 104.74 also reinforces the requirement for the training of representatives. ASIC expects that licensees will: (a)

identify the knowledge and skills your representatives need to competently provide your financial services;

(b)

ensure that they have the necessary knowledge and skills;

(c)

ensure that they undertake continuing training programs to maintain and update their knowledge and skills; ….

FINANCIAL PRODUCT [9.250] Chapter 7 of the Corporations Act 2001 does not regulate financial products – but identifies them. However, it does regulate financial services and financial services providers. The identification of financial products is important since according to Ch 7 a person cannot deal in financial products unless they comply with the licensing requirements as set out in Ch 7. 18 Section 763A of the Corporations Act 2001 provides a general definition of “financial product” which is subject to specific inclusions and exclusions contained in ss 764A and 765A, respectively. According to the terms of s 763A(1), for the purpose of Ch 7, a “financial product is a facility through which, or through the acquisition of which, a person does one or more of the following”: • makes a financial investment; • manages financial risk; or • makes non-cash payments.

What is a facility? [9.260] A “facility” is defined broadly in s 762C and includes intangible property, an arrangement or a term of an arrangement (including a term implied by law or required to be included by law) or a combination of intangible property and an arrangement or term of an arrangement. Any arrangement involving the activities listed in s 763A(1) above would constitute an arrangement – for instance, a share is intangible property and by acquiring a share in a company an investor makes a financial investment. If a financial product is part of a broader facility, Ch 7 of the Corporations Act 2001 only applies to the facility to the extent that it consists of the component that is the financial product: s 762B. It follows that two or more arrangements may be regarded as a single arrangement and that an arrangement that would otherwise be a financial product cannot be split into component parts to avoid Ch 7 compliance. For example, in a derivative transaction the parties could enter a deliverable commodity agreement followed by a further agreement whereby the receiver of the goods agrees to sell back a similar quantity of goods at market price. 18

Similar sections exist in the ASIC Act s 12BAA. [9.260] 197

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Making a financial investment [9.270] According to s 763B, an investor makes a financial investment if: (a)

the investor gives money or money’s worth (the contribution) to another person and any of the following apply:

(b)

(i)

the other person uses the contribution to generate a financial return, or other benefit, for the investor;

(ii)

the investor intends that the other person will use the contribution to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated);

(iii)

the other person intends that the contribution will be used to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated); and

the investor has no day-to-day control over the use of the contribution to generate the return or benefit.

Thus, a financial investment would include investments in shares, debentures and managed funds. In the case of the issue of shares in a company, the funds raised by the company are used to generate dividends for the investor while the shareholder does not have control of the day-to-day affairs of the company. Similarly, the acquisition of an interest in a managed investment scheme does not give the scheme member day-to-day control over the operation of the scheme; that is a matter for the responsible entity. Simply giving money to a financial services licensee to buy shares does not constitute a financial investment, but the subsequent purchase of the shares will be a financial investment by the investor. Despite the similarity of the definitions of “making a financial investment” in s 763B of the Corporations Act 2001 (Cth) and a “managed investment scheme” in s 9 of the same Act, they are intended to operate independently. 19 For financial investment there is no requirement for the pooling of investments. Nor is there a requirement for the pooling of investments in a common enterprise, as is required in a non-corporate pooled investment or managed investment scheme.

Managing financial risk [9.280] Section 763C states that an investor manages a financial risk if they: (a)

manage the financial consequences to them of particular circumstances happening; or

(b)

avoid or limit the financial consequences of fluctuations in, or in the value of, receipts or costs (including prices and interest rates).

This provision is designed to catch insurance and derivatives where a liability is hedged by, for example, acquiring a futures contract or entering into a currency swap. 19

Financial Services Reform Bill 2001 (Cth), Explanatory Memorandum at [6.52].

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Making non-cash payments [9.290] A person makes non-cash payments if they make payments, or cause payments to be made, otherwise than by the physical delivery of Australian or foreign currency in the form of notes and/or coins: s 763D(1). This would include: • direct debit facilities; • cheques; • purchased payment facilities, such as smart cards; • electronic cash arrangements; and • the use of travellers’ cheques or travel money cards. As credit facilities (which include mortgages, guarantees and third party securities) are excluded from the Ch 7 regime (see s 765A(1)(h)), credit cards, which enable the making of non-cash payments, are not regarded as financial products. While Ch 7 specifically excludes credit facilities as financial products, they are specifically included in the definition of “financial product” in the ASIC Act. The following situations do not amount to making non-cash payments (s 763D(2)): • where there is only one person to whom payments can be made via the facility, eg store cards and vouchers, phone cards or where the facility is excluded under the regulations; and

• where payments are made by means of a line of credit from a financial institution, a cheque drawn by a financial institution on itself, eg a bank cheque, or a guarantee given by a financial institution.

Incidental financial products [9.300] According to s 763E(1), if a financial product is: (a)

(b)

(i)

an incidental component of a facility that also has other components; or

(ii)

a facility that is incidental to one or more other facilities; and

it is reasonable to assume that the main purpose of: [the facility] is not a financial product purpose.

This definition covers product warranties, which would otherwise be considered as managing a financial risk.

Specific inclusions as financial products [9.310] Section 764A(1) includes the following as financial products: (a) (b)

a security; any of the following in relation to a registered scheme: (i)

an interest in the scheme; [9.310] 199

Law of Investments and Financial Markets

(ba)

(ii)

a legal or equitable right or interest in an interest covered by subparagraph (i);

(iii)

an option to acquire, by way of issue, an interest or right covered by subparagraph (i) or (ii);

any of the following in relation to a managed investment scheme that is not a registered scheme, other than a scheme (whether or not operated in this jurisdiction) in relation to which none of paragraphs 601ED(1)(a), (b) and (c) are satisfied: (i)

an interest in the scheme;

(ii)

a legal or equitable right or interest in an interest covered by subparagraph (i);

(iii)

an option to acquire, by way of issue, an interest or right covered by subparagraph (i) or (ii);

(c)

a derivative;

(d)

a contract of insurance that is not a life policy, or a sinking fund policy, within the meaning of the Life Insurance Act 1995, but not including such a contract of insurance: …

(e)

a life policy, or a sinking fund policy, within the meaning of the Life Insurance Act 1995, that is a contract of insurance, but not including such a policy: …

(f)

a life policy, or a sinking fund policy, within the meaning of the Life Insurance Act 1995, that is not a contract of insurance, but not including such a policy: …

(g)

a superannuation interest within the meaning of the Superannuation Industry (Supervision) Act 1993;

(h)

an RSA (retirement savings account) within the meaning of the Retirement Savings Accounts Act 1997;

(ha)

an FHSA (short for first home saver account) within the meaning of the First Home Saver Accounts Act 2008;

(i)

any deposit-taking facility made available by an ADI (within the meaning of the Banking Act 1959) in the course of its banking business (within the meaning of that Act), other than an RSA (RSAs are covered by paragraph (h));

(j)

a debenture, stock or bond issued or proposed to be issued by a government;

(k)

a foreign exchange contract that is not: (i)

a derivative (derivatives are covered by paragraph (c)); or

(ii)

a contract to exchange one currency (whether Australian or not) for another that is to be settled immediately;

(l)

a margin lending facility;

(m)

anything declared by the regulations to be a financial product for the purposes of this section.

Section 764A(l) relating to margin lending facilities was introduced into Ch 7 in 2009 as a result of retail investors being caught in the Storm Financial and Opes 200 [9.310]

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Prime disasters. 20 The result is that margin loans are not a financial product and those involved in selling these products or advising on these products need an AFSL. Margin loan is defined in s 761EA of Ch 7 and the Act includes provisions relating to margin lending facilities and in particular rules about “responsible lending conduct for margin lending facilities”. These rules apply to a licensee who is issuing or increasing a facility to a retail client. 21 The rules require the licensee to assess the suitability of the client in relation to the product. 22 A breach of these rules may result in penalties being imposed on the license holder. Section 985K states: (1)

The provider must not: (a)

issue the margin lending facility to the retail client; or

(b)

increase the limit of the margin lending facility that was issued to the retail client; if the facility is unsuitable for the retail client under subsection (2). (2)

The margin lending facility is unsuitable for the retail client if, at the time it is issued or the limit is increased: (a)

it is likely that, if the facility were to go into margin call, the retail client: (i)

would be unable to comply with the retail client’s financial obligations under the terms of the facility; or

(ii)

could only comply with substantial hardship; or (b) if the regulations prescribe circumstances in which a margin lending facility is unsuitable – those circumstances apply to the margin lending facility.

Securities [9.320] In Ch 7, “security” has the meaning given by s 761A: a share or debenture in a body, a legal or equitable right or interest in such a security or an option to acquire, by way of issue, a security covered by the above, but does not include an excluded security. Options and futures come within the definition of “derivative” (see below). The definition of “security” takes precedence over the definition of “derivative”: s 761D(3)(d). This means that a hybrid security and a derivative product will be regarded as a security as well as a financial product under s 764A(1)(a).

Derivatives [9.330] The definition of “derivative” focuses on the functions or commercial nature of derivatives rather than attempting to identify each product to be regarded as a derivative. This definition covers futures contracts and option 20 21 22

Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 (Cth). Corporations Act 2001 (Cth) ss 985EA – 985K. Corporations Act 2001 (Cth) ss 985E – 985J.

[9.330] 201

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contracts. The main types of derivatives are futures, options and swaps and they represent fertile ground for the development of innovative financial products. Investment in derivatives usually involves institutional or high net worth investors, but retail investors have increasing exposure to derivatives via hedge fund vehicles, which are managed investment schemes under Ch 5C and interests in such schemes are “financial products” for the purposes of Ch 7. Section 761D(1) defines a “derivative” as an arrangement whereby: (1)

(2)

(a)

under the arrangement, a party to the arrangement must, or may be required to, provide at some future time consideration of a particular kind or kinds to someone; and

(b)

that future time is not less than the number of days, prescribed by regulations made for the purposes of this paragraph, after the day on which the arrangement is entered into; and

(c)

the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, for example, one or more of the following: (i)

an asset;

(ii)

a rate (including an interest rate or exchange rate);

(iii)

an index;

(iv)

a commodity.

Without limiting subsection (1), anything declared by the regulations to be a derivative for the purposes of this section is a derivative for the purposes of this Chapter. A thing so declared is a derivative despite anything in subsections (3) and (4).

Section 761D(2) provides ASIC with the opportunity to declare anything to be a derivative for the purposes of s 761D and s 761D(3) lists arrangements that are not derivatives. In an arrangement under which one party has an obligation to buy, and the other has an obligation to sell, property is not a derivative for the purposes of Ch 7 merely because the arrangement provides for the consideration to be varied by reference to a general inflation index, such as the Consumer Price Index: s 761D(4). Some hybrid products may be regarded as both derivatives and securities. Where this is the case the legislation treats the product as a security rather than a derivative: s 761D(3)(c). This has ramifications in relation to disclosure requirements, ie the application of the fundraising provisions of Ch 6D, rather than of Pt 7.9. Further, for the purposes of Ch 7, interests in managed investment schemes are not “securities” but “financial products”, and hence similar disclosure considerations arise.

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Specific exclusions from definition of “financial product” [9.340] Certain products are specifically excluded by s 765A from the definition of “financial product” and hence the Ch 7 regime. Exclusions include an excluded security, ie a share, debenture or interest in a managed investment scheme which has attached to it, or is constituted by, a right to participate in a retirement village scheme and credit facilities which include mortgages, guarantees and third party securities. Credit facilities are covered in reg 7.1.06 of the Corporations Regulations 2001 (Cth). Further, ASIC can declare that a specified facility, interest or other thing is not a financial product for the purposes of Ch 7: s 765(2). These overriding exclusions apply regardless of whether the facilities or arrangements come within the general definition of “financial product” (s 763A) or the list of specific inclusions in s 764A.

FINANCIAL SERVICES [9.350] The definition of “financial services”, together with the definition of “financial product”, is pivotal to financial services regulation and hence adviser compliance and investor protection. As in the case of financial products, “financial services” are defined quite widely in a five-limb definition. The provision of financial services determines licensing, conduct and disclosure requirements.

What is a financial service? [9.360] According to s 766A(1), 23 a person provides a financial service if they: (a)

provide financial product advice (see section 766B); or

(b)

deal in a financial product (see section 766C); or

(c)

make a market for a financial product (see section 766D); or

(d)

operate a registered scheme; or

(e)

provide a custodial or depository service (see section 766E); or

(f)

engage in conduct of a kind prescribed by regulations made for the purposes of this paragraph. Provision of traditional trustee company services by trustee company (1A)

Subject to paragraph (2)(b), the provision by a trustee company of a traditional trustee company service constitutes the provision, by the company, of a financial service. Note: Trustee companies may also provide other kinds of financial service mentioned in subsection (1).

It seems likely that most of the participants in the financial services industry either provide financial product advice or deal in a financial product and therefore need to be licensed accordingly. A person is not a financial service provider if the relevant conduct is in the course of work usually carried out by clerks or cashiers: s 766A(3). Further, a 23

A similar section exists in the ASIC Act s 12BAB. [9.360] 203

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person does not operate a registered scheme merely because they are acting as an agent or employee of another person, or they are taking steps to wind up the scheme: s 766A(4).

Financial product advice [9.370] Few investors in financial products would act without some form of advice. Thus, a key activity of financial service providers is the provision of financial product advice. It is important under the Ch 7 regime to distinguish whether the advice is given to a retail, as opposed to a wholesale, client and is of a personal or general nature. According to the terms of s 766B(1), “financial product advice” means a recommendation or a statement of opinion, or a report of either of those things, that: (a)

is intended to influence a person or persons in making a decision in relation to a particular financial product or class of financial products, or an interest in a particular financial product or class of financial products; or

(b)

could reasonably be regarded as being intended to have such an influence.

However, the giving of an exempt document or statement, such as a prospectus under Ch 6D of the Corporations Act 2001, is not to be taken to be a provision of financial product advice. “Exempt document” (or “statement”) means a document prepared, or a statement given, in accordance with the requirements of Ch 7, other than a statement of advice or a document or statement of a kind prescribed by the regulations for the purposes of s 766B: s 766B(9). Regulation 7.1.08 of the Corporations Regulations 2001 (Cth) prescribes, and hence excludes from the definition of “exempt document” or “statement”, the following: • a product disclosure statement that contains personal advice; or contains general advice about a financial product other than a financial product to which the statement relates;

• a financial services guide that contains personal advice; • a record of advice given in the case of execution-related telephone advice under s 946B(3A); and

• a product disclosure statement distributed for advertising purposes pursuant to s 1018A: Corporations Regulations 2001 (Cth) reg 7.1.08(1).

Documents, information and statements that do not contain personal advice but are required by, and prepared as a result of, a requirement of Australian law and are included in a class specified by ASIC are prescribed, and hence are exempt documents or statements: reg 7.1.08(3). The provision of promotional material or material not expressing an opinion or recommendation would not constitute financial product advice.

Electronic information [9.375] Increasing investor reliance on electronic information websites has lead to debate as to the nature of the material provided. In the case of ASIC v Online 204 [9.370]

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Investors Advantage Inc 24 the licensee, Online had an AFSL, which only permitted Online to provide general product advice about securities, however the website responded to information entered by the user of the site, and as a result Moynihan J decided that Online provided both financial advice and was a financial product: a subscriber to the website gains access to data about US securities and means to organise, analyse and evaluate data to support decisions in respect of buying and selling stock generally and in respect of specific securities. The operation of the website generates recommendations as to the acquisition, holding or sale of categories of securities or securities in terms of the criteria selected by the user and applied by the system.[109] The website serves as a source of financial advice in respect of a particular financial product or class of financial product in terms of s 766B.[125] … and manages financial risk in terms of ss 763A(b) and 763C [126].

The website was promoted by seminars and instruction manuals, however, the decision that the actual website was a financial product was unexpected. Under s 763A(1)(b) of the Corporations Act 2001 a financial product is a facility through which, or through the acquisition of which, a person “manages financial risk”. Section 762C defines a “facility” as “intangible property” or “an arrangement” or both of these things. This definition can include a website like Online’s, as an “intangible” facility. Under s 763C a person manages financial risk if they: • Manage the financial consequences to them of particular circumstances; or • Avoid or limit the financial consequences of fluctuations in or in the value of

receipts or costs.

Moynihan J said that a subscriber to the Online website gains access to information about US securities and that the website caters for the management of individual portfolios and specific securities. The Corporations Act 2001 includes the situation where the subscriber manages financial risk, and therefore the website was held to be a financial product. In determining that the website was a financial product, Moynihan J referred to Re Market Wizard Systems (UK) Ltd, 25 where the software provided for the downloading of daily securities information and other information and the user could compare the information to determine sell/hold signals. The Court said it was irrelevant that the users could receive advice from other sources and that they were bound to follow the information generated by the computer program. In Australian Securities and Investments Commission v Oxford Investments (Tasmania) Pty Ltd 26 the defendants provided instructions in a computer system for trading futures contracts. It was held: (1) 24

25 26

On the facts, there was an expression of opinion, being a representation that in specified circumstances arising from a particular kind of market analysis, ASIC v Online Investors Advantage Inc [2005] QSC 324.

Re Market Wizard Systems (UK) Ltd [1998] 2 BCLC 282. Australian Securities and Investments Commission v Oxford Investments (Tasmania) Pty Ltd (2008) 169 FCR 522. [9.375] 205

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trading in a particular way was likely to be profitable, and there was the provision of technical aids that assisted in identifying those circumstances from day to day. The combined effect of these things was the provision of financial product advice. [22]

Personal and general advice [9.380] There are two types of financial product advice: personal advice and general advice. “Personal advice” is financial product advice that is given or directed to a person (including by electronic means) in circumstances where (s 766B(3)): (a)

the provider of the advice has considered one or more of the person’s objectives, financial situation and needs; or

(b)

a reasonable person might expect the provider to have considered one or more of those matters.

“General advice” is financial product advice that is not personal advice: s 766B(4). According to s 766B(5), the following advice is not financial product advice: (a)

advice given by a lawyer in his or her professional capacity, about matters of law, legal interpretation or the application of the law to any facts;

(b)

… any other advice given by a lawyer in the ordinary course of activities as a lawyer, that is reasonably regarded as a necessary part of those activities;

(c)

… advice given by a tax agent registered under Part VIIA of the Income Tax Assessment Act 1936, that is given in the ordinary course of activities as such an agent and that is reasonably regarded as a necessary part of those activities.

If these professionals carry on a financial services business, they require an Australian financial services licence. The importance of the distinction between personal and general advice is emphasised in the application of the conduct and disclosure provisions of Ch 7. In particular, note that s 944AA provides that Div 3, which includes the suitability rule and Statement of Advice requirements, applies where personal advice is provided by an adviser to an investor who is a retail client. Some clarification of the position of qualified accountants is provided by Corporations Regulations 2001 (Cth), reg 7.129. Certain services are determined by ASIC to be exempt services and these exemptions would be applicable to all professional advisers providing incidental financial services. Some examples of “exempt services” in reg 7.1.29(3) refer to a person who provides advice: • in relation to the preparation or auditing of financial reports or audit reports; or • on the risk associated with carrying on a business and identifies generic financial products or generic classes of financial product that will mitigate that risk, other than advice for inclusion in an exempt document or statement; or

• on the acquisition or disposal, administration, due diligence, establishment, structuring or valuation of an incorporated or unincorporated entity.

A person also provides an exempt service (reg 7.1.29(4)) if: 206 [9.380]

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• the person provides advice to another person on taxation issues including advice in relation to the taxation implications of financial products; and

• the person will not receive a benefit (other than from the person advised or an associate of the person advised) as a result of the person advised acquiring a financial product mentioned in the advice, or a financial product that falls within a class of financial products mentioned in the advice; and

• either the advice does not constitute financial product advice to a retail client or the advice constitutes financial product advice to a retail client and it includes, or is accompanied by, a written statement that: – the person providing the advice is not licensed to provide financial product advice under the Corporations Act 2001; and – taxation is only one of the matters that must be considered when making a decision on a financial product; and – the client should consider taking advice from the holder of an Australian Financial Services Licence before making a decision on a financial product.

Dealing in a financial product [9.390] Section 766C(1) identifies conduct which constitutes “dealing” in a financial product: (a)

applying for or acquiring a financial product;

(b)

issuing a financial product;

(c)

in relation to securities or managed investment interests – underwriting the securities or interests;

(d)

varying a financial product;

(e)

disposing of a financial product.

The activities of participants in the securities industry previously covered by a securities dealers’ licence, such as stockbrokers, come within s 766C(1). A person who arranges for another person to engage in dealing in a financial product, as above, is also dealing in a financial product unless the actions concerned amount to providing financial product advice: s 766C(2). It is not dealing in a financial product if a person deals in the product on their own behalf unless the person is an issuer of financial products and the dealing is in relation to those products: s 766C(3). Transactions entered into by government or local government authorities, public authorities, a body corporate or an unincorporated body, do not constitute dealing in a financial product if the transaction relates only to securities of the particular entity or, if the entity is a government, debentures, stocks or bonds issued by that government: s 766C(4). This does not apply in the case of a body corporate or unincorporated body that carries on a business of investment in securities, interests in land or other investments and, in the course of carrying out that business, invests funds subscribed, whether directly or indirectly, after an offer or invitation to the public made on terms that the funds subscribed would be invested: s 766C(5). [9.390] 207

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Making a market for a financial product [9.400] A person makes a market for a financial product (s 766D): • if they regularly state the prices at which they propose to acquire or dispose of financial products on their own behalf; and

• other persons have a reasonable expectation that they will be able to regularly effect transactions at the stated prices; and

• the actions of the person do not constitute operating a financial market, or would not constitute the operation of a financial market because of s 767A(2)(a).

This does not apply if the person is the issuer of products which are superannuation products, managed investment products or financial products relating to unregistered managed investment schemes: s 766D(2). Thus, simply quoting unit prices relating to interests in managed investment schemes will not constitute “making a market”.

What is a financial market? [9.410] According to the terms of s 767A(1), a “financial market” is a facility through which: (a)

offers to acquire or dispose of financial products are regularly made or accepted; or

(b)

offers or invitations are regularly made to acquire or dispose of financial products that are intended to result or may reasonably be expected to result, directly or indirectly, in: (i)

the making of offers to acquire or dispose of financial products; or

(ii)

the acceptance of such offers.

A person operating a financial market in Australia is required to have an Australian market licence authorising the person to operate the market in Australia: s 791A(1).

What is a clearing and settlement facility? [9.420] A clearing and settlement (CS) facility is a facility that provides a regular mechanism for the parties to transactions relating to financial products to meet obligations to each other: s 768A. The following examples of clearing and settlement facilities are given in s 768A(1): • a facility that provides a regular mechanism for stockbrokers to pay for the shares they buy and to be paid for the shares they sell, and for records of those transactions to be processed to facilitate registration of the new ownership of the shares; or

• a facility that provides a regular mechanism for registering trade in derivatives on a futures market and that enables the calculation of payments that market participants owe by way of margins.

RETAIL AND WHOLESALE CLIENTS [9.430] The distinction between retail and wholesale clients is important since an investor who is a retail client will have the full extent of investor protection in 208 [9.400]

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relation to conduct and disclosure available to them, as discussed in Chapter 10. Most of the investor protection provisions of Ch 7 relate only to services provided to retail clients. Chapter 7 does not define the term “retail client”; rather, the type of the financial product determines whether the investor is a retail client.

General insurance products [9.440] In relation to general insurance products, the product or service is provided to the person as a retail client if (s 761G(5)): (a)

(b)

either: (i)

the person is an individual; or

(ii)

the insurance product is or would be for use in connection with a small business; and

the general insurance product is: (i)

a motor vehicle insurance product (as defined in the regulations); or

(ii)

a home building insurance product (as defined in the regulations); or

(iii)

a home contents insurance product (as defined in the regulations); or

(iv)

a sickness and accident insurance product (as defined in the regulations); or

(v)

a consumer credit insurance product (as defined in the regulations); or

(vi)

a travel insurance product (as defined in the regulations); or

(vii)

a personal and domestic property insurance product (as defined in the regulations); or

(viii)

a kind of general insurance product prescribed by regulations made for the purposes of [s 761G(5)].

A small business is a business employing less than 100 people (if the business is or includes the manufacture of goods), or less than 20 people (if the business does not include the manufacture of goods): s 761G(12).

Superannuation and retirement savings account products [9.450] If a financial product provided to a person is a superannuation product or a “retirement savings account” (RSA) product, or if services related to such products are provided, the product or services are provided to the person as a retail client: s 761G(6).

Other types of financial product [9.460] If a financial product is not, or a financial service (other than a traditional trustee company service) provided to a person does not relate to a general insurance product, a superannuation product or a RSA product, the product or service is provided to the person as a retail client, unless (s 761G(7)): (a)

the price for the provision of the financial product, or the value of the financial product to which the financial service relates, equals or exceeds the amount specified in regulations … [9.460] 209

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(b)

the financial product, or the financial service, is provided for use in connection with a business that is not a small business

(c)

the financial product, or the financial service, is not provided for use in connection with a business, and the person who acquires the product or service gives the provider of the product or service, before the provision of the product or service, a copy of a certificate given within the preceding 6 months by a qualified accountant … that states that the person:

(d)

(i)

has net assets of at least the amount specified in regulations made for the purposes of this subparagraph; or

(ii)

has a gross income for each of the last 2 financial years of at least the amount specified in regulations made for the purposes of this subparagraph a year;

the person is a professional investor.

Packaging of general insurance products and other types of financial products [9.470] If a combination of financial products is provided, s 761G(5) applies to the transaction or service so far as it relates to the general insurance products. Section 761G(6) or (7), as the case requires, applies to the transaction or service so far as it relates to other financial products: s 761G(11).

LEGAL PROCEEDINGS [9.480] In offence matters, the provider of the product or service has to discharge the burden of proof when claiming that the client was not a retail client in relation to other kinds of financial product: ss 761G(8) and 761GA. In non-criminal proceedings, there is a rebuttable presumption in relation to these products that the product or service was provided to the person as a retail client: s 761G(9).

RECENT LAW REFORM [9.490] In February 2009 the Parliamentary Joint Committee on Corporations and Financial Services, 27 set up a committee to report on the issues associated with recent financial product and services provider collapses, such as Storm Financial, Opes Prime and other similar collapses, with particular reference to: 1. 2.

the role of financial advisers; the general regulatory environment for these products and services;

3.

the role played by commission arrangements relating to product sales and advice, including the potential for conflicts of interest, the need for appropriate disclosure, and remuneration models for financial advisers;

4.

the role played by marketing and advertising campaigns;

5.

the adequacy of licensing arrangements for those who sold the products and services;

27

Known as the Ripoll Inquiry.

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6.

the appropriateness of information and advice provided to consumers considering investing in those products and services, and how the interests of consumers can best be served;

7. 8.

consumer education and understanding of these financial products and services;

9.

the need for any legislative or regulatory change.

the adequacy of professional indemnity insurance arrangements for those who sold the products and services, and the impact on consumers; and

In March 2009 the terms of reference were extended to include an investigation of the involvement of the banking and finance industry in providing finance for investors in and through Storm Financial, Opes Prime and other similar businesses, and the practices of banks and other financial institutions in relation to margin lending associated with those businesses. In recent years, several amendments have occurred. The government released a package of proposed amendments called the Future of Financial Advice (FOFA) reforms. These included two new Acts: • Corporations Amendment (Future of Financial Advice) Act 2012; • Corporations Amendment (Further Future of Financial Advice Measures) Act 2012; followed by a new Corporations Amendment (Streamlining Future of Financial Advice) Regulation 2014, which commenced on 1 July 2014, but was disallowed by the Senate on 19 November 2014, followed by the following two bipartisan regulations: • Corporations Amendment (Revising Future of Financial Advice) Regulation 2014, which commenced on 16 December 2014;

• Corporations Amendment (Financial Advice) Regulation 2015, which commenced on 1 July 2015;

and then, followed by another Act amending the Corporations Act 2001 (Cth), namely, the Corporations Amendment (Financial Advice Measures) Act 2016, which was passed on 1 March 2016 and commenced on 19 March 2016. 2012 amendments The Corporations Amendment (Future of Financial Advice) Act 2012 and the Corporations Amendment (Further Future of Financial Advice Measures) Act 2012, together introduced, voluntarily from 1 July 2012 and mandatorily from 1 July 2013: • a ban on conflicted remuneration structures, including up-front and trailing

commissions and volume-based payments, including volume rebates from platform providers to dealer groups; • a requirement for advisers to obtain their client’s consent to their fees, every two

years; • an annual fee disclosure statement; • enhanced ASIC powers; • a ban on soft dollar benefits, where a combined annual benefit is $300 or more),

except benefits genuinely provided for the purposes of professional development relevant to the client, and administrative IT services; [9.490] 211

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• a new form of limited advice called scaled advice, which can be provided by a

range of advice providers, including superannuation trustees, financial planners and potentially accountants, creating a level playing field for people who provide advice. Scaled advice is advice about one area of an investor’s needs, such as insurance, or about a limited range of issues; and • a limited carve out from elements of the ban on conflicted remuneration and best

interests duty for basic banking products where employees of an Australian Deposit-taking Institution (ADI) are advising on and selling their employer ADI’s basic banking products. Basic banking products are basic deposit products (eg savings accounts), first home saver account deposit accounts and non-cash payment products (eg travellers cheques and cheque accounts).

2016 amendments The 2016 amendments in the Corporations Amendment (Financial Advice Measures) Act 2016 increased the time given to advisers to send renewal notices to their clients, from 30-60 days. It clarified the position in relation to basic insurance and non-cash payments (such as travel money cards) still constituting financial products and broadened the education and training provisions, and provides for a best interests duty for advice on a general insurance product and to ADI employees/agents giving advice on basic banking products, general insurance products, and consumer credit insurance. The training exemption for soft dollar benefits has also been broadened – it no longer needs to be relevant to the provision of financial product advice to clients; now it is satisfactory if the training benefit is relevant to the carrying on of a financial services business. These provisions will be considered in more detail in following chapters, but given the degree of reform in this sector, a chronological outline of these reforms may assist the reader in tracing the development of the law in this area.

212 [9.490]

CHAPTER 10 Conduct and Disclosure in the Investment Advisory Process [10.10]

Introduction ............................................................................................... 214 [10.20] [10.30]

[10.40] [10.60]

Key points .................................................................................................... 214 Key terms ..................................................................................................... 215

Conduct of Business Rules: Corporations Act 2001, Part 7.7........... 215 Part 7.7A: Conduct obligations for personal advice to retail clients. 216 [10.60] Definition of Advice Provider .................................................................. 216 [10.80] Advice providers must act in retail client’s best interests: s 961B ..... 216 [10.95] Modified best interest duty for basic banking products and general insurance products ............................................................ 223 [10.100] Advice providers must only give appropriate advice to retail clients ................................................................................................. 223 [10.110] Advice providers must warn retail clients of incomplete or inaccurate information .................................................................... 224 [10.120] Advice providers must prioritise the interests of the client .... 225 [10.130] Licensee’s obligations and liability ............................................... 225 [10.140] Authorised representative’s obligations and liability ................ 226 [10.150] ASIC’s approach ............................................................................... 226 [10.160] Secondary services ........................................................................... 227 [10.170] General advice .................................................................................. 229

[10.180]

Disclosure................................................................................................... 231 [10.190] [10.200] [10.210] [10.220] [10.230] [10.240] [10.250] [10.260] [10.270]

[10.280]

What constitutes good disclosure? ........................................................ 233 Disclosure requirements elsewhere in the law .................................... 233 Disclosure through documentation ....................................................... 235 Financial services disclosure: Part 7.7 ................................................... 235 Financial Services Guide .......................................................................... 236 Circumstances where a FSG is required ............................................... 236 When a FSG is provided ......................................................................... 237 Contents of a FSG ..................................................................................... 237 Main requirements of FSG: s 942B ........................................................ 237

Statement of Advice................................................................................. 239 [10.290] Appropriate advice rule ........................................................................... 239 [10.300] Obligation to give client a SoA .............................................................. 239 [10.310] Circumstances where a SoA is not given ............................................. 239 [10.320] Small investments ............................................................................ 240 [10.330] Further market-related advice ....................................................... 240 [10.340] When a SoA is provided .......................................................................... 240 [10.350] Content of SoA .......................................................................................... 241

[10.360]

Financial product disclosure: Part 7.9................................................... 242 213

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[10.360] [10.370] [10.380] [10.390] [10.400] [10.410] [10.420] [10.430] [10.440] [10.450] [10.460]

[10.470]

Product Disclosure Statements (PDS) .................................................... 242 Obligation to provide PDS ...................................................................... 244 Situations requiring PDS to be provided ............................................. 244 Tailored PDS .............................................................................................. 244 Shorter, simpler PDS ................................................................................ 244 Incorporation by reference ...................................................................... 245 PDS content requirements ....................................................................... 245 PDS content requirements: s 1013D ....................................................... 246 Advertising and PDSs .............................................................................. 247 Cooling off .................................................................................................. 247 Circumstances where a PDS is not required ........................................ 247

Liability for contravention of conduct and disclosure rules ............ 249 [10.480] Criminal liability ....................................................................................... [10.480] Failure to provide disclosure documents .................................... [10.490] Defective disclosure documents .................................................... [10.500] Civil liability .............................................................................................. [10.510] Misleading or deceptive conduct .................................................. [10.520] Administrative action ...................................................................... [10.530] Disclosure and the no conflict of interest rule ....................................

249 249 249 250 251 252 253

INTRODUCTION [10.10] Australian Financial Services Licensees (AFSLs) and their authorised representatives must act with integrity and there must be adequate disclosure in regard to financial services and products to enable informed choices by investors. These principles are embodied in the “Conduct of Business” rules, that is to “know your client, know your product” rule and the “disclosure rule”. These rules are contained in Pt 7.7 – Financial Services Disclosure, Part 7.7A – Best Interest Calculations and Remuneration, and Pt 7.9 – Financial Product Disclosure – of the Corporations Act 2001 (Cth) Chapter 7. The ASIC Regulatory Guide RG 175 Licensing: Financial Product Advisers – Conduct and Disclosure and RG 168 Disclosure: Product Disclosure Statements (and other disclosure obligations) set out the conduct and disclosure requirements for the provision of financial product advice to retail clients. In RG 175.33, ASIC (Australian Securities and Investments Commission) indicates that it will “pay particular attention to whether consumers are being provided with clear, concise and effective disclosure that satisfies their information needs and whether they are being provided with personal advice that is appropriate”.

Key points [10.20] This chapter will provide a greater understanding of: • the “rules” that apply to the investment industry in order to ensure diligence on behalf of advisers; 214 [10.10]

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• the specific disclosures required to be made on the part of advisers to ensure open communication with investors;

• the format and manner in which the mandatory disclosures are to be made available to investors;

• the recourse available to investors in the event of misstatement or misinformation provided by advisers; and

• protection given to retail clients by disclosure requirements.

Key terms [10.30] These terms are of critical importance to an understanding of conduct and disclosure: • Conduct of Business Rules • Financial Services Guide (FSG) • Product Disclosure Statement (PDS) • Statement of Advice (SoA) • Appropriate Advice • Know your client • Know your product • Conflict of interest • Administrative action

CONDUCT OF BUSINESS RULES: CORPORATIONS ACT 2001, PART 7.7 [10.40] The conduct and disclosure obligations imposed on providing entities and on persons providing a financial service (and particularly financial product advice) provider represent the most significant obligations placed on investment advisers and go to the heart of Chapter 7 of the Corporations Act 2001 (Cth). These laws changed recently. As the new provisions now mandatorily apply from 1 July 2013, this chapter will discuss the law current as at 1 July 2013. Both financial service providers as well as the actual individual advisers are required to comply with conduct and disclosure obligations when providing financial product advice to retail clients. These principles are the cornerstone of the investment advice process and support the general obligations placed upon licensees in parts of s 912A(1), including that advisers: (a)

do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly; and

(b)

have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative; and … [10.40] 215

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(e)

maintain the competence to provide those financial services; and

(f)

ensure that its representatives are adequately trained, and are competent, to provide those financial services …

PART 7.7A: CONDUCT OBLIGATIONS FOR PERSONAL ADVICE TO RETAIL CLIENTS Definition of Advice Provider [10.60] A “provider” is an individual who provides personal advice to a retail client: s 961(1) and (2). If two or more individuals provide the advice, each is a “provider”: s 961(3). If it is not possible to identify the individual or individuals providing the advice, the person (or entity) who provides the advice will be considered to be the “provider”: s 961(5). It is irrelevant whether the individual is a representative of a licensee: s 961(4). The person is a provider even if the advice is provided by means of a computer program: s 961(6). Although only tangentially relevant to the definition of “advice provider”, it is worth noting that ASIC has recently taken an interest in the area of “digital advice” or “robo-advice”. In March 2016, ASIC issued a Consultation Paper 254, Regulating digital financial product advice 1 and also issued a companion draft Regulatory Guide relating to digital advice. 2 Comments and submissions were due by 16 May 2016 and ASIC has indicated that it expects its new regulatory guide on this topic to be released in August 2016.

Advice providers must act in retail client's best interests: s 961B [10.80] When giving personal advice to retail clients, each “provider” must act in the best interests of the client: s 961B(1). Under s 961B(2), which provides a “safe harbour” under which advisers can operate, this duty will be satisfied where the provider has: (a)

identified the objectives, financial situation and needs of the client that were disclosed to the provider by the client through instructions;

(b)

identified:

(c)

1 2

(i)

the subject matter of the advice that has been sought by the client (whether explicitly or implicitly); and

(ii)

the objectives, financial situation and needs of the client that would reasonably be considered as relevant to advice sought on that subject matter (the client’s relevant circumstances);

where it was reasonably apparent that information relating to the client’s relevant circumstances was incomplete or inaccurate, made reasonable inquiries to obtain complete and accurate information; See http://download.asic.gov.au/media/3583180/cp254-published-21-march-2016.pdf (accessed 12 May 2016). See http://download.asic.gov.au/media/3583174/attachment-to-cp254-published-21-march-2016.pdf (accessed 8 May 2016).

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(d)

assessed whether the provider has the expertise required to provide the client advice on the subject matter sought and, if not, declined to provide the advice;

(e)

if, in considering the subject matter of the advice sought, it would be reasonable to consider recommending a financial product: (i)

conducted a reasonable investigation into the financial products that might achieve those of the objectives and meet those of the needs of the client that would reasonably be considered as relevant to advice on that subject matter; and

(ii)

assessed the information gathered in the investigation;

(f)

based all judgements in advising the client on the client’s relevant circumstances;

(g)

taken any other step that, at the time the advice is provided, would reasonably be regarded as being in the best interests of the client, given the client’s relevant circumstances.

A note to that subsection makes it clear that these matters “relate to the subject matter of the advice …. and the circumstances of the client relevant to that subject matter (the client’s relevant circumstances). That subject matter and the client’s relevant circumstances may be broad or narrow, and so… a client may seek scaled advice and that the inquiries made by the provider will be tailored to the advice sought.” The section also prescribes the steps necessary for personal advice to retail clients on basic banking products and on general insurance products. ASIC notes in RG175.250-256, that the “instructions” may be contained in a series of communciations, may result from clarifications sought by the advisor, and may require the adviser to exercise judgment to determine the subject matter of the advice sought. In some cases (for example client sensitivity to the cost of advice), the adviser and the client may work together to narrow or clarify the schope of the advice sought: RG 175.271-280. Section 961B(2)(c) refers to “where it was reasonably apparent that information relating to the client’s relevant circumstances was incomplete or inaccurate”. According to section 961C, this means: “if it would be apparent to a person with a reasonable level of expertise in the subject matter of the advice that has been sought by the client, were that person exercising care and objectively assessing the information given to the provider by the client”. Section 961B(2)(e)(i) refers to conducting a “reasonable investigation into the financial products that might achieve those of the objectives and meet those of the needs of the client that would reasonably be considered relevant to advice on the subject matters ought by the client”. Section 961D clarifies that this does not require an investigation into every financial product available, but must include an investigation into any financial product specified by the client. Section 961E states that “It would reasonably be regarded as in the best interests of the client to take a step, if a person with a reasonable level of expertise in the subject matter of the advice that has been sought by the client, [10.80] 217

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exercising care and objectively assessing the client’s relevant circumstances, would regard it as in the best interests of the client, given the client’s relevant circumstances, to take that step.” In RG175-225-227, ASIC explains: When assessing whether an advice provider has complied with the best interests duty, we will consider whether a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. This depends on the circumstances and includes the following factors: (a)

the position the client would have been in if they did not follow the advice, which is to be assessed at the time the advice is provided;

(b)

the facts at the time the advice is provided that the advice provider had, or should have had, if they followed their obligations. In particular, we will not examine investment performance retrospectively, with the benefit of hindsight …;

(c)

the subject matter of the advice sought by the client;

(d)

the client’s objectives, financial situation and needs. Many clients seek advice with the objective of improving their financial position. However, a client’s objectives, financial situation and needs may also encompass other things, such as:

(e)

(i)

improving a client’s understanding of their financial position;

(ii)

aligning their financial position with their appetite for risk;

(iii)

reassuring them that that they do not need to change their strategy or product holdings as a result of a review; or

(iv)

increasing their confidence to spend or donate their money…;

where relevant, product features that the client particularly values, provided that the client understands the cost of, and is prepared to pay for, those features. For example, a client may particularly value online access to information about their investment holdings as well as understanding and being prepared to pay for the cost of this feature …; and

(f)

that the client receives a benefit that is more than trivial…. We do not expect an advice provider to give “perfect advice” to establish that the client is likely to be in a better position if the client follows the advice.

ASIC further explains, in RG 175.234: We expect that processes for complying with the best interests duty will ensure that, within the subject matter of the advice sought by the client: (a)

the scope of the advice includes all the issues that must be considered for the advice to meet the client’s objectives, financial situation and needs (including the client’s tolerance for risk);

(b)

if the scope of the advice changes, the change is consistent with the client’s objectives, financial situation and needs;

(c)

the client’s objectives, financial situation and needs are identified through inquiries or otherwise; and

(d)

the advice provider focuses on providing advice that is not product specific, or on a combination of advice that is both product specific and non-product specific, where this would better suit the client’s objectives, financial situation and needs. Advice that is not product specific may include advice to do nothing.

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In RG 175.287-289, ASIC explains that for advice on financial products with an investment component, ASIC considers that: we consider that–depending on the subject matter of advice sought by the client–the client’s relevant circumstances may include the client’s: (a)

need for regular income (e.g. retirement income);

(b)

need for capital growth;

(c)

desire to minimise fees and costs;

(d)

tolerance for the risk of capital loss, especially where this is a significant possibility if the advice is followed;

(e)

tolerance for the risk that the advice (if followed) will not produce the expected benefits. For example, in the context of retirement advice, this may include considering longevity risk, market risk and inflation risk;

(f)

existing investment portfolio;

(g)

existing debts;

(h)

investment horizon;

(i)

need to be able to readily “cash in” the investment;

(j)

capacity to service any loan used to acquire a financial product, including the client’s ability to respond to any margin call or make good any losses sustained while investing in leveraged products; and

(k)

tax position, social security entitlements, family commitments, employment security and expected retirement age. … This is not an exhaustive list…. The client’s relevant circumstances include any other matter that would reasonably be considered relevant to the advice, based on the advice provider’s obligations in s 961B. This would normally encompass any matter that the client indicates is important. Advice providers must form their own view about how far s 961B requires inquiries to be made into the client’s attitude to environmental, social or ethical considerations. Advice providers may need to ascertain whether environmental, social or ethical considerations are important to the client and, if they are, conduct inquiries about them.

To rely on the safe harbour, advice providers must assess whether they have sufficient expertise to provide advice on the matter. If not, they must not provide the advice: s 961B(2)(d). In making this assessment, ASIC states in RG175.297 that advice provides must consider: (a)

for individual advice providers, any specific requirements for, or limitations on, providing advice that are imposed on them by their AFS licensee or authorised representative and the basis for these requirements or limitations;

(b)

for individual advice providers, their professional qualifications and training. This includes the extent to which their qualifications and training cover determining the strategy the advice is based on;

(c)

for individual advice providers, their knowledge and skills in relation to the strategy and financial product(s) they are advising the client on (as relevant). This includes understanding the features of any financial products they recommend to clients; and

(d)

the AFS licence authorisations of their licensee, or of the advice provider if the advice provider is the licensee. The AFS licence authorisations are relevant because AFS licensees have an obligation to: [10.80] 219

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(i)

ensure that they are competent to provide the financial services they are authorised to provide;

(ii)

maintain the competence to provide those financial services; and

(iii)

ensure that their representatives are adequately trained, and are competent, to provide those financial services: s 912A(1).

To rely on the safe harbour, ASIC also states at RG 175.335 that advice providers: must base all judgements they make in advising the client on the client’s relevant circumstances: s 961B(2)(f). This includes the judgements that the advice provider makes about: (a)

the scope of the advice;

(b)

the extent of the inquiries they make into the client’s relevant circumstances;

(c)

the strategies, and types of financial product and specific financial products they investigate;

(d)

the strategies, types of financial product and specific financial products the advice provider makes recommendations about; and

(e)

how the client should acquire financial products, where relevant – for example,w hether the client should acquire the products directly or through a platform.

On pages 61-64 of RG175, ASIC gives the following examples of compliance with the s 961B duty: Example 1: No ‘retrospective testing’ Scenario An advice provider gives advice recommending that a client invest in an Australian equities fund. This advice is appropriate for the client. The client invests in the fund and loses money because of a fall in unit prices for the fund caused by a downturn in the performance of equity markets. Commentary Losses caused by a downturn in financial markets are irrelevant in considering whether the best interests duty has been complied with. The best interests duty is concerned with what occurred at the time the advice was provided—not the performance of the client’s investment.

Example 2: A ‘health check’ on a client’s financial affairs Scenario A client seeks personal advice to get a ‘health check’ on the state of their financial affairs in light of their long-term financial goals. The advice provider reviews the client’s financial situation and provides them with advice that they are on track to meet these goals. The advice provider does not recommend that the client acquire or dispose of any financial products, and the client does not do so. Commentary In this situation, a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice (i.e. by taking the advice into account). This is because the client has received reassurance that they are on track to meet their goals, is better informed and is less likely to make a change that would be adverse to their interests. The advice provider has complied with the best interests duty.

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Example 3: Advice to a client on providing for a relative Scenario A client seeks and obtains personal advice from an advice provider on how to restructure their financial arrangements so that they can pay for the medical expenses of a sick relative. Commentary This advice does not involve any ongoing improvement in the client’s financial situation. However, a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. This is because following the advice would result in meeting the client’s objective to pay for their relative’s medical expenses. The advice provider has complied with the best interests duty.

Example 4: Advice that the client’s expectations are unrealistic Scenario A 60-year-old asks an advice provider for advice on whether they will have enough money to retire at age 65. They give the advice provider details on the lifestyle they expect to have in retirement. Based on the client’s finances and their expected lifestyle in retirement, the advice provider tells the client that that they will not have enough money to provide the income they expect for their planned retirement at age 65. The advice provider gives the client advice that is not product specific on: * the advantages and disadvantages of different options for saving for and living in retirement, such as working for longer, increasing superannuation contributions, downsizing to a smaller property or travelling less after retirement; and * how much superannuation income the client can afford in retirement, given the size of their superannuation balance. Commentary In this situation, a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. This is despite the fact that the advice provider has advised the client that their financial circumstances will not allow them to achieve their goals or meet their needs. Instead, the advice provider has advised the client on how to change their goals and needs in retirement so that these are more realistic. The advice provider has complied with the best interests duty.

Example 5: Advice that is likely to leave the client in a better position Scenario A client holds a portfolio of products through a platform. They have told their advice provider that they find the consolidated reporting generated by the platform difficult to understand and they want to be able to understand these reports. They would be prepared to pay more for better quality reporting if they feel the increase in fees is commensurate with the value they place on receiving better quality reporting. The advice provider recommends that the client switch to another platform because the format of its consolidated reports on the client’s holdings will be easier for the client to follow. Compared with the fees the client is currently paying, the fees for this other platform are higher by 0.1% of the value of the client’s assets administered by the platform. The client views a sample consolidated report from the other platform, says that they find this format of reporting easier to understand and indicates that they are prepared to pay the higher fees for this better quality reporting. Commentary In this scenario, we would consider that a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. The advice provider has complied with the best interests duty.

Example 6: Advice that is unlikely to leave the client in a better position Scenario A client holds a portfolio of products through a platform. They have told their advice provider that they believe their current platform is providing an acceptable service and they can understand the reporting provided but they are concerned about the fees they are paying for using the platform.

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The advice provider discusses the reports with the client and believes that the client understands them, even though they are presented in a complex manner. The advice provider recommends that the client switch to another platform because the format of its consolidated reports on the client’s holdings will be easier for the client to follow. Compared with the fees the client is currently paying, the fees for this other platform are higher by 0.1% of the value of the client’s assets administered by the platform. Commentary In this scenario, we would not consider that a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. This is because the client was concerned about costs but was switched to a platform with higher costs. The advice provider has not complied with the best interests duty.

Example 7: Providing advice that is not product specific Scenario A client who is 33 years old approaches an advice provider for advice on wealth accumulation strategies. The client has recently received a promotion and has considerable surplus income. On assessment, the advice provider establishes that, because of the high level of income the client receives, they have limited ability to add more funds to superannuation through ‘salary sacrifice’ concessional contributions. The client’s mortgage is significant, but manageable, given their current income and personal circumstances. The advice provider provides recommendations to salary sacrifice up to the maximum limit for concessional contributions, and to use the surplus funds to repay the mortgage. Commentary The subject matter of advice sought by the client is wealth accumulation strategies. The advice provider has complied with the best interests duty because they have provided the client with advice that is not product specific and is consistent with the subject matter of the advice sought by the client.

ASIC does not consider this duty to be inconsistent with, or require, the use of approved product lists that have been specified by licensees for use by their advice providers (RG175.328). ASIC notes at RG175.329-332: In some cases, an advice provider can conduct a reasonable investigation into financial products under s 961B(2)(e) by investigating the products on their AFS licensee’s approved product list. In other cases, an advice provider will need to investigate and consider a product that is not on their AFS licensee’s approved product list to show that they have acted in the best interests of the client when providing them with personal advice - for example: (a)

if the client’s existing products are not on the approved product list of the advice provider’s licensee and these products might be able to meet the client’s relevant circumstances;

(b)

if an approved product list used by an advice provider is restricted to one class of product and there are products that are not in that class that would better meet the client’s relevant circumstances, considering the subject matter of the advice sought by the client; or

(c)

if the client requests the advice provider to consider a specified financial product that is not on the approved product list of the advice provider’s licensee. Advice providers are expected to exercise judgement in determining whether s 961B(2)(e) requires them to consider products that are not on their AFS licensee’s approved product list. If an advice provider recommends a product that is not on their AFS licensee’s approved product list, they must ensure that they have the appropriate authorisations and approvals from their licensee to provide the advice. Their AFS licensee must ensure that the advice is provided in a way that complies with the relevant legal and regulatory requirements (e.g. the requirement for AFS licensees to have adequate professional indemnity insurance).

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Modified best interest duty for basic banking products and general insurance products [10.95] Section 961B also prescribes the steps necessary for personal advice to retail clients on basic banking products and on general insurance products. This forms a “modified best interests duty” for these two products (and products which are a combination of these two product types). Section 961B was amended by the Corporations Amendment (Financial Advice Measures) Act 2016, which commenced on 19 March 2016. The amended section extends the availability of this modified duty to an authorised deposit-taking institution (ADI) (and its employees and agents) to advice on consumer credit products, general insurance products, as well as basic banking products — and any combination of these. Previously, the modified best interests duty only applied to basic banking products where the advice was given by an ADI and to general insurance products. The amendments also extend the modified duty to persons “otherwise acting by arrangement with an Australian ADI under the name of the Australian ADI”, even if no express agency is in place. Under the new provisions, similar to the old provisions, when accessing the modified best interests duty in respect of advice given about a general insurance product, there is no need for the giver of advice to be an agent/employee/representative/ acting in the name of, an ADI. Regulatory Guide 175 has not been amended since the 2016 amendments and thus, at the time this book being finalised, still reflects the current law and is misleading as to the nature of the amendments. ASIC has outlined further information on how to provide scaled advice when the modified best interests duty applies, in RG244.

Advice providers must only give “appropriate advice” to retail clients [10.100] Financial product advice that is personal advice must only be provided to a retail client if it would be reasonable to conclude that the advice is appropriate to the client, had the provider satisfied the duty under s 961B to act in the client’s best interests: section 961G. Note that this obligation does not apply to the giving of general advice. ASIC considers that advice is appropriate if, at the time, following the advice would likely satisfy the client’s relevant circumstances, and the client is likely to be in a better position if they followed the advice (RG 175.225). At RG 175.226, ASIC notes that this issue depends on the following factors: (a)

the position the client would have been in if they did not follow the advice, which is to be assessed at the time the advice is provided;

(b)

the facts at the time the advice is provided that the advice provider had, or should have had, if they followed their obligations. In particular, we will not examine investment performance retrospectively, with the benefit of hindsight;

(c)

the subject matter of the advice sought by the client;

(d)

the client’s objectives, financial situation and needs. Many clients seek advice with the objective of improving their financial position. However, a client’s objectives, financial situation and needs may also encompass other things, such as: [10.100] 223

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(i)

improving a client’s understanding of their financial position;

(ii)

aligning their financial position with their appetite for risk;

(iii)

reassuring them that that they do not need to change their strategy or product holdings as a result of a review; or

(iv)

increasing their confidence to spend or donate their money;

(e)

where relevant, product features that the client particularly values, provided that the client understands the cost of, and is prepared to pay for, those features. For example, a client may particularly value online access to information about their investment holdings as well as understanding and being prepared to pay for the cost of this feature; and

(f)

that the client receives a benefit that is more than trivial.

If the advice takes into account tax considerations, this should be stated in the advice: RG 175.162. ASIC also states in RG 175.357: When there are material tax implications that go beyond an advice provider’s competence, two ways that the advice provider can act in the best interests of their client and give appropriate advice are: (a)

the advice can be based on advice given to the client by someone with appropriate expertise, such as a registered tax agent. In this case, the advice provider must ensure that they make clear in the SOA and in discussions with the client that they are assuming the tax advice is appropriate, rather than endorsing it; or

(b)

the advice can be limited to matters on which the advice provider is competent to advise—in which case, the advice provider must take steps so that it is reasonable to believe the client understands that they should seek tax advice from a person with appropriate expertise (or forms their own view if they have appropriate expertise) before following the advice provider’s advice.

Advice providers must warn retail clients of incomplete or inaccurate information [10.110] Pursuant to s 961H(1), if it is reasonably apparent that information relating to the objectives, financial situation and needs of the retail client is based is incomplete or inaccurate, the provider must warn the retail client that the advice is, or may be, based on incomplete or inaccurate information relating to the client’s relevant personal circumstances, and because of that, the client should consider the appropriateness of the advice, having regard to the client’s objectives, financial situation and needs, before acting on the advice. This warning must be given at the same time as the advice and by the same means: s 961H(2). If a Statement of Advice is given, the Statement of Advice must set out or record this warning (ss 947B(2)(f) and 947C(2)(g)) and can in fact include it (s 961H(3)). If there are multiple advice providers in relation to a single piece of advice, the warning need only be given by one of them: s 961H(4). In RG175.373 ASIC notes its expectation that: that the more material the conflict of interest between the client and the advice provider or their related party, the more the advice provider will need to do to prioritise the client’s interests. 224 [10.110]

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Advice providers must prioritise the interests of the client [10.120] Under section 961J, if the provider knows, or ought to know, that there is a conflict between the interests of the client and the interests of the provider, or the licensee, or an authorised representative who authorised the provision of the service (or an associate of any of these), the provider must give priority to the client’s interests. This does not apply if the subject matter of the advice is solely a basic banking product and the provider is employed by, or acting under the name of the bank or Australian ADI offering the financial product and the product is either a basic banking product, a general insurance product, consumer credit insurance, or any combination of these or, if the subject matter of the advice is solely a general insurance product. At RG175.377, ASIC notes that this rule means: (a)

an advice provider must not recommend a product or service of a related party to create extra revenue for themselves, their AFS licensee or the related party, where additional benefits for the client cannot be demonstrated;

(b)

where an advice provider uses an approved product list that only has products issued by a related party on it, the advice provider must not recommend a product on the approved product list, unless a reasonable advice provider would be satisfied that it is in the client’s interests to recommend a related party product rather than another product with similar features and costs; NOTE: One way that an advice provider may be able to do this is by benchmarking the product against the market for similar products to establish its competitiveness on key criteria such as performance history, features, fees and risk. The benchmarking must be reasonably representative of the market for similar products that are offered by a variety of different issuers.

(c)

an advice provider must not “over-service” the client to generate more remuneration for themselves or one of their related parties. This means that the advice provider must provide a level of service commensurate with the client’s needs. For example, they must not recommend an unduly complex strategy if the client is unlikely to seek ongoing advice; and

(d)

an advice provider must recommend non-financial product solutions relevant to the client’s situation, where appropriate, even if this means the client is less likely to need financial advice in the future (e.g. advice on debt reduction, estate planning and/or Centrelink benefits).

Licensee's obligations and liability [10.130] Section 961L obliges licensees to take reasonable steps to ensure that the licensee’s representatives comply with ss 961B, 961G, 961H and 961J. The licensee will breach s 961K, which is a civil penalty provision, if either the licensee, or a representative other than an authorised representative of the licensee, contravenes any of these sections. In these circumstances, the client also has the legal right to pursue the licensee for compensation for the amount of loss or damage suffered by the client as a result of the breach: s 961M. [10.130] 225

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Authorised representative's obligations and liability [10.140] An authorised representative of a licensee will breach s 961Q, which is also a civil penalty provision, if the authorised representative contravenes any of ss 961B, 961G, 961H and 961J, unless the failure to comply occurred solely because of the authorised representative’s reasonable reliance on information or instructions provided by the licensee.

ASIC's approach [10.150] In RG175.214, ASIC explains the policy principles that will guide its administration of these obligations: The following basic policy principles will guide our administration of the best interests duty and related obligations in Div 2 of Pt 7.7A: (a)

the provisions are intended to enhance trust and confidence in the financial advice industry;

(b)

increased trust and confidence in the financial advice industry should lead to more consumers accessing financial advice;

(c)

the provisions should lead to a higher quality of advice being provided compared to the general standard of advice being provided under s 945A and 945B;

(d)

a reasonable advice provider should believe that the client is likely to be in a better position if the client follows the advice …; and

(e)

the best interests duty in s 961B, the appropriate advice requirement in s 961G and the conflicts priority rule in s961J are separate obligations that operate alongside each other and apply every time personal advice is provided.

Furthermore, in RG175.218-219, ASIC explains that: We consider that any process of giving good quality financial advice has some or all of the following features: (a)

a clearly defined scope that is appropriate to the subject matter of advice sought by the client and the client’s relevant circumstances;

(b)

an investigation of the client’s relevant circumstances;

(c)

assistance given by the advice provider to the client, if required, to set prioritised, specific and measurable goals and objectives;

(d)

where relevant, consideration of potential strategies and options that are available to the client to meet their objectives and needs;

(e)

where relevant, consideration of all aspects of the impact of the advice–for example, tax or social security consequences;

(f)

(g)

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good communication with the client. This includes: (i)

providing an SOA that is logically structured and easy to understand, if one is required; and

(ii)

if appropriate, depending on how the advice is provided, verbal interactions that aim to ensure that the advice and recommendations are understood; and

where relevant, strategic and product recommendations that are appropriate for the client’s relevant circumstances.

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If an advice provider makes a product recommendation, we consider it is good practice to articulate clearly how the strategy of the advice is linked to, or might be achieved by, the recommendation.

Secondary services [10.160] The above obligations will also apply to a person who indirectly provide financial product advice, by means of a secondary service (that is, via an intermediary). ASIC provides the following discussion on secondary services at RG 175.112–114: Financial product advice may be provided as a secondary service where an AFS licensee (or authorised representative) causes or authorises financial product advice to be given or directed to a retail client (within the meaning of s 52). Causing or authorising does not always need to be express. In our view, the licensee (or authorised representative) is likely to be providing a secondary service if: (a)

it knows (or should know) that the advice or any part of it will be passed on to a third party (the recipient); and

(b)

the advice is passed on and attributed to the licensee (or authorizsed representative). The AFS licensee (or authorised representative) does not authorise the provision of advice by mere inactivity if it did not know or have reason to suspect that the advice might be passed on and attributed to it (University of New South Wales v Moorhouse & Angus & Robertson (Publishers) Pty Ltd (1975) 133 CLR 1 at 12–14 per Gibbs J). RG 175.114 If the intermediary provides financial product advice to the retail client as its own, without attributing it to the AFS licensee (or authorised representative), it will not be financial product advice provided by the licensee (or authorized representative) to the retail client. This is the case even if the advice provided by the licensee (or authorised representative) to the intermediary helped that intermediary to formulate its own advice.

ASIC explains at RG 175.115–116 that: If all of the following three requirements are met, we would ordinarily expect that a person (the adviser) would not be providing financial product advice to a retail client, even if their advice is later passed on to a retail client and attributed to the adviser: (a)

Requirement 1: the adviser expressly prohibits the intermediary (ie, the adviser’s wholesale client) from passing on the adviser’s advice to any retail client;

(b)

Requirement 2: the adviser includes a prominent statement in the adviser’s advice to the intermediary that it is only intended for use by wholesale clients and must not be made available to any retail client; and

Requirement 3: there is no reasonable basis to believe that the intermediary will fail to comply with the adviser’s express prohibition in Requirement 1. Meeting these three requirements should amount to reasonable steps to prevent the secondary service from occurring. As a result, it is our view that an adviser ordinarily would not be considered to be causing or authorising, either directly or implicitly, the giving or directing (dissemination) of the adviser’s advice to retail clients via the intermediary. (c)

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ASIC explains the distinction in Appendix 2 of RG 175 (pp 101–102): Table 8: Examples of secondary services and how to avoid providing them Example Explanation B1 A stockbroker provides A financial planner seeks advice from a stockbroker about what advice to a financial planner share purchases should be made for a particular retail client. What for the financial planner’s cli- can the stockbroker do to ensure that they do not provide a ent secondary service to the retail client? The stockbroker could give advice to the financial planner, taking reasonable steps to prevent it from being passed on to the retail client as the stockbroker’s advice. The stockbroker could achieve this by meeting the three requirements listed in RG 175.115. The financial planner could then formulate their own advice, taking into account what the stockbroker has said. Alternatively, if the stockbroker allows the financial planner to pass on the stockbroker’s advice to the retail client, the stockbroker would need to meet all the retail client requirements, including arranging for an FSG to be provided by the financial planner to the retail client on their behalf. This would be necessary because, by allowing the financial planner to pass on their advice, the stockbroker is providing a secondary service to the retail client. However, if the advice is not attributed to the stockbroker, the stockbroker will not be providing a secondary service to the retail client and will not be obliged to give their FSG to that retail client. B2 An underwriting agency rec- A general insurance broker discusses particular details of the ommends insurance prod- insurance needs of their retail clients with an underwriting ucts for an insurance broker’s agency. The general insurance broker then asks the underwriting agency what particular products the underwriting agency might client recommend for those clients’ circumstances. The underwriting agency could avoid providing a secondary service to the retail clients by taking the three reasonable steps listed in RG 175.115. The general insurance broker could then formulate their own advice, taking into account what the underwriting agency has said. Alternatively, if the underwriting agency allows the general insurance broker to pass on the underwriting agency’s advice to the retail client, the underwriting agency would need to meet all the retail client requirements, including arranging for an FSG to be provided by the general insurance broker to the retail client on its behalf. This would be necessary because, by allowing the general insurance broker to pass on its advice, the underwriting agency is providing a secondary service to the retail client. However, if the advice is not attributed to the underwriting agency, the underwriting agency will not be providing a secondary service to the retail client and will not be obliged to give its FSG to that retail client. B3 A research house issues A research house issues a piece of research that includes general research that includes advice financial product advice to its various clients that are AFS licensees to licensee clients and those (licensee clients). The licensee clients post that research on their clients post the research on websites in a location that can be accessed by their retail clients their websites with an acknowledgement of the source of the research. Unless the research house has taken reasonable steps to prevent its advice being passed on to retail clients (such as the three reasonable steps listed in RG 175.115), it is likely to be providing financial product advice to the retail clients by implicitly causing or authorising the provision of its advice to the retail clients, and would need to meet all of the retail client requirements. If the research house allows the licensee clients to pass on its advice to the retail clients, the research house would need to meet all the retail client requirements, including arranging for an FSG to be provided by the licensee clients to the retail clients on its behalf. This would be necessary because, by allowing the licensee clients to pass on its advice, the research house is providing a secondary service to the retail clients.

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Table 8: Examples of secondary services and how to avoid providing them Example Explanation B4 A research house posts A research house issues a piece of research that includes general research that includes its financial product advice and posts this on its website, which is advice on its website accessible by the public. An AFS licensee takes the information from the website and passes that information on to its retail clients as the research house’s advice. The research house has no agreement or relationship with the licensee, and does not know the identity of the clients of the licensee. The research house will be providing the AFS licensee with general financial product advice. Although the research house may also be providing general advice to retail clients of the licensee, the research house will not be required to give those clients a copy of its FSG if s 940B applies. This is because s 940B provides that no breach occurs where there is ‘no reasonable opportunity’ to provide retail clients with an FSG. This defence is likely to be available in this example because, in the circumstances described, the research house does not know, and has no reasonable way of finding out, the identities or the addresses of the retail clients receiving the information taken and disseminated by the licensee.

General advice [10.170] The above obligations only apply to the provision of personal advice to retail clients. The distinction between personal advice and general advice is discussed in Chapter 9. The above obligations only apply to the provision of personal advice to retail clients. There is no specific requirement that general advice be appropriate for the client’s needs, and so this distinction between general advice and personal advice becomes important so as to know whether or not the above duties apply in given circumstances. In Regulatory Guide 175 at pages 98–99, ASIC sets out the following table, distinguishing between general advice and personal advice: Table 7: Examples of the difference between personal advice and general advice Example Explanation A1 Mailout to entire client list A stockbroker prepares periodic newsletters or research reports containing assessments of various financial products and sends them to their entire client list. We would expect that those newsletters or research reports would ordinarily be general advice and not personal advice. We would expect them to contain a general advice warning under s 949A. This is because the stockbroker would not ordinarily take into account any individual’s relevant circumstances in preparing and providing a periodic newsletter or research report that is sent to all of their clients, and nor would a reasonable person expect them to have done so. A2 Investment seminar for all A person invites all their clients to an investment seminar. clients We would expect that they would ordinarily provide general advice and not personal advice at an investment seminar that is open to all of their clients. We would expect them to provide a general advice warning under s949A at such a seminar. This is because the financial product advice the person provides at a seminar that is open to all their clients would not ordinarily take into account any individual’s relevant circumstances, and nor would a reasonable person expect it to have done so.

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Table 7: Examples of the difference between personal advice and general advice Example Explanation However, if the person wants to confine their seminar to providing general advice, they need to consider how the information in the seminar is communicated to the audience and, in particular, ensure that they clearly communicate that they are providing general advice. For example, it is important that the person: * does not use language in the presentation that gives the impression that they have considered the objectives, financial situation or needs of any audience members in providing the financial product advice that it contains; * does not respond to audience comments or questions in a way that gives the impression that the financial product advice that they are providing takes into account any audience member’s objectives, financial situation or needs; or * does not give personal advice in their response to audience questions. A3 Mailout of brochure in A product issuer, in response to client queries, sends out a response to a client query marketing brochure about a particular product or product range that they offer. We would expect that these brochures would ordinarily contain general advice and not personal advice. We would expect them to contain a general advice warning under s 949A. This is because a product issuer would not ordinarily take into account any individual’s relevant circumstances in providing a marketing brochure in response to a client query, and nor would a reasonable person expect them to have done so. A4 Quoting from a PDS in A product issuer responds to telephone queries about product response to a query features by either quoting from the PDS, or by using their own words to convey the information in the PDS. By quoting from the PDS in response to a telephone query about product features, the product issuer would not ordinarily take into account any individual’s relevant circumstances and nor would a reasonable person expect them to have done so. We would expect the product issuer to provide a general advice warning under s 949A. A5 Mailout to particular client A person sends different newsletters, research reports or margroups keting brochures to different segments of their client base. In general, we think this person is likely to be providing general advice when, in deciding to send a particular newsletter, research report or marketing brochure to a particular segment of their client list, they look at broad client groupings based on: * the size of a client’s portfolio; * whether a client currently invests in, or has expressed interest in receiving information about, any of the broad market sectors discussed in the newsletter (e.g. property trusts, the industrials sector); * a client’s age; * whether a client is employed or retired; or * whether a client has used the person’s services within a particular timeframe. A6 Marketing campaigns to a An insurance broker markets a product that is suitable for market segment people who are subject to a particular broad type of risk, and sends standardised marketing material for that product to clients who fall within that broad market segment. This situation falls within Example A5, and, for the same reasons, we think the broker is likely to be giving general advice. A7 Investment seminars for par- A person invites a particular segment of their client base to a ticular client groups seminar based on broad groupings, as described in Example A5, and provides a previously prepared presentation focusing on areas that are likely to be of interest to that broad client group.

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Table 7: Examples of the difference between personal advice and general advice Example Explanation These facts do not necessarily mean that the person has, or might be expected to have, taken into account any client’s objectives, financial situation or needs in giving them the financial product advice provided at the seminar. As in Examples A2 and A5, we are likely to take the view that the person is giving general advice.

When general advice is given to a retail client, the adviser has an obligation to warn the client that the advice does not take account of the client’s relevant personal circumstances, ie the client’s objectives, financial situation or needs: s 949A. In these circumstances, there is no need for a SoA to be given. The warning required under s 949A when general advice is provided by a financial services licensee or their authorised representative to a retail client is designed to cause the client to consider the appropriateness of the advice. Section 949A(2) requires the adviser to warn the client that: (a)

the advice has been prepared without taking account of the client’s objectives, financial situation or needs; and

(b)

because of that, the client should, before acting on the advice, consider the appropriateness of the advice, having regard to the client’s objectives, financial situation and needs; and

(c)

if the advice relates to the acquisition, or possible acquisition, of a particular financial product – the client should obtain a Product Disclosure Statement (see Division 2 of Part 7.9) relating to the product and consider the Statement before making any decision about whether to acquire the product.

The warning must be given to the client at the same time and by the same means as the advice is provided (s 949A(3)) and failure to comply with s 949A(2) is an offence: s 1311(1). An authorised representative of a financial services licensee has a defence under s 949A(4) in any proceedings for an offence against s 949A if: (a)

the licensee had provided the authorised representative with information or instructions about the requirements to be complied with in relation to the giving of personal advice; and

(b)

the representative’s failure to comply with subsection (1) occurred because the representative was acting in reliance on that information or those instructions; and

(c)

the representative’s reliance on that information or those instructions was reasonable.

The above defence does not apply to civil proceedings. Section 949A(5) provides that licensees must take reasonable steps to ensure that an authorised representative of the licensee complies with s 949A(2).

DISCLOSURE [10.180] The CLERP 6 policy proposal paper (1997) p 102 explains the importance of conflict of interest disclosure in a SoA: [10.180] 231

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The disclosure of benefits received by an intermediary and any conflicts of interest assists clients in assessing the merits of a product recommendation and reduces the opportunity for advisers to act in self-interest to the disadvantage of the client.

Disclosure requirements are designed to promote informed decision-making by both advisers and investors. In the context of financial services disclosure documents, the aim is to enable investors to compare and make informed choices relating to financial products. Chapter 7 of the Corporations Act 2001 institutes a regime of disclosure through documentation. A Financial Services Guide (FSG) must be given to a retail client provided with a financial service, while a Statement of Advice (SoA) must be given to a retail client provided with personal advice by a financial services licensee or their authorised representative. The requirements for FSGs and SoAs are contained in Pt 7.7 of the Act – “Financial Services Disclosure”. Part 7.9 – “Financial Product Disclosure” requires that a retail client must receive a Product Disclosure Statement (PDS) before acquiring a financial product. Sections 942B(2)(e) and (f), and 942C(2)(f) and (g) of the Corporations Act 2001, which apply to financial services licensees and authorised representatives respectively in relation to the content requirements of the Financial Services Guides, require disclosure of: • information about the remuneration (including commission) or other benefits that may be received by the financial services provider or related parties that are associated with the provision of the services; and

• information about any associations or relationships that might reasonably be expected to be capable of influencing the providing entity in providing the services.

Sections 947B(2)(d) and (e), 947C(2)(e) and (f) of the Corporations Act 2001, which apply to licensees and authorised representatives respectively concerning the contents of a SoA, require the following: • information about any remuneration (including commission) or other benefits to be received by the provider or related parties that might reasonably be expected to be or have been capable of influencing the provider in providing the advice; and

• information about any interests, whether pecuniary or not and whether direct or indirect, of the provider or related parties and any associations or relationships between providers and their associates and the issuers of any financial products that might reasonably be expected to be or have been capable of influencing the provider in providing the advice.

The requirements of Pts 7.7 and 7.9 cannot be contracted out of: ss 951A and 1020D. Regulatory Guide 168: Disclosure: Product Disclosure Statements (and other disclosure obligations), describes the PDS as “A document that must be given to a retail client for the offer or issue of a financial product.” Regulatory Guide 175: Licensing: Financial Product Advisers – Conduct and Disclosure sets out ASIC’s policy for administering the law on: • providing product advice; • preparing and providing a FSG; 232 [10.180]

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• preparing and providing suitable personal advice; and • preparing and providing a SoA. Where general advice is given to a retail client, a SoA is not required; however, warnings must accompany all general advice regardless of how the advice is provided: see s 949A.

What constitutes good disclosure? [10.190] Apart from the disclosure requirements set out in Ch 7 of the Corporations Act 2001, RGs 168 and 175 contain guidance relating to PDSs and conduct and disclosure under Corporations Act 2001. Regulatory Guide 168 introduces “good disclosure principles” which are discussed in detail in section C of the guide which, while directed towards issuers preparing a PDS, are equally applicable to all financial services disclosure. 3 These principles provide guidance on ASIC policy for all licensees, authorised representatives and product issuers who are preparing a PDS. The Good Disclosure Principles are outcome focused. The key outcomes that we seek to achieve are to help consumers make better decisions and to help consumers compare financial products. 4

Regulatory Guide 175 also refers to these principles in relation to the preparation of Financial Services Guides. The principles are that disclosure should: • be timely; • be relevant and complete; • promote product understanding; • promote comparison; • highlight important information; and • have regard to consumers’ needs.

Disclosure requirements elsewhere in the law [10.200] Chapter 6D – “Fundraising Provisions” of the Corporations Act 2001 includes a general disclosure test in s 710 in relation to prospectus content. A prospectus for a body’s securities must contain all the information that investors and their professional advisers would reasonably require in order to make an informed assessment. However, this is only to the extent to which it is reasonable for investors and their professional advisers to expect to find the information in the prospectus and only if a person whose knowledge is relevant actually knows the information or, in the circumstances, ought reasonably to have obtained the information by making inquiries. 3 4

RG 168 Section C, Key Points. RG 168.57, available at http://download.asic.gov.au/media/1240931/rg168-published-28-october2011.pdf (accessed 12 May 2016). [10.200] 233

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Introduced into the Corporations Act 2001 as a result of recommendations of CLERP 9, Ch 6CA recognises that disclosure of relevant information at the time that the financial product or security is first released on the market only protects a limited number of investors who choose to invest in a release of a new financial product or security, and that continuous disclosure of relevant information provides greater protection to a larger number of investors. Continuous disclosure principles have existed in the ASX listing rules for some time. Sections 674 and 675 of the Corporations Act 2001 provide generally that listed disclosing entities must disclose information that is not generally available to the public and that the information is such that a reasonable person would expect, if it were generally available, to have a material effect on the price or value of the security. Listed entities must disclose the information to the ASX (or other securities exchange on which the entity is listed), and unlisted entities must disclose it to ASIC. While the most useful remedies to investors for non-disclosure are found in legislation, the common law has developed principles relating to disclosure in the areas of misrepresentation and non-disclosure. The connection between misrepresentation and disclosure (silence as misrepresentation) is well-known and will not be explored here. However, the leading authority on unconscionable conduct in Australia, Commercial Bank of Australia Ltd v Amadio, 5 which saw the decision in favour of the guarantors on the grounds that it would be unconscionable to enforce the third party security because of the guarantor’s special disability, could just as easily have been couched in terms of misrepresentation and non-disclosure. The Amadio case provides a principle which describes a duty to disclose in terms of the natural and legitimate expectations of the guarantor. In the Amadio case, it was stated by the High Court of Australia in relation to the taking of guarantees and third party securities that: A contract of Guarantee is not uberrimae fidei. However, the principal creditor is under a duty to disclose anything in the transaction between the creditor and the debtor which has the effect that the position of the debtor is different from that which the intending surety would naturally expect, particularly if it affects the nature or degree of the surety’s responsibility. 6

A contract of insurance is a contract of the utmost good faith (uberrimae fidei) whereby all matters relevant to the risk being undertaken by the issuer have to be disclosed. It appears from the principle above that contracts of guarantee approximate to similar disclosure requirements. In the present context, it is interesting to note that a financial services licensee must not, in or in relation to the provision of a financial service, engage in conduct that is, in all the circumstances, unconscionable: s 991A. These circumstances could include non-disclosure. 5

6

Commercial Bank of Australia Ltd v Amadio (1983) 151 CLR 447; 46 ALR 402.

Commercial Bank of Australia Ltd v Amadio (1983) 151 CLR 447; 46 ALR 402 at 403.

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Disclosure through documentation [10.210] Regulatory Guide 168.1 sets out, from a consumer’s perspective, documentary disclosure that is required under Ch 7 of the Corporations Act 2001, with each document representing different stages of the investment process: Disclosure required at each stage of investment process What service am I getting? What advice am I getting? What product am I buying?

Disclosure is in a Financial Services Guide (FSG) Disclosure is in a Statement of Advice (SoA) if the advice is personal Disclosure is in a PDS and can be in a Short-Form PDS

Each must be “worded and presented in a clear, concise and effective manner”. 7

Financial services disclosure: Part 7.7 [10.220] Under Pt 7.7 of the Corporations Act 2001 both licensees and authorised representatives are required to provide disclosure documents to retail clients, as set out in the following flowchart on RG 168, page 9:

7

RG 168.17 (accessed 24 May 2015). [10.220] 235

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Financial Services Guide [10.230] Financial services licensees and authorised representatives who provide financial services to retail clients are required to give the retail client a Financial Services Guide (FSG). This obligation applies whether personal or general financial product advice or any other financial service is provided: s 941A (licensee) and s 941B (authorised representative). The purpose of a FSG is to enable retail clients to make an informed decision as to whether to obtain financial services from a particular provider. The level of detail required in the FSG is that which would reasonably be required by a person for the purpose of making a decision as to whether to acquire financial services as a retail client: ss 942B(3) and 942C(3). A FSG must be worded and presented in a clear, concise and effective manner: ss 942B(6A) and 942C(6A). The FSG must not contain information or statements that are misleading or deceptive.

Circumstances where a FSG is required [10.240] Financial service providers, whether licensees or their representatives, have an obligation to give a retail client an FSG whenever it is likely that financial services will be provided: s 941D. The FSG should be supplied before any services are provided so that the client can make an informed decision whether to receive the available services. Under s 941C a FSG does not have to be provided where: • the client is not a retail client; • no financial service is provided; • the retail client has already received an FSG containing the required information; • the providing entity is the product issuer dealing in its own products; • the providing entity is the responsible entity operating a managed investment scheme; • general advice is provided in a public forum; and • if the financial service is a dealing in, or relates to a basic deposit product, a facility for making non-cash payments that is related to a basic deposit product or other exemptions specified by the regulations.

The exemptions for product issuers and responsible entities are due to the required information being contained in the PDS required under Pt 7.9 of the Corporations Act 2001. If either the product issuer or responsible entity provides other services, or any dealing is through an intermediary, an FSG must be provided. For example, in the case of dealing in derivatives, the licensee effecting the trade on a financial market would be the product issuer and would need only to provide a PDS in relation to that dealing. However, an FSG would need to be given in relation to the intermediary services necessarily provided, such as advice.

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When a FSG is provided [10.250] The FSG must be given to the client as soon as practicable after it becomes apparent to the providing entity that the financial service will be, or is likely to be, provided to the client. The FSG must in any event be given to the client before the financial service is provided: s 941D. Section 941D(2) provides that an FSG can be given after a financial service has been provided in “time critical cases” where: • the client expressly instructs that the financial service be provided immediately, or by a specified time; and

• it is not reasonably practicable to give the FSG to the client before the service is provided as so instructed.

In these circumstances information relating to remuneration and possible conflicts of interest must be supplied before the FSG is provided (s 941D(3)) and the client must be given the FSG within five days after being given the s 941(3) statement, or sooner if practicable: s 941D(4).

Contents of a FSG [10.260] The title “Financial Services Guide” must be used on the cover of, or at or near the front of, a Financial Services Guide. In any other part of a Financial Services Guide, “Financial Services Guide” may be abbreviated to “FSG”: s 942A. The content requirements of FSGs provided by financial services licensees and authorised representatives are set out in ss 942B and 942C, respectively. The FSG must include certain statements and information and the level of information about a matter that is required is such as a person would reasonably require for the purpose of making a decision whether to acquire financial services from the providing entity as a retail client: ss 942B(3) and 942C(3).

Main requirements of FSG: s 942B [10.270] The FSG must include the following statements and information: (a)

a statement setting out the name and contact details of the providing entity; and

(b)

a statement setting out any special instructions about how the client may provide instructions to the providing entity; and

(c)

information about the kinds of financial services (the authorised services) that the providing entity is authorised by its licence to provide, and the kinds of financial products to which those services relate; and

(d)

information about who the providing entity acts for when providing the authorised services; and

(e)

information about the remuneration (including commission) or other benefits that any of the following is to receive in respect of, or that is attributable to, the provision of any of the authorised services: (i)

the providing entity;

(ii)

a related body corporate of the providing entity; [10.270] 237

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(iii)

a director or employee of the providing entity or a related body corporate;

(iv)

an associate of any of the above;

(v)

any other person in relation to whom the regulations require the information to be provided;

(f)

information about any associations or relationships between the providing entity, or any related body corporate, and the issuers of any financial products, being associations or relationships that might reasonably be expected to be capable of influencing the providing entity in providing any of the authorised services; and

(g)

if the providing entity provides further market-related advice (see subsection 946B(1)) – a statement in relation to which the following requirements are satisfied: (i)

the statement must indicate that the client may request a record of further market-related advice that is provided to them, if they have not already been provided with a record of that advice;

(ii)

the statement must set out particulars of how the client may request such a record;

(iii)

any limitations in those particulars on the time within which the client may request such a record must be consistent with any applicable requirements in regulations made for the purposes of this subparagraph or, if there are no such applicable requirements, must be such as to allow the client a reasonable opportunity to request a record of the advice; and

(h)

information about the dispute resolution system that covers complaints by persons to whom the providing entity provides financial services, and about how that system may be accessed; and

(i)

if the providing entity acts under a binder in providing any of the authorised services – a statement that: (i)

identifies the services provided under the binder; and

(ii)

states that they are provided under a binder; and

(iii)

explains the significance of the services being provided under a binder; and

(j)

if the providing entity is a participant in a licensed market or a licensed CS facility – a statement that the providing entity is a participant in that market or facility; and

(k)

any other statements or information required by the regulations.

Similar provisions are found in s 942C for the circumstance when an authorised representative issues a financial services guide. A Supplementary FSG (SFSG) can correct misleading or deceptive statements or omissions in a FSG or update the information contained in the FSG. The licensee must authorise the distribution of a SFSG by their authorised representative: s 943A.

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STATEMENT OF ADVICE [10.280] According to ss 947B(3) and 947C(3), the Statement of Advice (SoA) should contain a level of detail as to what a person would reasonably require for the purpose of deciding whether to act on the advice as a retail client and it must be worded and presented in a clear, concise and effective manner: ss 947B(6) and 947C(6).

Appropriate advice rule [10.290] All personal advice must comply with the “appropriate advice” and “best interests of the client” obligations discussed above. Accordingly, the SoA must clearly and unambiguously set out the provider’s advice as well as the reasoning that led to that advice. It must also identify all conflicts of interest that may affect the advice, eg commission and other benefits. This requirement is consistent with the fiduciary obligations that arise out of the adviser-investor relationship.

Obligation to give client a SoA [10.300] The provision of personal advice to a retail client must be accompanied by a SoA: s 946A. The SoA may be a record of the advice given or the means by which the advice is given, as in the case of a financial plan. The title “Statement of Advice” must be used on the cover of, or at or near the front of a SoA; elsewhere the abbreviation “SoA” may be used: s 947A. The obligation to prepare and provide a SoA applies to personal financial product advice but not to general advice. The amount of information that should be in a SoA is determined by reference to what a retail client would reasonably require in order to make a decision whether to act on the advice of a provider: ss 947B(3) and 947C(3).

Circumstances where a SoA is not given [10.310] Regulatory Guide 175.147 lists circumstances where a SoA is not required: 8

8

(a)

where the advice is provided to a client who is not a retail client;

(b)

where the advice relates to a cash management trust, basic deposit products, non-cash payment products related to a basic deposit product or traveller’s cheques (but only if the information mentioned in s 946B(6) is provided) (reg 7.7.10);

(c)

where the advice relates to a general insurance product (except for advice about sickness and accident or consumer credit insurance) (reg 7.7.10);

(d)

in the case of further advice (reg 7.7.10AE)…;

(e)

where the advice does not recommend or state an opinion about the acquisition or disposal of a financial product and where the providing entity and certain associates do not receive any remuneration or benefit in elation Also Corporations Regulations 2001 (Cth) regs 7.7.02 and 7.7.02A. [10.310] 239

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to the advice (but only ifthe information mentioned in s 947B(2)(d) and 947B(2)(e), or s 947C(2)(e) and 947C(2)(f), is provided) (s 946B(7)). (f)

where the advice relates to financial investments whose value does not exceed $15,000 (s 946AA and reg 7.7.09A). (Note: This exemption does not generally apply for advice about derivatives, general insurance products or life insurance products. When relying on this exemption, the providing entity must keep a record of the advice provided: s946AA(4) and reg 7.7.08C. This record of advice (including the information mentioned in s 947B(2)(d) and 947B(2)(e), or s 947C(2)(e) and 947C(2)(f)) must be given to the client: s 946AA(5)).

Small investments [10.320] A SoA is not required pursuant to s 946AA where the advice: • is small investment advice, ie the total amount to be invested is below the “threshold amount” ($15,000); 9 and

• does not relate to derivatives, general insurance, life insurance, superannuation or RSA products.

However, if advice is given in relation to “small investments”, the entity providing the advice must keep a record of that advice and provide the client with a copy. 10

Further market-related advice [10.330] A SOA is not required pursuant to s 946B where: • the entity providing the advice is a participant in a licensed market and has previously given the client a SoA (within the last 12 months) and the current advice relates to financial products or securities that can be traded on the licensed market; furthermore, the entity providing the advice must be certain that the client’s circumstances are unchanged, that the advice is required promptly and that it is provided by telephone, fax, email or other electronic means;

• the advice relates to basic deposit products; or • the advice does not recommend or state an opinion in respect of the acquisition or disposal of a financial product, or the modification of an investment strategy, and no benefit flows to the entity providing the advice, their employees, directors or associates.

In all these circumstances, a “record of advice” must be kept by the advising entity.

When a SoA is provided [10.340] If the SoA is not the means by which the advice is provided, a SoA must be given to the client at the same time as, or as soon as practicable after, the advice is provided. In any event, the SoA must be given to the client before the 9 10

Corporations Regulations 2001 (Cth) reg 7.7.09A(1) sets out the threshold amount and also gives examples of how this regulation works in practice. Corporations Regulations 2001 (Cth) 7.7.09A(10) and 7.7.08C and Corporations Act 2001 (Cth) s 946AA(4) & (5)) s 946AA(4)

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providing entity provides another financial service to the client that arises out of or is connected with the advice, such as arranging for a financial product to be issued to the client: s 946C(1). If the SoA is not given to the client when the advice is provided, the provider must, when the advice is provided, give the client a statement that contains the information that would be required by ss 947B(2)(d) and (e), 947C(2)(e) and (f), as the case requires, and by s 947D, if applicable. There may occur “time critical” cases where the client expressly instructs that they require a further financial service that arises out of, or is connected with, the advice to be provided immediately, or by a specified time, and it is not reasonably practicable to give the SoA to the client before that further service is provided as so instructed. The providing entity must then give the client the SoA within five days after providing that further service, or sooner if practicable: s 946C(3).

Content of SoA [10.350] The content requirements for SoAs provided by licensees or authorised representatives are set out in ss 947B and 947C respectively of the Corporations Act 2001. The differences arise out of the need of the representative to disclose the nature of the licensee-representative relationship. In RG 175.15, ASIC indicates that in administering the law it will expect a SoA to contain: (a)

the title “Statement of Advice” on the cover, or at or near the front, of the document (s 947A);

(b)

the name and contact details of the providing entity (ss 947B(2)(c) and 947C(2)(c)) and, if the providing entity is a licensee, its AFS licence number (s 912F and reg 7.6.01C(1)(e));

(c)

where the providing entity is providing the advice as an authorised representative – the name, contact details and AFS licence number of the authorising licensee(s), and a statement that the providing entity is the authorised representative of that licensee or those licensees (s 947C(2)(d) and reg 7.7.11A);

(d)

a statement setting out the advice (ss 947B(2)(a) and 947C(2)(a));

(e)

information about the basis on which the advice is or was given (ss 947B(2)(b) and 947C(2)(b)): see RG 175.168–RG 175.171;

(f)

information about the remuneration, commission and other benefits that the providing entity (and other persons specified in ss 947B(2)(d) or 947C(2)(e)) will, or reasonably expects to, receive that might reasonably be expected to be, or have been capable of, influencing the providing entity in providing the advice (s 947B(2)(d) and 947C(2)(e), regs 7.7.11 and 7.7.12);

(g)

information about the remuneration, commissions and other benefits that a person has received or is to receive for referring another person to the licensee or providing entity (regs 7.7.11 and 7.7.12);

(h)

details of any interests, associations or relationships that might reasonably be expected to be, or to have been capable of, influencing the providing entity in providing the advice (ss 947B(2)(e) and 947C(2)(f)); and [10.350] 241

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(i)

if s 961H requires a warning to be given to the client – a statement setting out or recording the required warning (ss 947B(2)(f) and 947C(2)(g)). Furthermore, the SOA should be dated and specify the period of time the advice remains current

The SoA reproduces some contents of the FSG but concentrates on the advice given by the provider and its basis and the disclosure of any possible conflicts of interest. The level of detail about a matter that is required is such as a person would reasonably require for the purpose of deciding whether to act on the advice as a retail client: ss 947B(3) and 947C(3). The statements and information included in the SoA must be worded and presented in a clear, concise and effective manner: ss 947B(6) and 947C(6). There are additional SoA content requirements when the personal advice recommends replacement (in full or part) of one financial product with another (also known as switching): ss 947B(5) and 947C(5). These requirements are contained in s 947D(2), which specifies the information which must be included in the SoA to the extent that the information is known to, or could reasonably be found out by, the providing entity. These obligations were summarised by ASIC in 175.155 as requiring additional statements about the following: (a)

that the client’s existing product has been considered;

(b)

the cost of the recommended action (i.e. the disposal of the existing product and acquisition of the replacement product);

(c)

the potential benefits (pecuniary or otherwise) that may be lost; and

(d)

any other significant consequences of the switch for the client.

The SoA must also include information about any other significant consequences for the client of taking the recommended action that the providing entity knows, or ought reasonably to know, are likely; as well as any other information required by regulations made for the purposes of s 947D. It is noted in RG 175.160 that the SoA should include information about the exit fees applying to the withdrawal, the loss of access to rights (such as insurance cover) or other opportunities, including incidental opportunities (such as access to product discounts) associated with the existing product (including rights or opportunities not presently available to the client but which may become available in future) and the entry and ongoing fees applying to the replacement product. The s 947D additional disclosure requirements are clearly designed to discourage “churning” by advisers in order to maximise commissions earned.

FINANCIAL PRODUCT DISCLOSURE: PART 7.9 Product Disclosure Statements (PDS) [10.360] Part 7.9 of the Corporations Act 2001 covers financial product disclosure and other provisions relating to the issue and sale of financial products. Part 7.9, however, generally does not apply to disclosure in relation to securities, which is 242 [10.360]

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covered by Ch 6D (and Ch 6CA continuous disclosure): s 1010A. Under Ch 7 of the Corporations Act 2001, interests in managed investment schemes are classed as financial products and are required to comply with the PDS requirements of Part 7.9. While Part 7.9 does not apply to financial products not issued in the course of a business of issuing financial products, the issue of any managed investment product or superannuation product is taken to occur in the course of such a business: s 1010B. Regulatory Guide 168: Disclosure: Product Disclosure Statements (and other disclosure obligations), provides the detail on PDSs. This guide states that: RG 168.36: A PDS is to be prepared by or on behalf of the issuer or seller of the financial product: see s 1013A A PDS must contain sufficient information so that a retail client may make an informed decision about whether to purchase a financial product: s 1013D. RG 168.37: The broad objectives of PDS disclosure are to help consumers compare and make informed choices about financial products. To achieve these objectives, the legislation requires that all information contained in a PDS must be worded and presented in a clear, concise and effective manner: s 1013D.

A PDS has to be provided to a consumer before the investor applies for a financial product and ss 1016A and 1013C(3) provide that information included in a PDS must be worded in a clear, concise and effective manner. The PDS requirements are designed to promote financial product understanding for retail clients, allow comparison of financial products and help investors to make informed decisions to acquire particular financial products. Regulatory Guide 168, Part C encourages those persons issuing PDSs to consider the “good disclosure principles” when drawing up PDSs, namely: 1. 2.

Disclosure should be timely.

3. 4.

Disclosure should promote product understanding.

5. 6.

Disclosure should highlight important information.

Disclosure should be relevant and complete. Disclosure should promote product comparison. Disclosure should have regard to consumers’ needs.

Despite the above, the Parliamentary Joint Committee on Corporations and Financial Services (PJC) commented that in the case of Storm Financial these objectives were not being pursued by the relevant financial advisers. The limited understanding that some Storm clients had of their financial arrangements is of concern to the committee. The committee acknowledges that some of these clients admit they did not have a strong understanding of the leverage and margin loan arrangements that they signed up to. Indeed, some explained that it was out of awareness of their limited knowledge that they sought the guidance of, and acted on the recommendations of, professional financial advisers. 11 11

PJC at 3.43. [10.360] 243

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Obligation to provide PDS [10.370] A PDS must be provided to a retail client by a regulated person (eg the issuer of the financial product, seller of the financial product, any financial services licensee or their authorised representative) when personal advice includes a recommendation that the client acquire a particular financial product: ss 1012A – 1012C.

Situations requiring PDS to be provided [10.380] The circumstances in which a PDS must be provided to a retail client are: • a recommendation situation where there is personal advice recommending the acquisition of a particular financial product: s 1012A;

• an issue situation where a person initially offers to issue or arrange for the issue, or does issue a financial product to a retail client: s 1012B; or

• a sale situation where a person offers to sell a financial product (other than securities) to a retail client: s 1012C.

Tailored PDS [10.390] Since 1 January 2011, a tailored PDS regime has applied to PDSs for standard margin lending facilities. The tailored regime for standard margin lending facilities: (a)

removes the usual PDS content requirements for financial products in s 1013D of the Corporations Act 2001 (Cth);

(b)

substitutes new PDS content requirements which are more prescriptive and specifically address the key information a person acquiring a superannuation product would wish to know (Sch 10C); and

(c)

requires a maximum page limit of four A4 pages (or equivalent) for the PDS, with an expectation that the person responsible for the PDS will make substantial use of incorporation by reference to provide additional information for clients. 12

This tailored regime also now applies to First Home Saver Accounts (Corporations Regulations 2001 (Cth), Sch 10B and RG 168.129, simple managed investment schemes (Corporations Regulations 2001 (Cth), Sch 10E) and superannuation products other than products that are solely defined benefit schemes (Corporations Regulations 2001 (Cth), Sch 10D).

Shorter, simpler PDS [10.400] For all financial products except those that are subject to a tailored regime, a Short-Form PDS may be provided if certain conditions are met: RG 168.107: The Short-Form PDS is intended to help product issuers avoid the problem of lengthy and complex product disclosure documents by allowing them to present a summary document rather than a full-length PDS. In general, a 12

RG 168.128.

244 [10.370]

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Short-Form PDS summarises the key information in a PDS (eg information about the issuer, benefits, risks, costs, return, dispute resolution and cooling off) and complies with Div 3A of Pt 7.9.

Incorporation by reference [10.410] A person responsible for producing a PDS need not include certain statements or information that would otherwise be required to be included. These statements or information can be “incorporated by reference” if it is in writing and is publicly available in a document other than the PDS, including electronic sources such as the internet. The information cannot be incorporated from a Short-Form PDS. Incorporation by reference reduces the length of disclosure documents by allowing some of the required information to be incorporated, by providing a reference in the PDS to another document, instead of including the information in full in the PDS. 13 However, if the client requests the information that is included by reference, then it must be provided as soon as possible.

PDS content requirements [10.420] Generally, the PDS must be prepared by the issuer of the financial product and is called an issue statement: Corporations Act 2001 (Cth) s 1013A. In RG 168.97, it is noted that product issuers should focus not only on the technical content requirements that apply to PDSs, but also the quality of the information being provided to consumers, and in particular, the “clear, concise and effective requirement”. ASIC notes at RG 168.98 that this may require: (a) (b) (c)

(d) (e)

monitoring carefully the class of consumers to whom the PDS is directed; producing a PDS that is based on a format that has been consumer tested; producing a PDS that has taken into account feedback (including complaints) from consumers about past or current point-of-sale offer documents used by the product issuer; personalising the information contained in the PDS for the consumer; or improving the quality of the disclosure in the PDS to promote product understanding by consumers (e.g. drafting a PDS to improve the comparability of competing financial products.

The title “Product Disclosure Statement” must be used on the cover of, or at or near the front of, a PDS. In any other part of a PDS, “Product Disclosure Statement” may be abbreviated to “PDS”: s 1013B. While prospectuses have a limited life time, PDSs have no expiry date but must be kept up-to-date: s 1012J. The content requirements for PDSs are contained in ss 1013C – 1013F. Essentially, PDSs are required to contain: • the statements and information required by s 1013D: s 1013C(1)(a)(i); • any other information that might reasonably be expected to have a material influence on the decision of a reasonable retail client whether to acquire the product: s 1013E; and

• other Pt 7.9 requirements such as date (s 1013G) and title (s 1013B). 13

Corporations Regulations 2001 (Cth) reg 7.9.15DA. [10.420] 245

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PDS content requirements: s 1013D [10.430] Section 1013D(1) sets out the main content requirements for PDSs (emphasis added): (a)

a statement setting out the name and contact details of: (i)

the issuer of the financial product; and

(ii)

if the Statement is a sale Statement – the seller; and

(b)

information about any significant benefits to which a holder of the product will or may become entitled, the circumstances in which and times at which those benefits will or may be provided, and the way in which those benefits will or may be provided; and

(c)

information about any significant risks associated with holding the product; and

(d)

information about: (i)

the cost of the product; and

(ii)

any amounts that will or may be payable by a holder of the product in respect of the product after its acquisition, and the times at which those amounts will or may be payable; and

(iii)

if the amounts paid in respect of the financial product and the amounts paid in respect of other financial products are paid into a common fund – any amounts that will or may be deducted from the fund by way of fees, expenses or charges; and

(e)

if the product will or may generate a return to a holder of the product – information about any commission, or other similar payments, that will or may impact on the amount of such a return; and

(f)

information about any other significant characteristics or features of the product or of the rights, terms, conditions and obligations attaching to the product; and

(g)

information about the dispute resolution system that covers complaints by holders of the product and about how that system may be accessed; and

(h)

general information about any significant taxation implications of financial products of that kind; and

(i)

information about any cooling-off regime that applies in respect of acquisitions of the product (whether the regime is provided for by a law or otherwise); and

(j)

if the product issuer (in the case of an issue Statement) or the seller (in the case of a sale Statement) makes other information relating to the product available to holders or prospective holders of the product, or to people more generally – a statement of how that information may be accessed; and

(k)

any other statements or information required by the regulations; and

(l)

if the product has an investment component – the extent to which labour standards or environmental, social or ethical considerations are taken into account in the selection, retention or realisation of the investment; and

(m)

…

Despite anything in s 1013D or s 1013E, information is not required to be included in a PDS if it would not be reasonable for a person considering, as a 246 [10.430]

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retail client, whether to acquire the product to expect to find the information in the statement. In determining this, the matters that may be taken into account include: • the nature of the product (including its risk profile); • the extent to which the product is well understood by the kinds of person who commonly acquire products of that kind as retail clients;

• the kinds of things such persons may reasonably be expected to know; • if the product is an enhanced disclosure security, the effect of Ch 2M as it applies to disclosing entities and ss 674 and 675;

• the way in which the product is promoted, sold or distributed; and • any other matters specified in the regulations: s 1013F(2).

Advertising and PDSs [10.440] Advertising or promotional material that is reasonably likely to induce people to acquire a product that is available, or likely to become available, for acquisition by retail clients must (s 1018A): • identify the issuer; • indicate that a PDS for the product is available and where it can be obtained; and • indicate that a person should consider the PDS in deciding to acquire, or continue to hold the product.

Cooling off [10.450] A cooling off period of 14 days applies to the following financial products issued or sold pursuant to an offer (s 1019A): • risk insurance products; • investment life insurance products; • managed investment products; • superannuation products; and • retirement savings account products. An investor exercising cooling off rights has the right to return the financial product to the responsible person and to have the money already paid for the product repaid. This is so even if the responsible person is being wound up: s 1019B. The right can only be exercised during the period of 14 days beginning on the earlier of the time when any confirmation requirements are complied with or the end of the fifth day after the day on which the product was issued or sold: s 1019B(3).

Circumstances where a PDS is not required [10.460] A PDS is not required where: • the client is not a retail client; • the product is not a financial product; [10.460] 247

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• the financial product is not issued in the course of a business issuing financial products: s 1010B;

• the client has already received an up-to-date PDS: s 1012D(1); • the client has or has access to up-to-date information: s 1012D(2); • the client already holds a financial product of the same kind and the advice relates or the offer is made under a distribution reinvestment plan or switching facility: s 1012D(3);

• no consideration is to be provided to acquire an interest in a managed investment scheme or the financial product is an option and no consideration is to be provided on the exercise of the option: s 1012D(5) and (6);

• the offer is made as consideration for an offer made under a takeover bid and the offer is accompanied by a bidder’s statement: s 1012D(7);

• the responsible entity of an unregistered managed investment scheme is an exempt body: s 1012D(8);

• the financial product is an interim contract of insurance, eg cover notes: s 1012D(9); • the client is associated with the responsible entity of a registered managed investment scheme: s 1012D(9A); and

• the financial product constitutes a small scale offering (20 issues or sales in 12 months) of managed investment and other prescribed financial products and all of the financial products are issued by the same person and the amounts raised by the issuer do not exceed $2 million in a 12-month period: s 1012E.

Section 761GA allows the adviser to treat a client as a “sophisticated investor” and not as a retail client and therefore not provide a PDS if the licensee is satisfied on reasonable grounds that the client has previous experience in using financial services and investing in financial products that allows the client to assess: (d) (i)

the merits of the product or service; and

(ii)

the value of the product or service; and

(iii)

the risks associated with holding the product; and

(iv)

the client’s own information needs; and

(v)

the adequacy of the information given by the licensee and the product issuer; and

(e)

the licensee gives the client before, or at the time when, the product or advice is provided a written statement of the licensee’s reasons for being satisfied as to those matters; and

(f)

the client signs a written acknowledgment before, or at the time when, the product or service is provided that: (i)

the licensee has not given the client a Product Disclosure Statement; …

However, this section will not protect the adviser against negligent advice claims – its purpose is to recognise sophisticated investors who do not require the level of disclosure that is necessary for retail clients. 248 [10.460]

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LIABILITY FOR CONTRAVENTION OF CONDUCT AND DISCLOSURE RULES [10.470] Where there is non-compliance with the conduct and disclosure requirements of Pts 7.7 and 7.9 of the Corporations Act 2001, or a defective disclosure document is provided, the enforcement provisions provide for offences against the service provider or product issuer and the civil remedy of compensation for investors who suffer loss or damage caused by the contraventions or defects.

Criminal liability Failure to provide disclosure documents [10.480] It is an offence not to provide a disclosure document when one is required for a FSG and a SoA (s 952C) and for a PDS: s 1021C. 952C Offence of failing to give a disclosure document or statement (1)

(2)

A person (the providing entity) commits an offence if: (a)

the providing entity is required by a provision of this Part to give another person a disclosure document or statement (the required disclosure document or statement); and

(b)

the providing entity does not give (within the meaning of section 940C) the other person anything purporting to be the required disclosure document or statement by the time they are required to do so. …

An offence based on subsection (1) is an offence of strict liability.

The offence provisions generally make licensees or authorised representatives liable for contravention of the provisions relating to FSGs and SoAs: ss 952D – 952M. There is a defence for authorised representatives who have reasonably relied on information provided by their authorising licensee; it is also a defence where a licensee or authorised representative took reasonable steps to ensure that the disclosure document is not defective. In relation to PDSs, similar offences exist for contraventions of the Pt 7.9 requirements; the majority of the offences are strict liability offences and hence afford no defences. The person liable for contravention is generally the preparer of the PDS, ie the issuer, although certain provisions, eg failure to provide a PDS, are directed at the relevant provider and defences in this instance (similar to those in Pt 7.7) are available.

Defective disclosure documents [10.490] It is also an offence to provide a defective disclosure document: ss 952D and 952E (FSG and SoA) and ss 1021D and 1021E (PDS). A disclosure document or statement is defective under ss 952B or 1021B if: • there is a misleading or deceptive statement in the disclosure document or statement; or • there is an omission from the FSG, SoA or PDS of material required by ss 942B or 942C, ss 947B, 947C or 947D, or s 1013C (other than title and date) respectively; or [10.490] 249

Law of Investments and Financial Markets

• there is an omission of any other information or statement of material required by the respective disclosure requirements,

being a statement, or an omission, that is or would be materially adverse from the point of view of a reasonable person considering whether to proceed to be provided with the financial service, to act in reliance on the advice, or whether to proceed to acquire the financial product, concerned. The term “materially adverse” means whether the investor’s appreciation of the risk is altered. Table 10.2 below summarises the legislative provision for Pts 7.7 and 7.9 disclosure documents together with the equivalent Ch 6D provisions: Defective disclosure documents Disclosure document Corporations Act 2001 (Cth) Pt 7.7 FSG SoA Corporations Act 2001 (Cth) Pt 7.9 PDS Corporations Act 2001 (Cth) Ch 6D Prospectus

Definitional provision s 952B

Civil action for loss or damage s 953B

s 1021B

s 1022B

s 728

s 729

Civil liability [10.500] An investor may suffer loss or damage because: • they were not given the disclosure document or statement that they should have been given; or

• the disclosure document or statement they were given was defective; or • there was a contravention of s 961B (duty to act in the best interests of the client), s 961G (duty to provide appropriate advice), s 961H (duty to warn the client if advice is based on incomplete or inaccurate information), or s 961J (duty to prioritise the interests of the client).

The investor may recover the amount of the loss or damage by action against a liable person being, in general, the financial services licensee under Pt 7.7, or the product issuer under Pt 7.9: ss 961M and 1022B. A person is not liable under s 953B or s 1022B in the case of a defective disclosure document or statement if the person took reasonable steps to ensure that the disclosure document or statement would not be defective: ss 953B(6) and 1022B(7). Investors have available as a remedy for a defective PDS or where the financial product disclosure requirements are not met, the right to return the product and have the money paid to acquire the product repaid: s 1016F. This right can only be exercised during the period of one month from the issue or sale of the product to the client.

250 [10.500]

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Misleading or deceptive conduct [10.510] There is a general prohibition against misleading or deceptive conduct and civil liability will arise if this conduct occurs (s 1041H of the Corporations Act 2001): 1041H Misleading or deceptive conduct (civil liability only) (1)

A person must not, in this jurisdiction, engage in conduct, in relation to a financial product or a financial service, that is misleading or deceptive or is likely to mislead or deceive.

Conduct that contravenes s 670A (misleading or deceptive takeover document) or s 728 (misleading or deceptive fundraising document) or conduct in relation to FSGs, SoAs or PDSs are excluded from the ambit of s 1041H (s 1041H(3)) as they are covered by a separate, self-contained disclosure regime. RG 168.154 provides that ambiguous statements may constitute misleading or deceptive conduct if one or more of the reasonably possible meanings is misleading or deceptive. ASIC notes, in RG 168-143-155, that: When assessing whether a PDS appears to be misleading or deceptive, we will pay particular attention to: (a)

statements about future matters such as forecasts (they should have reasonable grounds). A statement about any future matter is misleading or deceptive if the maker does not have reasonable grounds for making it. For example, a statement about prospective financial information based on a number of hypothetical assumptions is unlikely to be based on reasonable grounds;

(b)

statements about past performance;

(c)

statements of opinion (they should be formed honestly and reasonably);

(d)

the likely overall impression of the PDS;

(e)

the use of illustrations or examples to highlight an aspect of the disclosure being provided;

(f)

the use of disclaimers;

(g)

ambiguous statements;

(h)

whether statements draw inaccurate, unfair or inappropriate comparisons;

(i)

the currency of information; and

(j)

how information is set out and the prominence given to particular pieces of information. Care should be taken when showing past performance information including, in particular, giving consideration to any misleading or deceptive representation that may arise from: (a)

the currency of past performance information (e.g. does the information need to be updated, including by means of a supplementary PDS?);

(b)

the length of time a product or investment strategy has been in existence or the investment period selected;

(c)

the periods for which past performance information is shown (e.g. different sub-periods in the life of any past performance information may produce entirely different past performance figures); [10.510] 251

Law of Investments and Financial Markets

(d)

whether the past performance information is shown in accordance with any industry standards;

(e)

any explicit or implicit suggestion of a link between past performance and future prospects;

(f)

the use of hypothetical or reconstructed past performance figures;

(g)

changes in the state of the market such that returns in the short to medium term are likely to be significantly less than the past performance being quoted; and

(h)

changes in the method or mechanism by which the investment strategy is implemented (e.g. appointment of a new investment manager). A statement about past performance should be accompanied by a prominent warning that past performance is not necessarily a guide to future performance. A statement of opinion that amounts to a representation may be misleading or deceptive in the following circumstances: (a)

an opinion may be a statement about a future matter, in which case it must be based on reasonable grounds. If this is not the case, the expression of opinion may be regarded as misleading or deceptive;

(b)

an opinion may convey that there is a basis for the opinion, that it is honestly held, and when expressed as the opinion of an expert that it is honestly held on rational grounds involving the application of the relevant expertise. If this is not the case, the expression of opinion may be regarded as misleading or deceptive (see Bateman v Slayter (1987) ATPR 40–762); and

(c)

a statement of opinion involving a state of mind may convey the meaning (expressly or by implication) that the maker had the particular state of mind when the statement was made and, commonly, that there was a basis for having that state of mind. If this is not so, such a statement may constitute misleading or deceptive conduct (see Stanton v ANZ Banking Group (1987) ATPR 40–755). A statement of opinion may become misleading or deceptive if it continues to be published when the maker no longer holds the opinion or the grounds on which it was made have substantially changed.

Administrative action [10.520] ASIC has the power to take action against licensees and their authorised representatives who breach the suitability and disclosure obligations. Administrative actions include: 1.

suspending or cancelling an AFS licence; (ss 915B and 915C); 14

2.

banning a person from providing financial services (s 920A);

3.

varying AFS licence conditions (s 914A);

4.

directing an AFS licensee to provide us with a statement, which we may require to be audited, containing specified information about the business, activities or services provided by the licensee or its representatives (s 912C);

14

The Parliamentary Joint Committee on Corporations and Financial Services (PJC) recommends that ss 915B and 915C of the Corporations Act 2001 (Cth) be amended to allow ASIC to deny an application, or suspend or cancel a licence, where there is a reasonable belief that the licensee “may not comply” with their obligations under the licence.

252 [10.520]

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5.

in the case of a contravention of the market integrity rules by an AFS licensee that is a market participant, asking the Markets Disciplinary Panel to issue an infringement notice (RG 216); and

6.

accepting an enforceable undertaking as an alternative to other remedies, where we consider it appropriate to do so.

Section 920A(1) provides that ASIC can make a banning order against a licensee if: … (b)

the person has not complied with their obligations under section 912A; or

(ba)

ASIC has reason to believe that the person will not comply with their obligations under section 912A; or …

(e)

the person has not complied with a financial services law; or

(f)

ASIC has reason to believe that the person will not comply with a financial services law.

A banning order is a written order that “prohibits a person from providing any financial services or specified financial services in specified circumstances or capacities”: s 920B. 15 Regulatory Guide 98 provides information on the administrative powers, including banning orders used by ASIC to enforce the financial services laws. 16

Disclosure and the no conflict of interest rule [10.530] The disclosure of any conflict of interest is considered to be a key issue in the provision of investment advice, both in relation to the suitability and disclosure rules. Section 912A sets out the general obligations of financial service licensees. The primary obligation as set out in s 912A(1)(a) states that the licensee must “do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly”. Section 912A(aa), which was inserted into s 912A of the Corporations Act 2001 (Cth) as a result of recommendations in CLERP 9, specifically addresses conflict of interest and is an example of the common law fiduciary principles that have gradually found their way into legislation. Section 912A(aa) provides: (aa)

15 16

have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative.

The Parliamentary Joint Committee on Corporations and Financial Services (PJC) has recommended that ASIC be given greater powers to ban individuals from the financial services industry. Available at http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-98licensing-administrative-action-against-financial-services-providers/ (accessed 8 May 2016). [10.530] 253

Law of Investments and Financial Markets

Regulatory Guide 181: Licensing: Managing Conflicts of Interest 17, explains ASIC’s approach to conflict of interest. This guide defines a “conflict of interest” as: [RG 181.15] … circumstances where some or all of the interests of people (clients) to whom a licensee (or its representative) provides financial services are inconsistent with, or diverge from, some or all of the interests of the licensee or its representatives. This includes actual, apparent and potential conflicts of interest.

The focus on conflicts of interest in the financial services sector is explained in the underlying principles to the regulatory guide: [RG 181.13] Adequate conflicts management arrangements help minimise the potential adverse impact of conflicts of interest on clients. Conflicts management arrangements thereby help promote consumer protection and maintain market integrity. Without adequate conflicts management arrangements, licensees whose interests conflict with those of the client are more likely to take advantage of that client in a way that may harm that client and may diminish confidence in the licensee or the market.

Three mechanisms to deal with conflict of interest are identified by RG 181. These are: controlling, disclosing and avoiding conflict. The key to these three mechanisms is to identify the problem so that it may be controlled, disclosed or avoided. The suitability rule is breached if the financial product advice is given on the basis of the licensee or authorised representative having a connection with, or benefit from, the financial product, and the disclosure rules are also breached if there is not a disclosure of the conflict of interest in the SoA document. It should be remembered that this document is supposed to disclose commissions or other benefits that would flow as a result of the client acting on the information in the SoA and any other information that might reasonably be expected to have influenced the entity providing the advice: ss 947B and 974C. ASIC’s submission to the Parliamentary Joint Committee on Corporations and Financial Services (PJC) indicates their concern in relation to commissions and conflict of interest: Today financial advisers usually play a dual role of providing advice services to clients and acting as the sales force for financial product manufacturers. Approximately 85% of financial advisers are associated with a product manufacturer, so that many advisers effectively act as a product pipeline. Of the remainder, the vast majority receive commissions from product manufacturers and so have incentives to sell products: see Section E. This structure creates potential conflicts of interest that may be inconsistent with providing quality advice and these conflicts may not be evident to consumers. 18

There is some evidence that the quality of advice is affected by conflicts of interest created by links to product issuers. 19 ASIC has illustrated the consequences of these conflicts of interests: 17 18 19

Available at http://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-181licensing-managing-conflicts-of-interest/ (accessed 12 May 2016). Parliamentary Joint Committee on Corporations and Financial Services (PJC) at 111. PJC at 114.

254 [10.530]

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Storm may be an example of the potential impact on clients of failure to manage conflicts of interest created by commissions and remuneration based on funds under advice. While our investigations are continuing, we understand that Storm advisers may have counted loans as funds under advice and took a percentage of funds under advice as remuneration, creating a possible incentive to recommend clients take out loans or increase the size of existing loans. 20

Following the recommendation of the Parliamentary Joint Committee on Corporations and Financial Services (PJC) the Corporations Act 2001 was amended to require advisers to disclose more prominently in marketing material restrictions on the advice they are able to provide consumers and any potential conflicts of interest and that appropriate mechanism be examined by which to cease payments from product manufacturers to financial advisers. 21 These reforms are known as The Future of Financial Advice (FOFA) reforms on 28 April 2011. They included: • A prospective ban on up-front and trailing commissions and like payments for both individual and group risk within superannuation from 1 July 2013.

• A prospective ban on any form of payment relating to volume or sales targets from any financial services business to dealer groups, authorised representatives or advisers, including volume rebates from platform providers to dealer groups.

• A prospective ban on soft dollar benefits, where a benefit is $300 or more (per benefit) from 1 July 2012.

These reforms were enacted and are discussed in Chapter 11.

20 21

PJC at 172.

PJC recommendations 3 and 4. [10.530] 255

CHAPTER 11 Investor Protection and Dispute Resolution [11.10]

[11.40]

Introduction ............................................................................................... 257 [11.20]

Key points ..................................................................................................... 258

[11.30]

Key terms ...................................................................................................... 258

Consumer protection laws...................................................................... 259 [11.60]

Common law obligations ........................................................................... 259

[11.80] Statutory obligations ................................................................................... 261 [11.80] Impact of financial services reform on the investment process ........................................................................... 261 [11.90]

Corporations Act .............................................................................. 262

[11.100] ASIC Act ............................................................................................ 262 [11.110] Unconscionable conduct ........................................................................... 263 [11.120] Misleading and deceptive conduct ........................................................ 264 [11.130] Specific issues ............................................................................................. 265 [11.140] Implied warranty to render financial services with due skill and care ...................................................................................................................... 265 [11.145] Unfair terms of consumer contracts ...................................................... 266 [11.150] Disclaimers, limitations and exclusions ................................................ 267

[11.160] [11.170]

Codes of conduct...................................................................................... 268 Dispute resolution in the investment industry................................... 269 [11.180] Internal dispute resolution ...................................................................... 270 [11.190] External dispute resolution ..................................................................... 271 [11.200] Financial Ombudsman Service ............................................................... 271

[11.220]

Enforcement, remedies and defences.................................................... 273 [11.220] Civil remedies ............................................................................................ 273 [11.230] Criminal liability ....................................................................................... 274 [11.235] Administrative action ............................................................................... 274

[11.250]

Conflict of interest .................................................................................... 274 [11.260] Conflicted remuneration .......................................................................... 275

[11.280]

Privacy and confidentiality issues......................................................... 279

INTRODUCTION [11.10] This chapter focuses on the relationship between advisers and their clients and the scope of protection available for investors. It also examines the legal liability and remedies that flow when compliance requirements are ignored. The impact of financial services reform on traditional consumer protection remedies is discussed and the nature and need for efficient and effective dispute resolution processes is examined. [11.10] 257

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Consumer protection is best achieved through a well-regulated, informed, appropriately trained and educated industry. This was one of the reasons for the implementation of Ch 7 of the Corporations Act 2001 (Cth), which deals with the general obligations of financial service licensees. These obligations overlap with common law and fiduciary duties. According to s 912A of the Corporations Act 2001, a financial services licensee is obliged to: • do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly;

• comply with any conditions imposed by the Australian Securities and Investments Commission (ASIC) on the licence;

• comply with the financial services laws; • take reasonable steps to ensure that its representatives comply with the financial services law;

• maintain sufficient financial, technological and human resources to properly provide financial services and supervise representatives;

• maintain the competence to provide those financial services; • ensure that its representatives are adequately trained, and are competent to provide those services;

• have internal and external dispute resolution procedures to handle complaints from retail clients;

• have adequate risk management systems; and • comply with any other obligations that are prescribed by regulations. These statutory obligations are a basis for a well-regulated industry which, by its very nature, provides consumer protection mechanisms.

Key points [11.20] This chapter will provide a greater understanding of: • the investor’s rights under common law; • the means by which Ch 7 of the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) provide investor protection;

• the impact of conflict of interest laws on financial services; and • the dispute resolution processes available in the investment industry.

Key terms [11.30] The key terms in this chapter are: • Statutory provisions • Unconscionable conduct • Misleading and deceptive conduct • Implied warranties as to due care and skill • Disclaimers (limiting liability) • Remedies 258 [11.20]

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• Conflict of interest • Dispute resolution – internal process • Dispute resolution – external process • Financial Ombudsman Service

CONSUMER PROTECTION LAWS [11.40] The legal basis of investor protection arises out of various common law and statutory duties. From an adviser’s position, investor’s rights correspond to compliance requirements. Whenever consumer protection is considered, the issues of the effectiveness of disclaimers, exclusions, exemptions and limitations are relevant. There is often overlap between the case law and legislation. For instance, the duty of an adviser to use reasonable care and skill is found in contract law, the tort of negligence, fiduciary duties and various pieces of consumer protection legislation.

Common law obligations [11.60] The legal nature of the adviser-investor relationship is both contractual and fiduciary. As with all legal relationships, rights and duties arise. The rights of investors can be related to the remedies that become available upon breach of the obligations of the adviser. Contractual terms, both expressed and implied, will initially determine the scope of an adviser’s duties owed to an investor. In the investor-adviser relationship there is a fiduciary duty to use reasonable diligence, care and skill. Advisers can also be liable for loss caused to investors by failure to take reasonable care to avoid foreseeable loss or damage under common law negligence. The law of negligence is relevant to professionals in the financial services sector. People who suffer losses as a result of negligent advice have often recovered the loss through a claim for damages for the negligence of the professional. In Daly v Sydney Stock Exchange Ltd, 1 Brennan J considered the nature of the adviser-investor relationship and said (at 385): Whenever a stockbroker or other person who holds himself out as having expertise in advising on investments is approached for advice on investments and undertakes to give it, in giving that advice the adviser stands in a fiduciary relationship to the person whom he advises. The adviser cannot assume a position where his self-interest might conflict with the honest and impartial giving of advice.

His Honour continued (at 385): The duty of an investment adviser who is approached by a client for advice and undertakes to give it, and who proposes to offer the client an investment in which the adviser has a financial interest, is a heavy one. 1

Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371. [11.60] 259

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Brennan J further stated (at 385): His duty is to furnish the client with all the relevant knowledge which the adviser possesses, concealing nothing that might reasonably be regarded as relevant to the making of the investment decision including the identity of the buyer or seller of the investment when that identity is relevant, to give the best advice which the adviser could give if he did not have, but a third party did have, a financial interest in the investment to be offered, to reveal fully the adviser’s financial interest, and to obtain for the client the best terms which the client would obtain from a third party if the adviser were to exercise due diligence on behalf of his client in such a transaction.

Gibbs CJ (at 377), with whom Wilson and Dawson JJ agreed, considered that the advisory function was fiduciary in nature: The firm, which held itself out as an adviser on matters of investment, undertook to advise Dr Daly, and Dr Daly relied on the advice which the firm gave him. In those circumstances the firm had a duty to disclose to Dr Daly the information in its possession, which would have revealed that the transaction was likely to be a most disadvantageous one from his point of view. Normally, the relation between a stockbroker and his client will be one of a fiduciary nature and such as to place on the broker an obligation to make to the client a full and accurate disclosure of the broker’s own interest in the transaction.

This emphasis on full and frank disclosure is consistent with the disclosure through documentation regime imposed on all financial service providers by Ch 7 of the Corporations Act 2001. This obligation stems from, in particular, Pts 7.7 – “Financial Services Disclosure” and 7.9 – “Financial Product Disclosure”, discussed in Chapter 10. In Newman v Financial Wisdom Ltd, 2 the court discussed (at [410]) the common law obligations of the investment adviser in circumstances where legislation was also an issue: I am therefore satisfied that Quarrell, by recommending the investment, acted in breach of a duty of care which he owed to Mr Newman in the circumstances. In my opinion, the recommendation of the investment in itself constituted negligence. In addition, there was negligence in the failure to ensure that there were reasonable grounds for recommending the investment, in the failure to make any proper inquiries or investigations concerning the investment and the persons involved in it and in the failure to explain the risks involved and to ensure that they were within the risks which Mr Newman was prepared to accept.

A person may limit or exclude their liability in tort and contract, although clauses that attempt to restrict the liability of one of the parties to a contract may be construed strictly by the courts. Regulatory Guide 175.74 provides that a failure to comply with any of the obligations relating to the provision of advice, including common law obligations, may mean, among other things, that the adviser has failed to comply with the obligation to act “efficiently, honestly and fairly” under s 912A(1)(a) of the Corporations Act 2001. The common law obligations include duties to: 2

Newman v Financial Wisdom Ltd (2004) 56 ATR 634; [2004] VSC 216.

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• disclose conflicts of interest that may affect the advice provided; and • adopt due care, diligence and competence in preparing advice. This recently updated regulatory guide (rereleased October 2013) recognises the importance of the common law duties of the adviser to the client and attempts to make these common law duties part of the statutory duties regime. The duty to provide services that comply with particular standards is a thread that is encountered in many areas of law. In every contract for services there are implied terms that the services will be rendered with due care and skill.

Statutory obligations Impact of financial services reform on the investment process [11.80] In circumstances where Ch 7 of the Corporations Act 2001 (Cth) applies, it is of paramount importance that the adviser act in accordance with the compliance requirements set out in that chapter. If an investor can show a breach of statutory duty, then reliance on the legislative remedies that flow from such breaches is probably the preferred path to be taken by the investor, despite various common law remedies also becoming available. Of course, the ultimate basis of legal liability will typically include all possible heads of claim as was the case in Ali v Hartley Poynton Ltd, 3 as discussed in Ch 1. In that case, the statutory remedies under the Trade Practices Act 1974 (Cth), 4 as well as the common law remedies of breach of contract, the tort of negligence, and breach of fiduciary duty, were all part of the statement of claim against the defendant. It is often easier for a plaintiff to use statutory remedies (where available) rather than common law remedies. This is because exclusion clauses or limitation of liability clauses in service contracts can limit the common law liability of the service provider and defences are also more readily available at common law. For example, a claim based on misleading and deceptive conduct under s 12DA of the ASIC Act is not affected by exclusion clauses or limitation of liability clauses in the contract or defences, 5 and may be preferable to an action which has to establish the complex rules of misrepresentation under the common law to succeed in a civil action against the adviser. In some circumstances, the only remedies available may arise out of common law negligence or contractual remedies and in these cases exclusion clauses in contracts between financial institutions and institutional investors may be valid. 6 The specific details of the clause and the relative bargaining power of the parties are important factors in determining the validity of the exclusion clause. 3 4 5 6

Ali v Hartley Poynton Ltd [2002] VSC 113. The Australian Securities and Investments Commission Act 2001 (Cth) would be used today in place of the Trade Practices Act 1974 (Cth). Note that the Trade Practices Act 1974 has been replaced by the Competition and Consumer Act 2010 (Cth). Section 12EB of the ASIC Act renders disclaimers and exclusions ineffective in consumer financial services transactions. Ingot Capital Investments Pty Ltd v Macquarie Equity Capital Markets Ltd [2008] NSWCA 206.

[11.80] 261

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The remedies available for loss and damage resulting from breach of the various compliance requirements of advisers under Ch 7 of the Corporations Act 2001 provide further avenues for the investor.

Corporations Act [11.90] The Corporations Act 2001 provides proactive consumer protection in an attempt to regulate the industry: • s 912A sets out the obligations owed by the licensee to the client. These obligations provide “consumer protection” because the obligations regulate the manner in which the licensee must conduct their business.

• ss 917A – 917E require the licensee to be responsible for the conduct of the authorised representative relating to the provision of financial services on which a client could reasonably be expected to rely and on which the client has relied in good faith. This is a form of consumer protection because the licensee is responsible for the representative’s actions.

• s 945A sets out the disclosure and conduct of business rules (discussed in previous chapters). These are primarily for the purpose of consumer protection. If the client is a retail client, the duties and responsibilities of the financial services provider are far greater, particularly in relation to the disclosure documents that must be provided to the client and also the responsibility of ensuring that the financial product and services match the needs of the client.

ASIC Act [11.100] One of ASIC’s key roles is consumer protection: We contribute to Australia’s economic reputation and wellbeing by ensuring that Australia’s financial markets are fair and transparent, supported by confident and informed investors and consumers. We are an independent Commonwealth Government body. We are set up under and administer the Australian Securities and Investments Commission Act (ASIC Act), and we carry out most of our work under the Corporations Act. The Australian Securities and Investments Commission Act 2001 requires us to: • maintain, facilitate and improve the performance of the financial system and

entities in it • promote confident and informed participation by investors and consumers in the

financial system • administer the law effectively and with minimal procedural requirements • enforce and give effect to the law • receive, process and store, efficiently and quickly, information that is given to us • make information about companies and other bodies available to the public as

soon as practicable. 7

The Financial Sector Reform (Consequential Amendments) Act 1998 (Cth), which inserted Pt 2 Div 2 within the ASIC Act, introduced broad consumer protection powers across all financial products and services. Initially credit was not 7

See ASIC website homepage: http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Our%20role (accessed 24 May 2016).

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regulated by ASIC, however the National Consumer Credit Protection Act 2009 (Cth) which replicates the State-based Uniform Consumer Credit Code now provides that ASIC licenses and regulates credit providers.

Unconscionable conduct [11.110] Part 2 Div 2 subdiv C of the ASIC Act focuses on unconscionable conduct in the provision of financial services and, like the Competition and Consumer Act 2010 (Cth), leaves the definition of “unconscionable conduct” to be determined by the courts. Sections 12CA, 12CB and 12CC of the ASIC Act relate to unconscionability: 12CA(1) A person must not, in trade or commerce, engage in conduct in relation to financial services if the conduct is unconscionable within the meaning of the unwritten law, from time to time, of the States and Territories.

This section prohibits unconscionable conduct but does not define the term. Instead, it refers to the “unwritten law”. This is a reference to case law, the original source of the legal concept of unconscionable conduct. The High Court decision of Commercial Bank of Australia Ltd v Amadio 8 introduced the concept of unconscionability into Australian law: Unconscionability is deemed to occur when one party by reason of some condition or circumstance is placed at a special disadvantage … and unfair and unconscientious advantage is then taken of the opportunity thereby created. 9

The “special disadvantage” referred to in the Amadio case was the elderly couple’s age, poor English, lack of business knowledge and lack of independent advice prior to the signing of the bank documents. Section 12CB prohibits unconscionable conduct in relation to financial services that are ordinarily acquired for personal, domestic or household use, thus providing an extra level of protection for the domestic consumer. Unconscionable conduct in financial services is also prohibited by s 12CB: 12CB Unconscionable conduct in financial services (1)

A person must not, in trade or commerce, in connection with: (a)

the supply or possible supply of financial services … to another person (other than a listed public company); or

(b)

the acquisition or possible acquisition of financial services … from another person (other than a listed public company); engage in conduct that is, in all the circumstances, unconscionable.

Despite the general nature of s 12CA, s 12CB does list some matters to be considered when determining if there has been unconscionable conduct in the supply of financial services. These include: (a)

8 9

the relative strengths of the bargaining positions of the supplier and the consumer; Commercial Bank of Australia Ltd v Amadio (1983) 151 CLR 447.

Commercial Bank of Australia v Amadio (1983) 151 CLR 447 at 474. [11.110] 263

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(b)

whether, as a result of conduct engaged in by the supplier, the consumer was required to comply with conditions that were not reasonably necessary for the protection of the legitimate interests of the supplier;

(c)

whether the consumer was able to understand any documents relating to the supply or possible supply of the services;

(d)

whether any undue influence or pressure was exerted on, or any unfair tactics were used against, the consumer or a person acting on behalf of the consumer by the supplier or a person acting on behalf of the supplier in relation to the supply or possible supply of the services;

(e)

the amount for which, and the circumstances under which, the consumer could have acquired identical or equivalent services from a person other than the supplier.

A person who has suffered economic loss as a result of the unconscionable conduct of another person can claim damages: s 12GF. The unconscionability sections in both the ASIC Act and the Competition and Consumer Act 2010 (Cth) are almost identical and therefore provide some reference for identifying unconscionable conduct in relation to the provision of financial services. In a recent case involving payday loans, the Federal Court of Australia has imposed record civil penalties of $18.975 million against The Cash Store Pty Ltd (in liquidation) and Assistive Finance Australia Pty Ltd for their failure to comply with consumer credit legislation, as well as failure to comply with s 12CB under the ASIC Act. 10

Misleading and deceptive conduct [11.120] Sections 12DA and 12DB of the ASIC Act focus on misleading and deceptive conduct and false or misleading representations. These sections are similar to that found in s 18 of the Second Schedule of the Competition and Consumer Act 2010 (Cth). Both s 12DA and s 12DB of the ASIC Act require that the prohibited conduct must occur in relation to financial services: 12DA(1) A person must not, in trade or commerce, engage in conduct in relation to financial services that is misleading or deceptive or is likely to mislead or deceive.

In the past, the courts have interpreted the term “misleading” to mean conduct which leads, or is likely to lead, into error, the person(s) to whom it is directed. There are a number of issues to be considered: 1.

The section does not require actual loss or damage to occur. The client need only demonstrate that he or she was likely to be led into error. The court will look at causation, ie that it was the defendant’s conduct which led to the misconception. It cannot merely be linked to their actions, or claimed that the act led to confusion. There must be a direct nexus.

2.

Fault is not an element of liability. It does not matter whether or not the defendant meant to mislead or deceive: the fact that their actions misled or deceived, or

10

Australian Securities and Investments Commission v Cash Store Pty Ltd (in liq) [2014] FCA 926.

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could have misled or deceived, is sufficient. This is true even if the defendant took all reasonable steps to prevent the possibility of the deception taking place.

3.

The test also considers what was not said. Silence can be misleading and deceiving, particularly if an adviser fails to advise of the complete situation.

Specific issues [11.130] Sections 12BB – 12DE of the ASIC Act prohibit misleading and deceptive conduct in providing financial services in regard to: • misrepresentations about the future, eg future performance; • misleading conduct as to purpose or quantity; • harassment and coercion; and • unsolicited financial services. However, in the case Avoca Consultants Pty Ltd v Millennium3 Financial Services Pty Ltd, 11 Barker J held that the Trade Practices Act 1974 (Cth) applied to an agreement between the licensee and the authorised representative as the agreement did not relate to engaging in conduct “in relation to the provision of financial advice”.

Implied warranty to render financial services with due skill and care [11.140] Whether this legislation applies is determined by the definitions of “consumer”, “financial product” and “financial services”. Section 12BC of the ASIC Act provides that a person is deemed to have acquired particular financial services as a consumer if: • the price of the services did not exceed $40,000; or • if the price of the services exceeded $40,000 – the services were of a kind ordinarily acquired for personal, domestic or household use; or

• if the services were acquired for use in connection with a small business and the price of the services exceeded $40,000 – the services were of a kind ordinarily acquired for business use.

In this context, “small business” means a business employing less than 20 people and, where the business involves the manufacture of goods, less than 100 people: s 12BC. In every contract for the supply of financial services to a consumer in the course of business, s 12ED provides that (except contracts of insurance: s 12ED(3)) there is an implied warranty that: • the services will be rendered with due care and skill; and • any materials supplied in connection with those services will be reasonably fit for the purpose for which they are supplied.

Section 12ED(2) also provides that where financial services are provided to a consumer in the course of a business and the consumer makes known either the 11

Avoca Consultants Pty Ltd v Millennium3 Financial Services Pty Ltd [2009] FCA 883. [11.140] 265

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purpose for which the services are required or the result that is desired to be achieved from the rendering of the services, there is an implied warranty that both: • the services supplied under the contract; and • any material supplied in connection with those services; will be reasonably fit for that purpose or of such a nature and quality that it might reasonably be expected to achieve that result, except if the circumstances show that the consumer does not rely, or that it is unreasonable to rely, on the adviser’s skill or judgment. This provision mirrors s 60 of the Competition and Consumer Act 2010 (Cth) and enshrines in legislation the common law duty to exercise reasonable care and skill. The use of the concept of “unreasonable reliance” in s 12ED(2) suggests that an adviser may be able to avoid a claim of lack of fitness for purpose by use of a qualification or limitation. However, this is unlikely because of s 12EB, which renders limitation of liability clauses void.

Unfair terms of consumer contracts [11.145] On 1 July 2010 major reforms were implemented in relation to consumer contracts. The result of these reforms was that the ASIC Act was amended to include sections relating to unfair terms in consumer contracts. 12 Section 12BF provides that an unfair term of a standard consumer contract, 13 for the provision of financial services or financial products, is void but the contract may continue if it is capable of operating without the unfair term. (1)

A term of a consumer contract is void if: (a)

the term is unfair; and

(b)

the contract is a standard form contract; and

(c)

the contract is: (i)

a financial product; or

(ii)

a contract for the supply, or possible supply, of services that are financial services.

(2)

The contract continues to bind the parties if it is capable of operating without the unfair term.

(3)

A consumer contract is a contract at least one of the parties to which is an individual whose acquisition of what is supplied under the contract is wholly or predominantly an acquisition for personal, domestic or household use or consumption.

The term “standard form contracts” is not defined, 14 but s 12BG does explain the term “unfair term”: 12 13 14

Introduced into the ASIC Act by the Trade Practices Amendment (Australian Consumer Law) Act (No 1) 2010 (Cth) and came into force on 1 July 2010. The term “consumer” is defined according to s 12BC of the ASIC Act. Section 12BK of the ASIC Act provides indicators of standard form contracts but states that “a court may take into account such matters as it thinks relevant”.

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(1)

(2)

(3)

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A term of a consumer contract referred to in subsection 12BF(1) is unfair if: (a)

it would cause a significant imbalance in the parties’ rights and obligations arising under the contract; and

(b)

it is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term; and

(c)

it would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.

In determining whether a term of a consumer contract is unfair under subsection (1), a court may take into account such matters as it thinks relevant, but must take into account the following: (b)

the extent to which the term is transparent;

(c)

the contract as a whole.

A term is transparent if the term is: (a)

expressed in reasonably plain language; and

(b)

legible; and

(c)

presented clearly; and

(d)

readily available to any party affected by the term.

These amendments will provide greater protection for consumers of financial services.

Disclaimers, limitations and exclusions [11.150] Disclaimers and exclusion of liability clauses are terms of an agreement that attempt to limit the liability of one of the parties and may be used to protect advisers from liability under both contract and tort: see Hedley Byrne v Heller & Co Ltd. 15 This would not apply in a retail investment situation where Div 2 of Pt 2 of the ASIC Act applies since s 12EB renders disclaimers and exclusions ineffective in consumer financial services transactions. Furthermore, in relation to financial services disclosure, s 951A of the Corporations Act 2001 provides that disclosure requirements of Pt 7.7 cannot be avoided by a condition of a contract for financial product or financial services. This condition will be void if it provides that a party to the contract is: • required or bound to waive compliance with any disclosure requirement of Pt 7.7; or • taken to have notice of any contract, document or matter not specifically referred to in a Financial Services Guide (FSG), Statement of Advice (SoA) or other document given to the party: s 951A(1) and (2).

Section 945B of the Corporations Act 2001 obliges the adviser to warn a client if the advice given is based on incomplete or inaccurate information. Sections 951A and 1020D make it clear that sections relating to financial services disclosure and financial product disclosure cannot be contracted out of. Section 1020D also provides that a term of a contract for the acquisition of a financial product is void if it provides that a party to the contract is: 15

Hedley Byrne v Heller & Co Ltd [1964] AC 465. [11.150] 267

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• required or bound to waive compliance with any requirement of Pt 7.9; or • if the acquisition occurs where a product disclosure statement (PDS) is required to be given, taken to have notice of any contract, document or matter not referred to in a PDS or supplementary PDS given to the party.

Disclaimers can be effective in the case of institutional investors in relation to implied terms but not in regard to the prohibitions against misleading and deceptive conduct (s 12DA of the ASIC Act) and unconscionable conduct: ss 12CA, 12CB and 12CC. The terms of the relevant sections render liability for such conduct non-excludable. However, disclaimers which purport to exclude the duty to take reasonable care, due skill and care or due diligence, are ineffective once the relevant consumer “gateway” is established. Section 12EB of the ASIC Act has the effect that the application of conditions and warranties in consumer transactions cannot be excluded, restricted or modified. It provides that a term of a contract is void if it purports or has the effect of excluding, restricting or modifying the: • application of terms implied into consumer transactions; • exercise of rights conferred by such implied terms; and • liability of a person for breach of a warranty implied by the legislation. Liability under provisions such as s 12ED can be limited if the contract is for the supply of financial services other than services ordinarily acquired for personal, domestic or household use and it is fair and reasonable for the supplier to rely on the limitation clause. For example, liability may be limited to the cost of resupply of the financial services under s 12EC of the ASIC Act.

CODES OF CONDUCT [11.160] Industry codes of conduct are part of the self-regulation of particular industries and are regarded as best practice and usually focus on the ethical standards expected of the particular industry. Generally, the financial services industry uses codes of conduct – for instance, there are codes for banking, financial planning, life insurance, general insurance companies, general insurance brokers, credit unions and building societies. Although such codes are not law, they indicate to the public and to the regulator the appropriate standard of conduct expected of the industry and that is generally used as a guide. As they are not law, financial planners cannot be sued for a direct breach of the code. Prior to the establishment of complaints schemes, almost all industry associations had developed codes of conduct. These codes set out the best practice for practitioners in the industry. Given that “good industry practice” is one of the three elements assessed by complaints schemes, such codes are an integral part of complaints handling and of conduct generally in the market. Often a distinction is drawn between a code of conduct and a code of practice: • a code of conduct sets out broad principles by which an industry should operate; 268 [11.160]

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• a code of practice is very prescriptive, and generally sets out a series of rules that should be adhered to.

Regulatory Guide 183 sets out guidelines for codes of conduct and the principles that will be used by ASIC to approve industry codes. 16 This RG states that, for ASIC’s purposes, there will be no distinction made between a code of practice and a code of conduct. The benefits to consumers of codes are set out in RG 183.4–183.5: We believe that the primary role of a financial services sector code is to raise standards and to complement the legislative requirements that already set out how product issuers and licensed firms (and their representatives) deal with consumers. We expect an effective code to do at least one of the following: (a)

address specific industry issues and consumer problems not covered by legislation;

(b)

elaborate upon legislation to deliver additional benefits to consumers; and/or

(c)

clarify what needs to be done from the perspective of a particular industry or practice or product to comply with legislation.

Thus, codes are an important part of investor protection in the financial services sector. The Financial Planning Association of Australia Ltd (FPA) has a Code of Professional Practice which includes three categories: 1.

Code of Ethics;

2.

Practice Standards; and

3.

Rules of Professional Conduct. 17

DISPUTE RESOLUTION IN THE INVESTMENT INDUSTRY [11.170] Using the courts to resolve disputes between a licensee and client is time consuming and expensive – for both parties. In the late 1980s, there was increasing interest in avoiding the cost and time associated with a court action by using alternative dispute resolution (ADR) to resolve problems. This was formalised in the financial sector with the establishment of the Australian Banking Industry Ombudsman in 1990. 18 Since that time, ADR has become a feature of the financial services landscape which must be considered when dealing with clients. The provision of appropriate dispute resolution mechanisms to process disputes is an integral part of any consumer protection regime. The general obligations of financial services licensees require that if a licensee provides financial services to a retail client, the licensee must have a dispute resolution system: Corporations Act 2001 (Cth) s 912A(1)(g). This system must include an 16 17 18

ASIC, RG 183 (March 2013): see http://asic.gov.au/regulatory-resources/find-a-document/regulatoryguides/rg-183-approval-of-financial-services-sector-codes-of-conduct/ (accessed 24 May 2016). Available at: http://fpa.com.au/wp-content/uploads/2015/09/FPA_CodeofPractice_July2013.pdf (accessed 24 May 2016). Replaced by the Financial Ombudsman Service (FOS).

[11.170] 269

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internal dispute resolution procedure, approved by ASIC, which covers complaints against the licensee by retail clients in relation to the provision of financial services covered by the licence, together with membership of an ASIC-approved external dispute resolution scheme, such as the Financial Ombudsman Service. Section 912A(2) states: To comply with this subsection, a dispute resolution system must consist of: (a)

(b)

an internal dispute resolution procedure that: (i)

complies with standards, and requirements, made or approved by ASIC in accordance with regulations made for the purposes of this subparagraph; and

(ii)

covers complaints against the licensee made by retail clients in connection with the provision of all financial services covered by the licence; and

membership of one or more external dispute resolution schemes that: (i)

is, or are, approved by ASIC …

Internal dispute resolution [11.180] Internal dispute resolution (IDR) refers to a dispute resolution process that is established within the licensee’s business. It is a mandatory requirement as proscribed by s 912A(1)(g) of the Corporations Act 2001 and an applicant for a financial services licence must have IDR systems in place when applying for a licence. Regulatory Guide 165 sets out the details of the IDR requirements. In ASIC’s view, fair handling of complaints requires AFS holders: • to ensure AFS holders’ internal dispute resolution process (IDR) is readily

accessible to complainants; • to follow fully the IDR process; • to provide genuine assistance to complainants in formulating their complaints,

including providing them with information relevant to their investment and the history of their contact with you; • to assess each complaint properly; • to communicate to each complainant clearly and fairly; • to make a clear decision supported by the material that is fair, reasonable and

genuine especially where numerous complaints are made out of the same or similar factual circumstances; and • to cooperate fully with any referrals to your external dispute resolution process

(EDR) which, in most cases, is the Financial Industry Complaints Service (FICS). ASIC will pay close attention to the number of referrals made to FICS that are determined in favour of the consumer. A high percentage of decisions upheld by FICS in favour of the complainant may indicate: • the IDR procedures are not working well; • AFS holders are not providing a fair deal to consumers; and/or • action by ASIC is necessary to ensure the genuine interests of consumers are

addressed fairly and not placed at further risk. 270 [11.180]

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ASIC expects AFS holders to be able to resolve most consumer complaints through the IDR process.

External dispute resolution [11.190] An external dispute resolution process (or EDR) is an external dispute resolution process that is approved by ASIC. It is a mandatory requirement that licence holders must be members of an approved EDR process. Regulatory Guide 139 sets out the procedure for ASIC approval of EDR schemes. Most licensees are members of the Financial Ombudsman Service (FOS), which is an approved EDR scheme.

Financial Ombudsman Service [11.200] The Financial Industry Complaints Service Limited (FICS) was replaced by the Financial Ombudsman Service (FOS) from 1 July 2008. 19 The FOS website states: The Financial Ombudsman Service (FOS) Australia offers fair, independent and accessible dispute resolution for consumers who are unable to resolve complaints with member financial services providers. A not-for-profit, non-government organisation, FOS resolves disputes quickly and efficiently, providing a cheaper alternative than going to court. Our service is free of charge for applicants, with the costs of running the service being met by our members. Our members include banks, insurers, credit providers, financial advisers and planners, debt collection agencies and other businesses that provide financial products and services. We resolve disputes between consumers and financial services providers: • in a cooperative, efficient, timely and fair manner; • with minimum formality and technicality, and • as transparently as possible, taking into account our obligations for confidentiality

and privacy. This involves understanding all aspects of a dispute without taking sides, and making decisions based on the specific facts and circumstance of each dispute. 20

The FOS Terms of Reference provide that the purpose of the service is to provide an independent forum to resolve disputes between applicants and financial services providers. 21 The service is free of charge for applicants. The costs of the service are met by the financial services providers. 22

19 20 21 22

Financial Ombudsman Service website https://www.fos.org.au/ (accessed 24 May 2016). FOS website “What we do” https://www.fos.org.au/about-us/. Available at https://www.fos.org.au/custom/files/docs/fos-terms-of-reference-1-january-2010-asamended-1-january-2015.pdf (amended 1 January 2015) (accessed 24 May 2016). FOS website “What we do” https://www.fos.org.au/about-us/.

[11.200] 271

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4.1 Eligibility to lodge a Dispute with FOS

FOS may only consider a Dispute if the Dispute is between a Financial Services Provider and: a)

an individual or individuals (including those acting as a trustee, legal personal representative or otherwise);

b)

a partnership comprising of individuals – if the partnership carries on a business, the business must be a Small Business;

c)

the corporate trustee of a self managed superannuation fund or a family trust – if the trust carries on a business, the business must be a Small Business;

d)

a Small Business …

e)

a club or incorporated association – if the club or incorporated association carries on a business, the business must be a Small Business;

f)

a body corporate of a strata title or company title building which is wholly occupied for residential or Small Business purposes; or

g)

the policy holder of a group life or group general insurance policy, where the dispute relates to the payment of benefits under that policy.

4.2 Types of Disputes that can be considered by FOS 23

FOS may only consider a Dispute between a Financial Services Provider and an Applicant: a)

that arises from a contract or obligation arising under Australian law; and

b)

that arises from or relates to: (i)

the provision of a Financial Service by the Financial Services Provider to the Applicant;

(ii)

the provision by the Applicant of a guarantee or security for, or repayment of, financial accommodation provided by the Financial Services Provider to a person or entity of the kind listed in paragraph 4.1;

(iii)

an entitlement or benefit under a Life Insurance Policy by a person who is specified or referred to in the Life Insurance Policy, …

(iv)

an entitlement or benefit under a General Insurance Policy by a person who is specified or referred to in the policy,

(v)

… (A)

a financial investment …

(B)

a facility under which a person seeks to manage financial risk or to avoid or limit the financial consequences of fluctuations in, or in the value of, an asset, receipts or costs (such as a derivatives contract);

(vi)

a claim under another person’s motor vehicle insurance policy for property damage to an Uninsured Motor Vehicle caused by a driver of the insured motor vehicle …

(vii)

where the Financial Service Provider is a mutual – the provision of a Financial Service by a third party through the agency of the mutual to a customer of the mutual; and

… c) 23

… approved deposit funds and of regulated superannuation funds … FOS Terms of Reference.

272 [11.200]

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FOS is also excluded from hearing some disputes 24 and may also refuse to consider, or continue to consider, a dispute, if it considers this course of action appropriate. On occasions, a licensee has argued that the external dispute resolution body does not have jurisdiction. In Financial Industry Complaints Service Ltd v Deakin Financial Services Pty Ltd, 25 the Federal Court determined that FICS could hear complaints against financial advisers who recommended clients invest in Westpoint promissory notes. One of the arguments put to the court by financial service licensees was that promissory notes and interests in unregistered managed investment schemes were not financial products. However, the court determined that they were financial products and that financial services were provided, and therefore FICS had jurisdiction.

ENFORCEMENT, REMEDIES AND DEFENCES Civil remedies [11.220] The most usual remedy sought by investors who have suffered financial loss is an action for damages, and issues of: • reliance on the disclosure or non-disclosure; and • causation – ie the damages suffered by the investor were caused by the advice relied on,

are common elements which must be proven by the aggrieved investor when claiming damages. Section 1041H of the Corporations Act 2001 and ss 12DA and 12DB of the ASIC Act prohibit misleading and deceptive conduct. A plaintiff must establish that the conduct is misleading and/or deceptive or likely to mislead or deceive, and that they reasonably relied on the disclosure or non-disclosure, and that the particular conduct caused the loss. The Corporations Act 2001 provides that a person who suffers loss or damage by conduct of another person that contravened s 1041H may recover the amount of the loss or damage by action against that person or anyone involved in the contravention: s 1041I. Section 12GI of the ASIC Act sets out the defences for allegations of misleading and deceptive conduct: • it was due to a reasonable mistake; • there was a reasonable reliance on information provided by a third person; and • the problem occurred due to another person, and reasonable precautions had been taken. 24 25

FOS Terms of reference 5.1 and 5.2 Financial Industry Complaints Service Ltd v Deakin Financial Services Pty Ltd (2006) 157 FCR 229; [2006] FCA 1805. [11.220] 273

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This is the only time where reasonable precautions can be used as a defence, ie, the event was the result of a third person.

Criminal liability [11.230] If disclosure documents are not provided to the retail client or the disclosure documents are defective, then a penalty may be imposed on the licensee and the authorised representative for breaches of Pt 7.7 of the Corporations Act 2001. Criminal liability will also arise for breach of s 945A. This section imposes an obligation on the licensee or authorised representative to have a reasonable basis for the advice given to a retail client and, if the personal information supplied by the client is incomplete, then the client must be warned that the advice is given on the basis of the incomplete advice. The ASIC Act also provides that misleading and deceptive conduct is a criminal offence but unconscionable conduct is not subject to criminal penalties. Section 50 of the ASIC Act provides that ASIC may commence civil proceedings in the name of a person where it is in the public interest to do so. The civil proceedings are commenced with the consent of the other person and the purpose is to recover damages or property.

Administrative action [11.235] Regulatory Guide 98 sets out the administrative powers ASIC uses to enforce financial services laws. The administrative powers that ASIC can use include: (a)

immediately suspending or cancelling an Australian Financial Services (AFS) licence in certain limited circumstances;

(b)

suspending or cancelling an AFS licence after offering a hearing;

(c)

banning a person from providing financial services (via a banning order), either immediately, in certain limited circumstances, or after offering a hearing;

(d)

varying AFS licence conditions after offering a hearing.

CONFLICT OF INTEREST [11.250] Investors are entitled to expect competence and integrity from advisers. Some remuneration arrangements can be perceived as promoting conflict situations. If advisers receive commissions from financial product promoters, and these are not disclosed to the client, this is a conflict of interest. Section 912A(1)(aa) of the Corporations Act 2001 (Cth) requires financial service licensees to have adequate arrangements in place for the management of conflicts of interest. The details pertaining to ASIC’s interpretation of “conflict of interest” are contained in Regulatory Guide 181: Licensing: Managing Conflicts of Interest, which states: [181.15] For the purposes of this policy, conflicts of interest are circumstances where some or all of the interests of people (clients) to whom a licensee (or its representative) provides financial services are inconsistent with, or diverge from, 274 [11.230]

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some or all of the interests of the licensee or its representatives. This includes actual, apparent and potential conflicts of interest.

Thus, the interpretation of the term “conflict of interest” has moved from a relatively straightforward common law fiduciary duty to a complex definition that incorporates actual, potential and apparent conflicts. Regulatory Guide 181 identifies key mechanisms to achieve outcomes aimed at enhancing investor confidence, and to provide fairness, honesty, professionalism and market integrity in resolving conflicts of interest. The key mechanisms are: 1.

identifying conflict;

2.

controlling conflict;

3.

disclosing conflict; and

4.

avoiding conflict.

As one of the fundamental tenets of Ch 7, disclosure plays an important part in managing conflicts of interest. However, RG 181 makes it clear that if the conflict of interest cannot be managed, it must be avoided.

Conflicted remuneration [11.260] The Future of Financial Advice reforms have significantly altered this area of the law in relation to adviser remuneration. These provisions were mandatory from 1 July 2013, and may mean that remuneration structures in many financial services businesses may need to be restructured. The following sections of the Corporations Act are relevant: • s 963E, which prohibits a licensee from accepting conflicted remuneration; • s 963F, which requires that a licensee must take reasonable steps to ensure that its representatives do not accept conflicted remuneration;

• s 963G, which prohibits an authorised representative from accepting conflicted remuneration;

• s 963H, which prohibits other representatives from accepting conflicted remuneration; • s 963J, which prohibits employers from giving employees conflicted remuneration; • s 963K, which prohibits a product issuer or seller from giving conflicted remuneration; and

• s 963L, which provides that volume-based benefits are presumed to be conflicted remuneration. A volume-based benefit is a benefit which is wholly or partially dependent on the total number or value of financial products recommended to or acquired by clients;

• s 964D, which provides that a licensee must not charge an asset-based fee on a borrowed amount used or to be used to acquire financial products by or on behalf of the client;

• s 964E, which provides that an authorized representative must not charge an asset-based fee on a borrowed amount used or to be used to acquire financial products by or on behalf of the client; and [11.260] 275

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• s 964A, which provides that a platform operator must not accept volume-based shelf-space fees.

[11.270] “Conflicted remuneration” is defined in s 963A as any benefit, whether monetary or non-monetary, given to a financial services licensee, or a representative of a financial services licensee, who provides financial product advice to persons as retail clients that, because of the nature of the benefit or the circumstances in which it is given: (a)

could reasonably be expected to influence the choice of financial product recommended by the licensee or representative to retail clients; or

(b)

could reasonably be expected to influence the financial product advice given to retail clients by the licensee or representative.

Regulatory Guide 246 was issued in March 2013 as a result of the Future of Financial Advice reforms, and provides guidance on what is conflicted remuneration for the purpose of the above sections and financial product advice given to retail clients. Table 1, set out on pages 8-9 of Regulatory Guide, outlines the obligations of advisers and licensees: Table 1: Other obligations in Pt 7.7A Best interests duty and related obligations Charging ongoing fees to clients These obligations apply when personal advice is These obligations apply when personal advice is provided to a retail client (see Div 2 of Pt 7.7A). provided to a retail client by an AFS licensee or NOTE: The person to whom these obligations representative and there is an ongoing fee arrangeapply is generally the individual who provides ment between the client and the licensee or reprethe personal advice. We refer to this person as sentative (see Div 3 of Pt 7.7A). the ‘advice provider’. Advice providers must: AFS licensees or representatives must: * act in the best interests of their clients in * give their client an annual fee disclosure statement relation to the advice; outlining information about the fees paid and the services received by the client over the previous year; and * only provide advice if, in light of the actions the * only charge an ongoing fee if the client ‘opts in’ to advice provider should have taken to comply continue the ongoing fee arrangement every two with the best interests duty, it is reasonable to years. This opt-in requirement applies unless ASIC is conclude that the resulting advice is appropriate satisfied that the licensee or representative is bound by a code of conduct that, among other things, for the client; obviates the need for complying with the opt-in requirement in the Corporations Act. * give a warning to the client if it is reasonably For more information, see Regulatory Guide 245 apparent that the advice is based on incomplete Fee disclosure statements (RG 245) and Regulatory or inaccurate information about the client’s Guide 183 Approval of financial services sector objectives, financial situation or needs; and codes of conduct (RG 183). * generally prioritise the interests of the client over their own interests and those of some of their related parties. Complying with the best interests duty and related obligations does not affect whether the conflicted remuneration provisions have been complied with. The best interests duty and related obligations and conflicted remuneration provisions impose separate obligations on AFS licensees and representatives that advise retail clients. For more information, see RG 175 and RG 244.

In Regulatory Guide 246 (RG 246.37), ASIC makes the point that conflicted remuneration may include monetary or non-monetary benefits, including free or 276 [11.270]

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subsidized equipment or services, hospitality services such as ticket or travel, shares or other interests in a product issuer, marketing assistance and employee promotion or recognition on the basis of product sales or recommendation. RG246.48 gives the following examples of benefits that are generally conflicted remuneration (although they are not necessarily conflicted remuneration if an exclusion applies, or they could not reasonably be expected to influence the advice given by the licensee or representative: (a)

commissions, whether upfront or trailing, fixed or variable, paid by a product issuer to a licensed dealer group, whether the payment is made directly or through some other arrangement;

(b)

volume-based payments from a platform operator to a licensed dealer group;

(c)

volume-based payments from a licensed dealer group to an authorised representative or other representative;

(d)

volume-based bonuses and other payments, such as a commission or one-off payment, to a financial adviser, which is calculated by reference to the number or value of financial products acquired by clients following the advice of the financial adviser. The payment could be made by:

(e)

(i)

the financial adviser’s dealer group;

(ii)

a platform operator; or

(iii)

a product issuer; and

a discount on the fees paid by an authorised representative to its AFS licensee based on client funds held in a particular financial product.

Even a product-neutral benefit can be conflicted remuneration, if the advice encourages the client to acquire a financial product they would not otherwise acquire, and it is not excluded from the conflicted remuneration provisions (RG 246.55). A benefit will not be conflicted remuneration, whether volume-based or not, if it is given by a retail client in relation to financial product advice given by the licensee or representative to the client, because this is seen as the retail client authorizing that benefit. The consent must be “genuine, express and specific” and knowledge of the benefit or proceeding after disclosure of the benefit, is insufficient consent (RG 246.64). A salary will not be conflicted remuneration, provided that neither the salary nor a component of it (or any increase in it) could be reasonably expected to influence the advice given. It will be conflicted remuneration if it is calculated by reference to the number or value of financial products recommended by the employee to clients (RG 246.68-71). Payments made by a licensee to its representatives to cover business expenses (eg business equipment such as office furniture) will not be conflicted remuneration provided these could not reasonably be expected to influence the advice given, or it is excluded from these provisions (RG 246.72-73). A non-monetary benefit worth under $300 is not conflicted remuneration provided it or identical or similar benefits is/are not given on a regular or [11.270] 277

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frequent basis. Regulation 7.8.11A requires licensees to keep records of benefits between $100 and $300, so that the regularity and frequency can be monitored. A volume-based benefit is presumed to be conflicted remuneration, but is not necessarily so. For example, if the benefit is then passed onto the client, or is so small that it could not reasonably be expected to influence the advice given, it is not likely to be conflicted remuneration (RG 246.118). Similarly benefits that received by the licensee, but are not passed on to the actual adviser, will be unlikely to influence that advice (RG 246.121). Employee benefits calculated from the profitability of the business as a whole, where the business is sufficiently large so that the individual employee’s sales would not affect the profitability of the entire business (RG 246.143). Non-monetary benefits that have a genuine educational or training purpose relevant to providing financial product advice to the client, or comprise information technology software or support for the purpose of providing financial product advice to retail clients, are also exempt from the provisions: section 963C(c) and (d) and Regulations 7.8.11A, 7.7A14 and 7.7A.15. Similarly, brokerage of no more than 100% of a brokerage fee, is not conflicted remuneration: Regulation 7.7.12D. Regulatory Guide 246 sets out the following table of considerations relating to performance benefits on pages 38-39: Table 3: Factors to consider when evaluating performance benefits Eligibility criteria What are the criteria that must be met for an employee to be eligible to receive a performance benefit, and could satisfying such criteria reasonably be expected to influence the advice given? For example, a relevant consideration is whether eligibility criteria explicitly or implicitly encourage the recommendation of a particular product. The more difficult it is to satisfy the eligibility criteria, the less likely that the performance benefit could reasonably be expected to influence the advice given. One way to measure this might be by reference to the proportion of employees who are able to meet the criteria. Purpose of the What behaviour does the employer appear to be trying to encourage through performance ben- the performance benefit? For example, the criteria that make up the scorecard may appear to be designed to encourage an employee to recommend that efit clients acquire specific financial products regardless of their interests, which means the performance benefit is likely to be conflicted remuneration. It may also cause advice to be given that does not comply with the best interests duty and related obligations in Div 2 of Pt 7.7A. Weighting of the What is the relative proportion of the benefit compared to the employee’s benefit in rela- overall remuneration? For example, the overall remuneration would include the tion to total performance benefit and any other forms of remuneration (e.g. salary). remuneration Link between the How direct is the link between the performance benefit and the value or benefit and finan- number of financial products recommended or acquired by clients, based on cial product the advice provided by the employee? For example, a performance benefit is more likely to be conflicted remuneration if it contains a criterion based on the advice volume of product sales compared with one that contains a criterion based on the profitability of an employee’s business unit: for more information, see RG 246.143. Involvement of How directly involved in the advice giving process is the recipient of the recipient in benefit? For example, if the recipient of a benefit helps prepare the advice but advice giving pro- does not provide input into the recommendations that are made to a retail client, the performance benefit is less likely to be conflicted remuneration. cess

278 [11.270]

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Table 3: Factors to consider when evaluating performance benefits Environment in In addition to the factors above, it is also relevant to consider whether the which the benefit benefit is given in an environment that encourages the provision of good quality financial product advice that is in the client’s interests. is given This could be specifically evidenced if, to qualify for the benefit, the recipient must also satisfy other criteria, such as criteria based on the quality of advice given, consumer satisfaction and compliance with internal processes and legal requirements. It may also be relevant to consider non-performance-based practices such as: * training; * monitoring and supervision; and * workplace policies and procedures, including the consequences of not complying with such policies and procedures. Excluded benefits If part of a performance benefit is not conflicted remuneration because one or more exclusions apply, it is not relevant to consider that part of the benefit in determining whether the rest of the performance benefit is conflicted remuneration.

PRIVACY AND CONFIDENTIALITY ISSUES [11.280] In order to provide appropriate advice, a financial planner must obtain personal and sometimes sensitive information from a client. Clients are often cautious in parting with this information, as they have genuine concerns as to where it may end up. Issues concerning privacy and confidentiality are not prescribed by any one body of law. They are generally a mix of industry practice, codes and common law. Accordingly, it is important that advisers have a broad knowledge of the basic issues. Privacy and confidentiality are paramount. Industry bodies strongly discourage the use of personal information for anything other than the purpose for which it was intended. Thus, most industry bodies prohibit the use of client information for on-selling, for mailing lists and for other areas not sought by the client within the practice. Most financial planners usually reassure clients by stating in their agreements the reasons the information is required and the way it will be used. The Privacy Act 1988 (Cth) defines personal information as: information or an opinion (including information or an opinion forming part of a database), whether true or not, and whether recorded in a material form or not, about an individual whose identity is apparent, or can reasonably be ascertained, from the information or opinion. 26

The Privacy Act 1988 (Cth) applies to businesses and non-government organisations that have a turnover of more than $3 million, credit providers, credit reporting agencies, organisations that trade in personal information and also to government departments and agencies as public entities and government agency contractors. 27 The Privacy Commissioner 28 has issued a series of privacy 26

27

Privacy Act 1988 (Cth) s 6.

Privacy Act 1988 (Cth) ss 6C, 6D. [11.280] 279

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standards known as the National Privacy Principles (NPP). 29 The NPP essentially set out best practice when dealing with customer information in any organisation. The NPP specifically preclude an organisation disclosing information of a personal nature other than for the primary purpose of collection. Exceptions are made for police and regulators, but not for family members. Some States have sought to implement the NPP as State privacy legislation. The key issue concerning confidentiality is in relation to client files. Financial Planning Association (FPA) Rules of Professional Conduct state that members must respect the confidentiality of, and safeguard, client documents. 30 There is also constant debate within the industry as to “who owns the client”. The common law is clear – the client files are “owned” by the licensed securities dealer, not the authorised representative. Thus, the authorised representative cannot treat these files as their property. To ensure that the files are the confidential property of the licensee, the “ownership” of such files is generally stated in the employment contract of the licensee. There have been successful prosecutions of authorised representatives who have taken possession of client files, thus breaching the contract with the licensed dealer. Consumer protection has many aspects – it is not just a remedy available to a disgruntled client. However, while consumer remedies are of value to the consumer, the industry receives little benefit from that form of consumer protection. Compensation claims occur through the actions (or inactions) of the professionals concerned and damage to the reputation of the industry may be a further consequence. Adherence to the principles set out in s 912A of the Corporations Act 2001 (see [11.10]) provides the most effective consumer protection for the investor and the industry generally.

28 29

30

On 1 November 2010 the Office of the Privacy Commissioner was integrated into the Office of the Australian Information Commissioner (OAIC). These principles are set out in Sch 3 to the Privacy Act 1988 (Cth). Financial Planning Association (FPA) Rules of Professional Conduct, PS [Practice Standard] 2.

280 [11.280]

CHAPTER 12 Insider Trading: Using Inside Information [12.10]

Introduction ............................................................................................... 281 [12.20] [12.30]

[12.40] [12.50]

Key points .................................................................................................... 282 Key terms ..................................................................................................... 283

General definitions ................................................................................... 283 The prohibitions........................................................................................ 283 [12.60] The trading prohibition .............................................................................. 284 [12.80] Analysis of the trading prohibition ......................................................... 285 [12.80] Non-trading ....................................................................................... 285 [12.90] Applying for ..................................................................................... 285 [12.100] Acquiring ........................................................................................... 285 [12.110] Person includes a company ........................................................... 285 [12.120] Fixed price contracts ........................................................................ 285 [12.130] The communication prohibition ............................................................. 285

[12.150]

Information ................................................................................................ 286 [12.150] [12.160] [12.170] [12.180]

[12.200]

Division 3 financial products ................................................................. 290 [12.200] [12.210] [12.220] [12.230]

[12.250]

What is information? ................................................................................ 286 Possession of information ........................................................................ 287 Material effect on price or value ............................................................ 288 Generally available or a readily observable matter ............................ 289 Securities ..................................................................................................... Derivatives ................................................................................................. Managed investment schemes ................................................................ Superannuation products ........................................................................

290 290 291 291

Consequences of insider trading ........................................................... 292 [12.250] Criminal prosecution ................................................................................ 292 [12.260] Civil liability .............................................................................................. 292

[12.270]

Reform proposals...................................................................................... 293 [12.280] yet [12.290] [12.300] [12.310]

Reform proposals accepted by the government in 2007 (but not legislated) .................................................................................................... Proposed reforms rejected by the government in 2007 ..................... Reform issues under consultation in 2007 ........................................... Conclusions ................................................................................................

294 296 297 300

INTRODUCTION [12.10] In general terms, information which affects the value of securities or shares is “inside information” if that information is not generally available to the public. This chapter discusses the specific prohibitions which oblige investors to not take advantage (or to allow others to take advantage) of “inside [12.10] 281

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information”. Such conduct is known as “insider trading”. The purpose of the prohibitions relating to insider trading is to ensure fairness and integrity in stock markets. The prohibition on insider trading does not only apply to directors (although they often have insider information); instead, it is targeted at anyone who has relevant information that can be characterised as “inside information”, even if that person does not trade. For example, it is an offence to transmit such information for the purposes of facilitating another person’s trading. It also does not matter how the information was obtained. Even a company can commit insider trading. For example, the German company, Hochtief Aktiengesellschaft has recently admitted that it contravened the insider trading provisions by procuring its Australian subsidiary, to acquire additional shares in Leighton Holdings Limited in 2014, at a point when Hochtief Aktiengesellschaft was in possession of inside information about Leighton Holdings Limited. 1 The Australian Securities Exchange (ASX) monitors trading patterns to detect insider trading and is required under ASIC Market Integrity Rules (ASX Market) 2010 Rule 5.11.1 to report any suspicions (on reasonable grounds) of insider trading to ASIC. In recent years, the Australian Securities and Investments Commission (ASIC) has pursued several successful prosecutions for insider trading. Consequently, it is extremely important for an investor to understand and comply with their obligations in this area. Criminal consequences can follow if an investor breaches these prohibitions, even if no profit or even a loss is made from the trade. The maximum penalty for insider trading is now 10 years imprisonment. The prohibition on insider trading is broad-ranging and breaches carry severe penalties. Investors should bear this in mind when deciding whether to execute a particular trade or to pass on inside information.

Key points [12.20] This chapter will provide a greater understanding of: • the concept of “insider trading” and certain subsidiary concepts; • the obligations on investors not to trade while possessing inside information or to communicate that information;

• the consequences of insider trading, and the defences that may apply; and • the significant reforms under discussion at the time of publication in relation to reform of our current insider trading laws.

1

See http://asic.gov.au/about-asic/media-centre/find-a-media-release/2016-releases/16-017mr-hochtiefag-admits-to-insider-trading-contravention/ (accessed 3 May 2016). At the time this book is being finalised, sentencing is before the Federal Court and the hearing has been adjourned to 25 May 2016.

282 [12.20]

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Key terms [12.30] The key terms in this chapter are: • Insider • Insider trading • Inside information

GENERAL DEFINITIONS [12.40] The Corporations Act 2001 (Cth) regulates “inside information”, which is defined as information that is not generally available and which a reasonable person would expect to have a material effect on the price or value of particular securities if it were generally available. 2 The meaning of “information” is discussed in more detail below. The provisions of the Corporations Act 2001 relevant to insider trading only regulate securities that are “relevant Division 3 financial products”, which include securities, 3 derivatives, 4 managed investment products, 5 and superannuation products other than those prescribed by regulations, and any other financial products able to be traded on a financial market. 6 These terms are also discussed in more detail below. “Financial market” means a financial market in Australia. Although financial markets in most jurisdictions prohibit insider trading, the exact wording, and therefore nature, of the prohibitions differ substantially in different jurisdictions. This chapter considers only the Australian provisions. However, it should be noted that the Australian provisions apply to: • conduct occurring in Australia, regardless of where the issuer of the financial products is formed, resides, is located, or carries on business;

• conduct occurring outside Australia, in relation to Div 3 financial products issued by a person carrying on business in Australia, or of a company registered in Australia. 7

THE “PROHIBITIONS” [12.50] Generally, there are two separate offences: • to trade Div 3 financial products on a financial market in Australia (known as the “trading prohibition”); and 2 3

4 5 6 7

Corporations Act 2001 (Cth) s 1042A. Withdrawing from an instruction to an agent to buy or sell securities, before that order is accepted, will not contravene the prohibition as the “entry” into the contract occurs upon acceptance: R v Evans [1999] VSC 488. Defined in Corporations Act 2001 (Cth) s 761A.

Defined in Corporations Act 2001 (Cth) s 761D. See Corporations Act 2001 (Cth) s 764(1)(b). See Corporations Act 2001 (Cth) s 764A(1)(g) and note Corporations Regulations 2001 (Cth) reg 7.10.1, which provides that superannuation products provided by proprietary companies do not fall within the definition. Corporations Act 2001 (Cth) s 1042B.

[12.50] 283

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• to communicate inside information to another person with the intent that they trade with that information (known as the “communication prohibition”).

The “trading” prohibition [12.60] It is an offence for a person to apply for, acquire or dispose of Div 3 financial products (or to enter into an agreement to do so) 8 if that person possesses “inside information” and knows, or ought reasonably to have known, that: • the information is not generally available; and • if the information were generally available, a reasonable person would expect it to have a material effect on the price or value of particular Div 3 financial products. 9

The prohibition also applies to a person who applies for, or procures another person to apply for, acquire or dispose of Div 3 financial products (or to enter into an agreement to do so): s 1043A(1)(c). This would include inciting, inducing or encouraging another person to do any of the above: s 1042F(1). Some case law has reflected on the meaning of “procure” — although not specifically in relation to this section. In A-G’s Reference (No 1) [1973] QB 773, Lord Widgery CJ said: “To procure means to produce by endeavor. You procure a thing by setting out to see that it happens and taking appropriate steps to produce that happening.” 10 To incite, requires intent for the conduct to occur. 11 Smart AJ also said at [77] 12 that it includes “to urge on, to spur on, to prompt to action”. The concepts of “command”, “request”, “propose”, “advise”, “encourage” and “authorise” are all encompassed by “incite”. 13 The meaning of “induce” does not necessarily require causation. 14 The meaning of “encourage” is extremely wide. In a New Zealand case, the court found that a director who was the directing mind and will of the company encouraged the company to enter into a transaction. 15 Encouragement does not require disclosure, or even a positive statement — it would include non-verbal signals such as a nudge or a wink. No causal connection is required — the “encouragement” does not need to “cause” the transaction to occur for the section to be contravened: R v Farris (2015) 107 ASCR 26. 8 9 10 11

Corporations Act 2001 (Cth) s 1043A(1)(c). Corporations Act 2001 (Cth) s 1043A(1). A-G’s Reference (No 1) [1973] QB 773 at 775. R v Chonka [2000] NSWCCA 466 at [50], per Fitzgerald JA and Ireland AJ.

15

Kincaid v Capital Markets Equities Ltd (No 2) (1995) 7 NZCLC 260,718 at 260,736.

12 13 14

R v Chonka [2000] NSWCCA 466. R v Massie [1999] 1 VR 542. Ryan v Triguboff [1976] 1 NSWLR 588 at 600.

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Analysis of the “trading” prohibition Non-trading [12.80] It is not an offence to not trade while possessing insider information. Thus, a person who has inside information and uses that information to decide not to trade in Div 3 financial products, or who decides to withdraw from a trade which has not yet been accepted, will not contravene the provision.

Applying for [12.90] “Applying” for financial products includes, for instance, applying for new financial products to be issued to the investor from the company. Thus, this prohibition does not merely regulate market conduct, but any application for financial products, whether on market or not.

Acquiring [12.100] “Acquiring” financial products includes both the acquisition of new financial products directly from the issuer, and the acquisition by way of purchase, transfer or gift from an existing holder of those financial products.

“Person” includes a company [12.110] “Person” includes a company. Thus, the relevant provisions of the Corporations Act 2001 (Cth) apply also to companies. However, there are some protections for companies, which are outlined below.

Fixed price contracts [12.120] Currently, it appears to be an offence to acquire securities while possessing inside information, even if the price was fixed before the person acquired the inside information and perhaps even if the obligation to acquire the securities became binding before the person acquired the inside information. In Westgold Resources NL v St George Bank Ltd, 16 the court attempted to minimise the potential injustice of the legislation by holding that the price of the securities being acquired by the person in that case would not be affected by the inside information already held by that person, and thus justice required the court to refuse relief. Although this reasoning arguably produces the fairest result, it is directly inconsistent with the clear wording of the section (s 1043A) and has prompted law reform proposals to clarify the position in relation to trading on the basis of a transaction which was agreed prior to the acquisition of inside information.

The “communication” prohibition [12.130] It is also prohibited for a person who possesses inside information (the insider) to directly or indirectly communicate that information to another person, if the insider who knows, or ought reasonably to know, that: 16

Westgold Resources NL v St George Bank Ltd (1998) 29 ACSR 396. [12.130] 285

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• the information is not generally available; • if the information were generally available, a reasonable person would expect it to have a material effect on the price or value of particular Div 3 financial products; and

• the person to whom the information is communicated would be likely to apply for, acquire, or dispose of, relevant Div 3 financial products, or enter into an agreement to do so, or procure a third person to do so. 17

Contravention will not occur if the information is communicated because of a requirement imposed by the Commonwealth, a State, a Territory or any regulatory authority such as ASIC or the ASX, and if the information was communicated to the person, and in the manner, required: s 1043E. This would not include disclosure required by a contractual or fiduciary obligation. It also does not include selective disclosure to market analysts – indeed, the reverse is true. In Australian Securities and Investments Commission v Southcorp Ltd, 18 a company was found to have breached the provision by providing information to selected analysts. More recently, the leakage of market-sensitive Australian Bureau of Statistics data, before its release to the public, by an ABS employee to a National Australia Bank (’NAB’) employee, for the purpose of the NAB employee using it to trade more favourably in foreign exchange derivative products in 2013 and 2014. Profits exceeded $7 million, which was confiscated by the Commonwealth and both men were charged with, and later pleaded guilty to, insider trading (amongst other charges). The men were sentenced to imprisonment of 7 years 3 months (the NAB employee) and 3 years 3 months (the ABS employee). 19

INFORMATION What is “information”? [12.150] Section 1042A of the Corporations Act 2001 (Cth) defines “information” to include: • matters of supposition and other matters that are insufficiently definite to warrant being made known to the public; and

• matters relating to the intentions, or the likely intentions, of a person. Price-sensitive information, which is not generally available, includes nonpublished financial results and decisions, including projections, plans and negotiations. 20 The information can relate to an entire industry (eg a 17 18 19

20

Corporations Act 2001 (Cth) s 1043A. Australian Securities and Investments Commission v Southcorp Ltd (2003) 130 FCR 406.

See http://asic.gov.au/about-asic/media-centre/find-a-media-release/2015-releases/15-058mr-twomen-sentenced-in-australia-s-largest-insider-trading-case/ and http://asic.gov.au/about-asic/mediacentre/find-a-media-release/2014-releases/14-100mr-two-men-arrested-for-insider-trading-and-abuseof-public-office-7-million-dollars-restrained/ (accessed 3 May 2016). ICAL Ltd v County Natwest Securities Aust Ltd (1988) 39 NSWLR 214 at 256 per Bryson J (NSWSC).

286 [12.150]

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forthcoming government policy regulation) and need not specifically originate from, or relate to, the company whose securities are involved in the potential insider trading. The prohibition relates to any information that can affect the price of a security on a market. It need not be specific, 21 and can include rumours and opinions if they are reputed to originate from a source that is likely to cause this effect on the market – eg, the opinion of a well-known and successful market analyst could have such an effect; so could an opinion of a person the market could presume would hold all relevant inside information – such as a director of the company. However, an exception to the trading prohibition (but not the communication prohibition) applies in relation to a person who trades while possessing information which either concerns their own intentions in relation to those financial products, or their own transactions in those financial products. 22 Nevertheless, this defence will not apply to knowledge of the person’s intent to disclose price-sensitive information. 23

“Possession” of information [12.160] It is irrelevant how a person acquires the information, but the person does need to be actually aware of the information for the provisions to be breached. Information that is in a person’s custody or control, but which is not known to that person, is insufficient to establish a breach of the insider trading prohibition. 24 However, evidence that a person controlled or had possession of information would allow the court, in the absence of evidence to the contrary, to infer that the person was aware of that information. It is also possible to infer possession of information from evidence that the person had the ability to access the information. 25 A company is “a person” and therefore can also contravene the insider trading prohibitions. A company “possesses” all information that comes into the possession of any of the company’s officers in the course of performing their duties as an officer of the company: s 1042G(1)(a). According to s 9, the following persons are officers: directors, company secretaries, receivers, external administrators of the company, and every person: • who makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation;

• who has the capacity to affect significantly the financial standing of the company; or 21 22 23 24 25

Hooker Investments Pty Ltd v Baring Bros Halkerston & Partners Securities Ltd (No 2) (1986) 5 NSWLR 157 per Young J. See Corporations Act 2001 (Cth) s 1043H in relation to natural persons, s 1043I in relation to companies and s 1043J in relation to officers of a company. Ampolex Ltd v Perpetual Trustee Trading Co (Canberra) Ltd (1996) 40 NSWLR 12. R v Hannes (2000) 158 FLR 359. R v Hannes (2000) 158 FLR 359.

[12.160] 287

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• in accordance with whose instructions or wishes the company’s directors are accustomed to act (excluding advice given by the person in the proper performance of functions attaching to the person’s professional capacity or their business relationship with the directors or the company);

• who is a partner in a partnership, and the partnership itself possesses information which came into the possession of: – any other partner in the partnership in the capacity as a member of the partnership; – any employee of the partnership that came into possession of the information in the course of the performance of their duties as a partnership employee. 26

To avoid unknowing contravention of the insider trading prohibition as a result of these provisions imputing knowledge within companies and partnership, some exemptions, known as “chinese walls”, apply. The “chinese wall” allows a company or partnership to isolate trading operations from information gathering or analyst operations. The exceptions will apply if the company or partnership: had in operation arrangements that could reasonably be expected to ensure that the information was not communicated to the person or persons who made the decision (to trade) and that no advice with respect to the transaction or agreement was given to that person, and the information was not communicated and the advice was not given. 27

However, these defences may not apply if the arrangement is not systematic and not part of the organisation’s structure. It is likely to be ineffective if persons on both sides of the “wall” work together occasionally. 28

Material effect on price or value [12.170] The prohibitions only apply to information that would, if it were generally available, have or reasonably be expected to have, a material effect on the price or value of the relevant financial products. The legislation specifies when a reasonable person would be taken to expect information to have a material effect on the price or value of particular Div 3 financial products – and that is the case if, and only if, the information would, or would be likely to, influence persons who commonly acquire Div 3 financial products in deciding whether or not to acquire or dispose of them: s 1042D. Courts are willing to consider market price changes that occur when information is actually announced, as well as expert evidence, to determine whether information can be categorised as “inside information”. 29 26 27 28 29

Corporations Act 2001 (Cth) s 1042H(1). See Corporations Act 2001 (Cth) s 1043F in relation to companies; and s 1043G in relation to partnerships. Bolkiah v KPMG [1998] UKHL 52; Mallesons Stephen Jaques v KPMG Peat Marwick [1990] 4 WAR 357. R v Rivkin (2004) 59 NSWLR 284; R v Hannes (2000) 158 FLR 359; Rivkin Financial Services Ltd v Sofcom Ltd (2005) 23 ACLC 42.

288 [12.170]

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“Generally available” or a “readily observable matter” [12.180] A person will not contravene the prohibitions if the information is “generally available”. This is defined in s 1042C, which provides that information is generally available if: • it consists of “readily observable matter”; or • it has been made known in a manner that would, or would be likely to, bring it to the attention of persons who commonly invest in Div 3 financial products of a kind whose price or value might be affected by the information, and since it was so made known, a reasonable period for it to be disseminated among such persons has elapsed; or

• it consists of deductions, conclusions or inferences made or drawn from either of the above kinds of information.

It is clear that information disclosed to the public by means of the stock exchange is information that is generally available. 30 However, there is considerable legal debate on the exact meaning of “readily observable matter”. Should it be limited to matters that are seen with the eyes? Or to information in the public arena? Are the words non-technical? Should it require that the information can be obtained without difficulty? Or does it mean information that is observable to a member of the public who happens to be in the right place at the right time, or who has expended considerable effort and expense in obtaining the information? Must the information be available to the public free of charge and/or in a public place, or would it be sufficient if it is available for those who have a subscription enabling them to access the information – eg details of computerised electronic trading. Must the information be available in Australia, or is it sufficient that it is available overseas? Must it be actually observed by someone? These matters are not clear and are the subject of considerable judicial, policy and literary debate, and until reform of the legislation clarifies the definitions, investors possessing information that could potentially be classified as “inside information” would be well advised to err on the side of caution. The second limb of the legislation allows information to become “generally available” if a reasonable time has elapsed after the information is made known in a manner which is likely to bring it to the attention of persons who commonly invest in those particular securities: s 1042C(1)(b). The information needs to be disclosed to a cross-section of investors, not merely a small proportion of the potential investors, 31 and thus a briefing of selected analysts would be insufficient. 32 In Australia, a system of “trading halts” allows the market time to respond to price-sensitive information and can thus prevent insider trading. The trading halt can be initiated by the market operator (such as the ASX) or requested by the company, and has the effect of stopping all trading on the company’s 30

31 32

Kinwat Holdings Pty Ltd v Platform Pty Ltd [1982] Qd R 370.

Corporations Legislation Amendment Act 1991 (Cth) Explanatory Memorandum. Australian Securities and Investments Commission v Southcorp Ltd (2003) 130 FCR 406. [12.180] 289

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securities for the duration of the halt. During the halt, investors can change or cancel existing orders, and/or initiate new orders, in response to the pricesensitive information. The halt can occur following disclosure of price-sensitive information, or if the company suspects that insider trading may occur or may be occurring.

DIVISION 3 FINANCIAL PRODUCTS Securities [12.200] For the purposes of the insider trading provisions, “security” is defined in s 761A to mean: (a)

a share in a body;

(b)

a debenture of a body;

(c)

a legal or equitable right or interest in a security covered by paragraph (a) or (b); or

(d)

an option to acquire, by way of issue, a security covered by paragraph (a), (b) or (c);

(e)

a right (whether existing or future, whether contingent or not) to acquire, by way of issue, a security covered by paragraph (a), (b), (c) or (d);

(f)

certain managed investment scheme products;

but excluding all “excluded securities”. An “excluded security” is either: • a share or debenture (or a unit in the share or debenture), if attached to that share or debenture there is a right to participate in a retirement village scheme, and each of the other rights (and each interest, if any) attached to the share or debenture is a right or interest that is merely incidental to the right to participate in that retirement village scheme; or

• an interest in a managed investment scheme constituted by a right to participate in a retirement village scheme. 33

Derivatives [12.210] A “derivative” is defined in s 761D(1) as an arrangement where:

33 34

(a)

a party to the arrangement must, or may be required to, provide at some future time consideration to someone;

(b)

that future time is not less than the prescribed number of days, 34 after the day on which the arrangement is entered into (3 days for foreign exchange contracts and 1 day for other contracts, under Regulation 7.1.04); and

(c)

the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and Corporations Act 2001 (Cth) s 9. Under the Corporations Regulations 2001 (Cth) reg 7.1.04(1), this period is one business day, but will be two business days for a “spot foreign exchange contract”, defined by reg 7.1.04(3) as a foreign exchange arrangement involving the giving of future consideration that is calculated by reference to the exchange rate on the date of the arrangement.

290 [12.200]

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whether or not deliverable), including, eg, an asset, a rate (including an interest rate or exchange rate), an index or a commodity.

However, an arrangement will not be a derivative merely because the price varies by reference to a general inflation index such as the Consumer Price Index (CPI): s 761D(4). The following are expressly excluded from the definition of “derivative” in s 761D(3) and (4): • a contract for the future provision of services; • an arrangement where a party has (or may have) an obligation to buy and the other to sell, tangible property other than currency at a price and on a date in the future, and the seller cannot discharge the obligation to deliver the property by transferring cash, or matching up with another arrangement of the same kind under which the seller has an offsetting obligation to buy;

• anything covered by the definition of “financial product” above, other than a financial product that is a derivative; and

• anything declared by the regulations not to be a derivative. 35 For example, Corporations Regulations 2001 (Cth) reg 7.1.04(2) states that an arrangement other than a spot foreign exchange contract will not be a derivative if the arrangement provides for one person to provide consideration where the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, eg an asset, a rate (including an interest rate or exchange rate), an index and/or a commodity.

Managed investment schemes [12.220] “Managed investment schemes” (MISs) are defined in s 9 of the Corporations Act 2001 and discussed in Chapter 7. The definition of “Division 3 financial products” includes interests in both registered and unregistered schemes.

Superannuation products [12.230] The definition of “Division 3 financial products” in reg 7.10.01 of the Corporations Regulations 2001 (Cth) includes “superannuation products” issued by a “public offer entity”. A “superannuation product” is a beneficial interest in a “superannuation entity”. 36 A “superannuation entity” is a regulated superannuation fund, an approved deposit fund, or a pooled superannuation trust. Thus, the insider trading prohibitions apply to beneficial interests in a regulated superannuation fund, an approved deposit fund, or a pooled superannuation trust that is a “public offer entity”. A “public offer entity” is 35 36

Corporations Act 2001 (Cth) s 761D(3). Section 764A(1)(g) of the Corporations Act 2001 (Cth), which refers to the Superannuation Industry (Supervision) Act 1993 (Cth) s 10. [12.230] 291

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defined 37 as a public offer superannuation fund, 38 an approved deposit fund that is not an excluded approved deposit fund, or a pooled superannuation trust. 39

CONSEQUENCES OF INSIDER TRADING Criminal prosecution [12.250] A person who can be proven in a court to a standard of “beyond reasonable doubt” to have contravened either the “trading prohibition” or the “communication prohibition” will be liable for the criminal consequences of insider trading. The onus then shifts to the “insider” to prove, if possible, that the insider is entitled to rely on one of the exceptions discussed above. For example, a person charged with insider trading could escape criminal liability if they could prove that the information was no longer “inside information” because they possessed the information as a result of dissemination of the information under s 1043C(1)(b) to persons who commonly invest in those securities: s 1043M. It is also a defence to the “trading prohibition” if the other party to the agreement or transaction was also aware of the information at the time, 40 and a defence to the “communication prohibition” if the person who received the information knew of it beforehand: s 1043M(3)(b). The penalties applicable for each criminal offence dramatically increased on 13 December 2010. The penalty for an individual is now imprisonment for 10 years or a maximum fine of $495,000 or three times the benefits accruing from the offence, whichever is greater: Corporations Act 2001 (Cth) Sch 3. A company risks a penalty of $4.95 million or three times the benefit accruing from the offence, whichever is greater: s 1312 and Sch 3.

Civil liability [12.260] In civil actions, the standard of proof is lessened to “on the balance of probabilities” rather than the standard of “beyond reasonable doubt” required for criminal prosecution. Even if a person is not criminally liable for insider trading, significant consequences arise as a result of civil prosecution – ie the insider risks substantial fines and liability for compensation. Both the “trading prohibition” and the “communication prohibition” are “financial services civil penalty provisions”: ss 1317DA and 1317E(1)(jf), (jg). 37 38 39 40

Superannuation Industry (Supervision) Act 1993 (Cth) s 10. Itself defined in Superannuation Industry (Supervision) Act 1993 (Cth) s 18. Section 10 of the Superannuation Industry (Supervision) Act 1993 (Cth) provides that this is a unit trust where the trustee is a constitutional corporation and the trust is covered by the Superannuation Industry (Supervision) Regulations 1994 (Cth) reg 1.04(5). Corporations Act 2001 (Cth) s 1043M(2)(b).

292 [12.250]

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Therefore: • ASIC or the company are entitled to apply to the court for a declaration confirming the contravention; and

• if the contravention is serious, or materially prejudices the interests of the issuer of the financial products, or those acquiring or disposing of the financial products, the court can order the person to pay a pecuniary penalty. The amount of the pecuniary penalty is up to $200,000 for each breach by a natural person and up to $1 million for each breach by a company. 41 (This is less than the penalty payable for a criminal offence.)

In addition, s 1317HA(1) entitles the court to order the person who has contravened either prohibition to compensate anyone who has suffered damage as a result. This includes return of any profits made as a result of the contravention: s 1317HA(2). The court may wholly or partially excuse the person from liability if the person has a defence if criminal proceedings were undertaken for the same conduct: s 1043N. The issuer of the financial products also has a direct right to compensation under s 1043L(2) if it suffered damage as a result of the insider acquiring financial products at a price less than the price that would have likely applied if the information had been generally available. The compensation is payable by the insider, or any other person involved in the contravention.

REFORM PROPOSALS [12.270] When the second edition of McLaren was published in 2007, we stated that insider trading was clearly on the corporate law reform agenda, as the Federal Government had just issued a discussion paper on insider trading law reform, in early March 2007. 42 The discussion paper noted recommendations made by the Corporations and Markets Advisory Committee (CAMAC) in November 2003 in relation to insider trading reform, 43 set out the government’s position in relation to those recommendations, and asked for submissions on certain aspects of the government’s position on particular proposed insider trading reforms. 44 In the discussion paper, the government accepted most of CAMAC’s recommendations, but asked for consultation and submissions in relation to some of its recommendations. Submissions were due by 2 June 2007, but, unusually, have not been published on the Treasury website (although perhaps the insider trading policy reform agenda was overtaken by the change in government that occurred as a result of the federal election on 24 November 2007). 41

42

43 44

Corporations Act 2001 (Cth) s 1317G.

Commonwealth Treasury, Insider Trading, Position and Consultation Paper (March 2007): http:// www.treasury.gov.au/documents/1235/PDF/Insider_trading_position_consultation.pdf (accessed 18 March 2011). CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011). Submissions closed 2 June 2007 but at the time of writing have not been made available.

[12.270] 293

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At the time of preparing the third edition of McLaren, in early 2011, there had been few changes to insider trading laws since 2007 (except for the increase in criminal penalties, discussed above) and it was unclear whether, and to what extent, the previous government’s insider trading reform policy, will be accepted by the current or future governments. As we prepare this book in 2016, insider trading laws have not changed. What has changed, however, is that in mid–2010 the responsibility for detection, investigation and enforcement of insider trading shifted from the ASX, to ASIC. ASIC has reportedly substantially increased its market surveillance, in an effort to improve detection and enforcement rates. It is likely that other reforms are “on hold” until the effect of this major regulatory change can be assessed (and perhaps, after solicitation of additional submissions on the reform agenda which can take into account such a major regulatory change). Nonetheless, the recommendations made by CAMAC and agreed to by the government in early 2007 are serious issues and reflect ongoing debate about how to improve our insider trading laws. This issue is far from over.

Reform proposals accepted by the government in 2007 (but not yet legislated) [12.280] The following CAMAC recommendations were accepted by the government in 2007 and thus may form part of our future insider trading laws (and related laws) at some point in the future: 45 1

To strengthen the reporting requirements for directors of listed companies, by amending s 205G: • to apply to all listed entities (but deeming exempt foreign entities to have

complied if their directors have complied with disclosure requirements of their incorporating jurisdiction); • to apply to all directors and senior executives including the chief

executive officer, and covering direct trading and trading through related parties, and directors and senior executives of any entity that substantially manages the affairs of a listed entity; • to cover transactions that occurred before a director’s resignation and

within one month thereafter; • with off-market transactions, a copy of the contract should also be

disclosed; • to disclose the closest approximate number of securities whenever it is

not reasonably possible to know the exact number; • to reduce the disclosure period from 14 days to two business days, except

for changes arising under dividend (distribution) reinvestment plans; • to not require disclosure of changes arising from transactions applying

equally to all shareholders, without individual shareholder election. 45

CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011), pp 4–8 and 25–30. The numbering reflects the original numbering in the CAMAC report.

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4

To clarify the relevant time for liability when trading through an intermediary – when instructions are given to the intermediary; the instructor should not contravene the provision unless a transaction takes place.

5

To extend the “Chinese walls” defence to cover the procuring offence.

6

To permit bid consortium members to acquire for the consortium, by amending the “own intentions” exemption to clarify that members of a prospective bid consortium can acquire on behalf of that consortium prior to the market becoming aware of the intended bid. However, these persons should not be entitled to trade on their own behalf before the market becomes aware of the bid, even with the consent of other bid consortium members.

7

To protect uninformed procured persons from civil liability, so that they should not be required to return any profit made or loss avoided by that person if they establish that the procuring insider did not receive any direct or indirect benefit from that transaction.

8

To extend the equal information defence to civil proceedings, by providing an equal information defence in civil proceedings similar to the defence that applies in criminal proceedings, namely that the counterparty to the transaction “knew or ought reasonably to have known” of the inside information.

9

To permit courts to extend the range of civil claimants who have traded in the market beyond the insider’s immediate market counterparty, using the concept of “aggrieved persons”.

12

To entitle an uninformed party requiring the exercise of option rights, whether or not fixed price, to require their informed counterparties (ie, anyone who holds inside information at the time of exercise) to honour their physical delivery obligations.

Exclusions to the application of the insider trading provisions are as follows: 13

The majority of the government considers that issuers making a general issue should not be subject to the insider trading provisions. (The minority does not support this exemption.) The Advisory Committee considered that offerees who subscribe for new issues when aware of inside information not known to the issuer should remain subject to the insider trading provisions.

15

Insider trading provisions should still apply to offerees under share buy-backs.

16

Transactions under non-discretionary trading plans (majority position) should be exempt from the insider trading provisions where: • the trading takes place in accordance with a plan entered into when

either the person was not aware of any inside information or any information of which the person was then aware was no longer inside information when any trading under the plan took place; • there are no discretions under the plan, other than to terminate it; and • the plan was entered into in good faith and not as part of a scheme to

evade the insider trading prohibitions.

The person relying on the exemption would have the legal onus of establishing the above elements, rather than merely an evidential onus to raise them. [12.280] 295

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Proposed reforms rejected by the government in 2007 [12.290] The recommendations made by CAMAC, that specific reform proposals not be adopted, were accepted by the government in relation to the reform proposals described below. If the government maintains this position, the original law reform proposals listed below will be likely to remain part of our insider trading laws (and related laws) and thus remain unchanged in the foreseeable future. 46 The CAMAC recommendations accepted by the government were that:

46

17

The “insider” definition should still include entities as well as natural persons.

18

The “information connection” approach, without any additional “person connection” test, should be retained.

19

There should be no rebuttable presumptions.

20

Decisions not to trade, disclosing inside information for that purpose and procuring another person not to trade, should continue to be excluded from the insider trading legislation.

21

There should be no obligation to inform recipients that information is inside information.

22

There should be no requirement that inside information be specific or precise.

23

Apart from the recommended exemption for informed persons trading pursuant to a pre-existing non-discretionary trading plan (recommendation 16), the insider trading legislation should not have a use requirement or a defence of non-use.

24

There should be no defence that an informed person traded contrary to inside information.

25

The communication and subscription exemptions for underwriting should be retained.

26

An intermediary who is aware that a client holds inside information should remain liable for aiding and abetting by trading in affected financial products for that client.

27

There should be no exemption for informed intermediaries acting for uninformed clients.

28

There should be no derivative civil liability provision.

29

There should be no specific exemption for target company directors in communicating inside information to white knights.

30

There should be no statutory exemption for white knights of takeover target companies.

31

Exchanges should not be obliged to publish any details of their referrals to ASIC of suspected insider trading.

32

There should not be different criminal and civil insider trading regimes. CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011), pp 4–8 and 25–30.

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33

CAMAC did not formally recommend whether ASIC should have a power to impose administrative penalties for insider trading. However, it considered that any further debate on this issue should take into account the recommendations in the ALRC Report, 47 that deal with procedural fairness and review of administrative decision-making. The government does not intend to extend infringement notices to insider trading at this time. 48

34

The existing rules for assessing the profit made or loss avoided should remain.

35

The existing law, under which companies whose financial products are traded are entitled to compensation, should remain, even where those companies have suffered no loss or damage.

36

There should be no new statutory prohibition on speculative trading.

37

There should be no specific statutory prohibition on short swing profits.

Reform issues under consultation in 2007 [12.300] In the Discussion Paper issued in 2007, the government specifically sought consultation on the following CAMAC recommendations (for ease of reference, the numbering in the CAMAC report has been retained). 49 The CAMAC recommendations for consultation were: Recommendation 2: whether to restrict the on-selling exemption for underwriters in s 1043C, given the apparent conflict between fairness to counterparties and market efficiency. Specifically, the government asked: • Are underwriters disadvantaging counterparties by using this exemption? • Will this result in less underwriting capacity, increased costs or otherwise impact on issuers’ ability to raise funds?

Recommendation 3: whether to repeal the exemption under reg 9.12.01(d) of the Corporations Regulations 2001 (Cth) (which provides that the trading and procuring offence in s 1043A does not apply to transactions entered into by liquidators, personal representatives of deceased persons and trustees in bankruptcy in good faith to perform their official powers), insofar as it applies to external administrators. The government asked: • What would be the effect on the willingness and ability of external administrators to perform their roles, and the cost of external administrators?

• What is the evidence of external administrators disadvantaging counterparties by using this exemption? 47 48 49

Australian Law Reform Commission, Report 95, Principled Regulation: Federal Civil and Administrative Penalties in Australia (31 October 2002): http://www.austlii.edu.au/au/other/alrc/publications/ reports/95 (accessed 18 March 2011). CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011), p 6. CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011), pp 8–23 and 31–42. [12.300] 297

Law of Investments and Financial Markets

• If the exemption is to be retained, should it be subject to conditions or limitations other than, or as well as, the current requirement that the transaction be in good faith to exercise their official powers?

The majority of CAMAC recommended that persons who, in good faith, entered into fixed exercise price physical delivery option contracts when they were not aware of inside information should be entitled to exercise their physical delivery rights, even where they hold inside information at the time of exercise. The government: • noted that this may give informed persons an advantage over uninformed persons, which is contrary to the market fairness rationale for prohibiting insider trading;

• noted that in some instances, informed persons may have a fiduciary duty not to publicly release the inside information and at the time they must choose whether to exercise their rights; and

• considered that there appear to be strong arguments for retaining the present position – ie not permitting informed parties to exercise their physical delivery option rights, given the advantage to persons with inside information.

The government asked whether there are any circumstances in which permitting informed persons to exercise their physical delivery option rights should be allowed. Recommendations 13–15: Under ss 761E and 1043A(1)(c) of the Corporations Act 2001, the insider trading provisions currently apply to issuers of new financial products (including under a general issue and under a private placement), and to buy-back entities (except for registered managed investment schemes): s 1043B. The government agreed with CAMAC’s majority view that issuers making a general issue of securities should not be subject to the insider trading provisions. However, the government asked: • Should issuers and wholesale offerees, in the case of placements, be exempt from the insider trading prohibition, as recommended by CAMAC’s majority?

• What evidence suggests that the insider trading prohibition discourages minimum holding buy-backs, employee share schemes and on-market buy-backs?

• How would application of the buy-back provisions affect companies’ willingness to undertake minimum holding buy-backs, employee share schemes and on-market buy-backs?

The government asked for submissions on whether CAMAC’s majority proposal to make consequential amendments to meet the needs of specific financial markets (particularly over-the-counter markets for financial products), and comments on how to solve these problems if CAMAC’s recommendation is not implemented. The amendments suggested by the CAMAC majority are new definitions of “disclosable information” and “announceable information” in s 1042A; and new references to such information in s 1043(1) and (2). The government described these concerns as follows: • Potential retrospectivity of the application of the insider trading offence, and the difficulty of determining at a particular time of trading, whether information is or ceases to be “inside information” according to a list of criteria (eg in continuous

298 [12.300]

Insider Trading: Using Inside Information

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disclosure requirements). 50 In addition, often it is not certain whether an entity will publicly announce information that it is not required to announce, which could affect trading in another entity’s securities. It would thus not be clear whether information is “announceable information”.

• The Commonwealth Attorney-General’s Department considers the definitions of “disclosable information” and “announceable information” to be insufficiently clear and certain for inclusion as an element of an offence. In particular, the opportunity exists for the ASX to excuse non-compliance with the Listing Rules.

• The amendments may increase the burden imposed on the prosecution and thus, in practice, may result in fewer successful convictions.

The government asked for comments on the specific, post-FSR problems associated with applying the insider trading legislation to particular financial markets and products, and for submissions on how these can be legislatively addressed other than by the amendments suggested by the CAMAC majority. Recommendation 10: The CAMAC majority recommended replacing the definition of “information generally available” (which is information that cannot be “inside information”) with the following new definition: 1042C(1) For the purposes of this Division, information “is generally available” only if it: (a)

is accessible to most persons who commonly invest in Division 3 financial products of a kind whose price or value might be affected by the information, or

(b)

consists of deductions, conclusions or inferences made or drawn from any information referred to in paragraph (a). 1042C(1A) Information is deemed to satisfy paragraph (1)(a) if it is disclosed pursuant to any prescribed disclosure procedure.

CAMAC’s minority considered that the current published information and readily observable matter tests of when information is generally available should remain, but the “readily observable matter” test should be modified so that the matter must be observable “by a cross-section of Australian investors; without resort to technical assistance beyond that likely to be used by a cross-section of investors; and for a reasonable period of time”. The government asked whether the definitions should be changed and, if so, whether any of the following options would be appropriate: (a)

clarifying the “readily observable matter” test as recommended by the minority;

(b)

leaving the question of interpretation to the courts, with the assistance of notes included in s 1042C providing examples of what fits within s 1042C(1)(a) and (b); and

(c)

amending the provisions (as suggested in the second approach in CAMAC’s Proposals Paper, paras 3.11-3.20) so that matter is readily observable if it either is disclosed in a public area or can be observed by the public without infringing rights of privacy, property or confidentiality, even if other users of the market

50

Australian Securities Exchange (ASX) Listing Rule 3.1A; Corporations Regulations 2001 (Cth) reg 6CA.1.01; and Corporations Act 2001 (Cth) ss 674 – 675. [12.300] 299

Law of Investments and Financial Markets

cannot obtain it because of limitations on their resources, expertise or competence or only on payment of a fee, and also even if it is only available overseas. 51

Conclusions [12.310] The CAMAC Discussion Paper was a substantial step in the policy debate about appropriate reform to Australia’s insider trading provisions, but its recommendations have not, to date, been incorporated into Australian law. Instead, a regulatory change has occurred and the effect of this change on the effectiveness of insider trading regulation and enforcement is, as yet, unknown. What is clear, however, is that the insider trading reform agenda is long-standing, comprehensive and wide-ranging and that the current laws relating to insider trading will be subject to ongoing debate and possible substantial change. We strongly recommend that investors active in Australian markets take notice of the progress of the reforms and take steps to ensure that their conduct does not contravene either the existing laws, or the potential future laws relating to insider trading.

51

CAMAC, Insider Trading Report (November 2003): http://www.camac.gov.au/camac/camac.nsf/ byHeadline/PDFFinal+Reports+2003/$file/Insider_Trading_Report_Nov03.pdf (accessed 18 March 2011), pp 22–23.

300 [12.310]

INDEX environmental, social, ethical considerations [12.300]

A Administrator administration process [5.210]-[5.220] first creditor’s meeting [5.210] second creditor’s meeting [5.220] deed of company arrangement [5.230] duties [5.190] liability [5.200] overview [5.180]-[5.200] powers [5.180] Advertising Product Disclosure Statement (PDS) and [12.380] Agency common law duties, overview [8.100] Australian financial services licence (AFSL) — see also Australian Financial Services Licensees (AFSLs) applying for [9.100] banning orders [9.120] compensation arrangements [9.190] disclosure requirements, action where contravention [12.480] disqualification by the court [9.130] exemptions from holding [9.60] financial service provider, requirement to hold [9.50] licensees, obligations of [9.70]-[9.80] Regulatory Guide 104, general obligations [9.75], [9.76], [9.78] Regulatory Guide 105, organisational competence [9.80]-[9.90] obligations imposed by [9.50] requirement to hold [9.50] suspension or cancellation [9.110] trustee companies, obligation to hold [9.50] Australian Financial Services Licensees (AFSLs) conduct of business rules [12.40] consumer protection under — see Consumer protection disclosure requirements — see Disclosure; Financial Services Guide (FSG); Product Disclosure Statement (PDS); Statement of Advice (SoA) liability for contravention of conduct/disclosure rules [12.470] overview [12.10] suitability rule [12.60] “appropriate advice” to client [12.290]

Australian Prudential Regulation Authority (APRA) overview [9.140] Australian Securities and Investment Commission (ASIC) Australian Securities and Investment Commission Act 2001(Cth) [9.180] functions and powers [9.130] overview [9.130] role [9.130] Australian Securities and Investment Commission Guidelines ASFLs obligations [9.75]-[9.90] codes of conduct, advisers [11.170] conduct and disclosure requirements [12.180]-[12.220] conflicts of interest, managing [12.530] dispute resolution [11.180]-[11.190] Australian Securities Exchange (ASX) ASX Group composition [9.150] ASX [9.150] ASX Clearing Corporation [9.150] ASX Compliance [9.150] ASX Settlement Corporation [9.150] Australian Securities Exchange Listing Rules share issue, restriction on [3.150] Authorised representative — see also Australian Financial Services Licensees (AFSLs); Financial service providers conditions to be satisfied [9.210] consumer protection under — see Consumer protection “holding out,” prohibition [9.220] licensees, liability for [9.230] Regulatory Guide 146 [9.240] overview [9.200] restriction on use of terminology [9.140], [9.150] training and ongoing education [9.240]

B Banking products Best interest, duty for [12.95] 301

Law of Investments and Financial Markets Bonds government and non-government [1.260]

C Clearing and settlement facility meaning [9.420] Client product determines [9.430] general insurance [9.440], [9.470] other types [9.460], [9.470] superannuation and retirement accounts [9.450] retail and wholesale, distinction [9.430] burden of proof [9.480] Codes of conduct financial services industry, use in [9.160] Common law agency, overview [8.100] application, overview of [9.170] companies, limits on majority voting power [2.230] consumer protection [11.60] contractual liability, overview [8.80] director’s duties [4.80] duties in the market place [8.50] fiduciary duties, overview [8.90] liabilities in the market place [8.50] meaning [8.40] negligent advice [8.70] tortious liability [8.60] Companies board of directors [1.120], [1.130] investors, influence on [1.130] role of [1.120] debt interests in [1.230] debenture interests [1.230] deregistration of [5.710] equity interests [1.170] membership rights [1.180] shares, nature of [1.190] financing — see Company financing; Debt fundraising; Equity fundraising formation [1.50] general meetings [2.120]-[2.160] attending [2.150] calling [2.130] notice of [2.140] role of [2.120] voting procedures at [2.160] “lifting the corporate veil” [1.90] limited liability [1.70] member, becoming a [1.140] member’s rights — see Member’s rights ownership and management, separation [1.110] registration of, reinstatement [5.720] 302

separate legal entity [1.80] exceptions [1.90] shares [1.160]-[1.210] ordinary [1.210] preference [1.200] power to issue [1.160] structure of [1.60] Company charges fixed [3.310] floating [3.320] insolvency and [3.350] nature of [3.300] priorities [3.340] registration of, history [3.330] Company financing capital investment [3.70] loan or debt capital [3.90] share capital [3.80] capital structure [3.50]-[3.90] equity/debt balance [3.50] gearing ratio [3.60] contractual restrictions, [3.135] debt fundraising [3.10], [3.220]-[3.350] charges [3.300]-[3.350] debentures [3.230]-[3.290] equity fundraising [3.10], [3.110] disclosure [3.160]-[3.190] restrictions on issue [3.120]-[3.150] overview [3.10] reform [3.490] Conflict of interest director’s duty to disclose [12.530] Consumer protection codes of conduct [11.160] common law obligations [11.60] conflict of interest [12.470], [11.530] disclaimers, limitations and exclusions [11.150] dispute resolution [11.170]-[11.190] due care and skill, implied warranty [11.140] licensee obligation to provide [11.170] external scheme [11.190] Financial Ombudsman Service [11.200] internal scheme [11.180] misleading and deceptive conduct [11.120], [11.130] overview [11.40] remedies, enforcement and defences [11.220]-[11.235] ASIC administrative action [11.235] civil remedies [11.220] liability, criminal [11.230] statutory obligations [11.80] ASIC Act, under [11.100] Corporations Act, under [11.90] unconscionable conduct [11.110] unfair terms of consumer contracts [11.145]

Index interests of company, act in [4.200] misuse of position or information [4.210]

Contract director’s duties [12.80], [12.90] liability in [8.80] Corporate governance — see also Director’s duties concept of [4.80] Corporations Act 2001 (Cth) application, overview [9.180] conduct of business rules [12.40] “financial investment”, making a, meaning [9.50] examples [9.50] licensing regime under [9.40] oppressive conduct under [2.240]-[2.260] remedies [2.260] what constitutes [2.250] share issue, restrictions [3.140] takeover provisions — see Takeovers

D Debentures [3.230] convertible [3.250] definition [3.230] exclusions [3.230] issuing, requirements [3.270]-[3.290] unsecured note [3.240] Debt fundraising borrowing money [3.220] charges [3.300] — see also Company charges debentures [3.230] — see also Debentures unsecured note [3.240] Derivatives meaning [9.330] insider trading context [12.210] overview [7.100] Directors board of [1.120], [1.130] investors, influence on [1.130] role of [1.120] duties — see Director’s duties insolvent trading [5.550]-[5.560] defences [5.560] director’s liability [5.550] winding up [5.410] court powers [5.460] duty to assist liquidator [5.360] suspension of powers during [5.410] Director’s duties breaches [4.190] James Hardie [4.310] statutory [4.190] conflicts of interest, disclose [4.180]

| F

Disclosure documentation, through [12.180] Financial Services Guide (FSG) [12.220] — see Financial Services Guide (FSG) “good disclosure” what is [12.190] liability for contravention of rules [12.470] civil [12.500] administrative action by ASIC [12.500] misleading and deceptive conduct [12.480] criminal [12.480] defective [12.490] failure to provide [12.480] “no conflict of interest” rule [12.530] Dispute resolution external scheme [11.190] Financial Ombudsman Service [11.200] internal scheme [11.180] licensee obligation to provide [11.170] Dividends declaration [2.70] funds for payment [2.80] overview [2.60] policy [2.90]

E Equitable duties director’s [4.110] Equities overview [9.80] Equity fundraising disclosure documents [3.160] contents [3.180] financial loss claims [3.190], [3.200] reforms [3.185] shares, issue [3.110] restrictions on [3.120]-[3.150]

F Fiduciary duty company director’s conflicts of interest, avoid [4.180] discretions, not to fetter [4.170] good faith, act in [4.150] nature of [4.140] proper purposes, act for [4.160] 303

Law of Investments and Financial Markets Regulatory Guide 146 [9.240] clients, distinction between retail and wholesale [9.430] compensation arrangements [9.190] legal reform [9.490] licence — see Australian financial services licence (AFSL) licensees, obligations of [9.70]-[9.80] licensing of [9.40] applying for [9.100] banning orders [9.120] disqualification by the court [9.130] exemptions [9.60] object of [9.40] requirement to hold AFSL [9.50] suspension or cancellation [9.110] margin lending facility client, obligation to assess suitability for [9.310] restriction on use of terminology [9.140], [9.150] suitability rule [12.60] “appropriate advice” to client [12.100] “know your client” [12.120] obligation to warn client [12.120] training and ongoing education [9.240] unlicensed adviser [9.160]-[9.180] consequences [9.160] rescind, right to [9.170] enforceability of agreement [9.180]

Financial investment diversification [1.240] low-risk portfolio [1.240] medium-risk portfolio [1.240] financial risk, managing [9.280], [9.375] foreign — see Foreign investment making a, defined [9.270] meaning [9.40] Corporations Act, under [9.50] real property as [9.40] Financial market clearing and settlement facility [9.420] making a market [9.400] meaning [9.410] Financial Ombudsman Service disputes it may consider [11.200] purpose [11.200] Financial product bonds, government and non-government [1.260] classes of, overview [9.60]-[9.105] deal in, meaning [9.390] definition [9.50], [9.250] “facility” [9.260], [9.375] incidental products [9.300] specific exclusions [9.340] specific inclusions [9.310] financial investment, making a, defined [9.270] financial risk, managing [9.280], [9.375] legal reform [9.490] non-cash payments [9.290] websites as [9.375] Financial product advice diversification, advice for [1.240] low-risk portfolio [1.240] medium-risk portfolio [1.240] financial service, part of [9.360] general [9.380] legal reform [9.490] meaning [9.370] electronic information and [9.375] exemptions [9.370], [9.380] personal [9.380] suitability rule [12.60] “appropriate advice” to client [12.100] “know your client” [12.120] obligation to warn client [12.120] types [9.380] Financial risk managing [9.280], [9.375] Financial service providers — see also Australian Financial Services Licensees (AFSLs) authorised representative of [9.50] liability for [9.230] 304

Financial services Corporations Act, under [9.10] legal reform [9.490] meaning [9.340], [9.360] Financial Product Disclosure circumstances when required [12.380] contents of [12.420] Fixed interest securities overview [9.70], [1.250] risk [1.270]

I Insider trading consequences of [12.250], [12.260] civil liability [12.260] criminal prosecution [12.250] financial market, definition [12.40] financial products, Div 3 [12.200]-[12.230] derivatives [12.210] managed investment schemes [12.220] securities [12.200] superannuation products [12.230] “information” [12.150]-[12.180] possession of [12.160] what constitutes [12.150], [12.180] “inside information,” definition [12.40] overview [12.10]

Index

Insider trading — cont

prohibitions [12.50]-[12.130] communication [12.130] trading [12.60]-[12.120] reform proposals [12.280]-[12.310]

Insolvency administrator [5.180]-[5.200] duties [5.190] liability [5.200] powers [5.180] creditor’s claims calculating debt [5.620] employees claims [5.670] exceptions to pari passu [5.660] members claims [5.680] pari passu rule [5.650] provable debts [5.600] secured creditors [5.630] unprovable debts [5.610] deregistration of company [5.710] insolvency, presumption where [5.60] insolvent trading [5.550]-[5.570] defences [5.560] director’s liability [5.550] holding company, liability [5.570] overview [5.10] registration of company, reinstatement [5.720] solvency, definition [5.50] statutory demands [5.80]-[5.100] formalities [5.90] service of [5.80] set aside, application to [5.100] voidable transactions [5.480] defences [5.530] definitions [5.490] insolvent transactions [5.500] voluntary administration [5.110]-[5.290] effect of [5.160]-[5.170] significance of [5.130]-[5.140] Insolvent trading director’s liability [5.550] defences [5.560] Insurance products Best interest, duty for [12.95] Investment advisers — see also Australian Financial Services Licensees (AFSLs); Financial service providers money laundering [9.200]

| M

Liquidator [5.300] appointment [5.340] company property, to take control [5.430] criteria [5.340] court involvement [5.380] court supervision [5.380] duties [5.370] to keep records [5.370] powers [5.360] access to company records [5.360] release of [5.700] voidable transactions [5.480]

M Managed investment schemes compliance committee [6.170] compliance plan [6.140] audit of [6.160] contents [6.150] constitution of [6.120] contents [6.130] diversification, advice for [1.240] low-risk portfolio [1.240] medium-risk portfolio [1.240] investor directed portfolio services [6.390] listed [6.60] managed funds industry [6.340] members, protection of [6.180] liability of responsible entity [6.185] voidable contracts [6.210] winding up and deregistration [6.330] withdrawal [6.310] non-liquid schemes from [6.320] mortgage investment schemes [6.380] overview [6.10] registration of [6.70], [6.80] how to [6.90] requirements for [6.70] responsible entity [6.90] PDS and [6.114] simple and, [6.117] scheme property, holding of [6.110] statutory duties of [6.100] serviced strata schemes [6.350], [6.360] property in [6.355] real estate agents, advice and [6.370] what constitutes [6.40] exclusions [6.50] winding up and deregistration [6.330]

L

Margin lending client, licensee to assess suitability [9.310] overview [9.105]

Law sources of [9.170]-[9.190] common law [9.170] regulators, action by [9.190] statutory law [9.180]

Member’s rights class rights, protection from variation [2.270] company books, inspection of [2.190] constitution [2.170], [2.180] 305

Law of Investments and Financial Markets Member’s rights — cont amending [2.170] enforcing [2.180] Corporations Act, oppressive conduct under [2.240]-[2.260] remedies [2.260] what constitutes [2.250] derivative actions [2.320] dividends [2.60]-[2.90] injunction, application [2.310] majority’s power, common law limits [2.230] member’s register, correcting [2.200] minority interests, protection [2.40], [2.220] overview [2.10] procedural irregularities, where [2.300] specific rights [2.110]-[2.200] voting rights [2.110] general meetings [2.120]-[2.160] winding up of company, apply for [2.280] Misleading and deceptive conduct overview [12.510] prohibition [11.130] Money laundering Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) (AMF/CTF Act) [9.200] “designated services” under [9.200] reporting entities, obligations [9.200] investment advisers and [9.200] Mortgage investment scheme overview [6.380]

N Negligence advice [8.70]

P Portfolio diversification, advice for [1.240] low-risk portfolio [1.240] medium-risk portfolio [1.240] investor directed services [6.390] Product Disclosure Statement (PDS) advertising and [12.380] content requirements [12.360]-[12.460] cooling off period [12.450] defective [12.490] not required, circumstances [12.460] obligation to provide [12.380]] shorter, simpler [12.400] tailored [12.390] 306

R Real estate agents managed investment schemes, advice and [6.370] Real property financial investment as, overview [7.90] Regulation law, source of, as [9.190] overview [9.10] purpose [9.110] regulators [9.130]-[9.150]

S Securities meaning [9.320] insider trading, context [12.200] Serviced strata schemes overview [6.350], [6.360] property in [6.355] real estate agents, advice and [6.370] Shares class rights, protection from variation [2.270] companies power to issue [1.160], [3.110] ordinary, nature of [1.210] preference, nature of [1.200] converting [1.200] cumulative [1.200] participating [1.200] redeemable [1.200] restrictions on issue [3.120]-[3.150] Corporations Act, under [3.140] internal rules [3.130] Listing Rules, under [3.150] Statement of Advice (SoA) content [12.300] not given, circumstances [12.310] small investments [12.320] obligation to give [12.300] suitability rule and [12.290] Suitability rule — see also Financial product advice; Financial service providers “know your client” [12.60] “appropriate advice” to client [12.80] environmental, social ethical considerations [12.110]

T Torts tortious liability, overview [8.60]

Index Trustee company ASFL requirement to hold [9.50] definition [9.50]

U Unconscionable conduct prohibition [11.110] Unfair terms of consumer contracts overview [11.145]

V Voidable transactions defences [5.530] definitions [5.490] uncommercial transaction [5.490] unfair preference [5.490] insolvent transaction [5.490], [5.500] unfair loan [5.520] unreasonable director related [5.510] overview [5.480] Voluntary administration [5.110] administration process [5.210]-[5.220] first creditor’s meeting [5.210] second creditor’s meeting [5.220] administrator [5.180]-[5.200] duties [5.190] liability [5.200] powers [5.80] court involvement in administration [5.260]-[5.290] deed of company arrangement [5.230] termination [5.290] effect of [5.160]-[5.170] insolvency, presumption where [5.60] liquidation, resolution to enter [5.240] overview [5.10] significance of [5.130]-[5.140] solvency, definition [5.50] statutory demands [5.80]-[5.100] formalities [5.90] service of [5.80] set aside, application to [5.100]

W Winding up application to [5.310]-[5.330] circumstances of [5.300] company officers [5.460] assist liquidator, duty to [5.360]

| W

court powers [5.460] during [5.400]-[5.450] company name [5.400] company property [5.430], [5.440] examinations [5.450] legal proceedings, suspension [5.420] investors’ liability [5.470] liquidation, meaning [5.300] liquidator [5.300] appointment [5.340] court involvement [5.380] duties [5.370] powers [5.360] Words and terms agency [8.100] appropriate advice [12.80] authorised representatives [9.200] clearing and settlement facility [9.420] common law [8.40] deal in a financial product [9.390] debentures [3.230] debt financing [3.10] derivatives [9.100], [9.330] dispute resolution procedure [11.170] equities [9.80] equity financing [3.110] facility [9.260] fiduciary duty [8.90] financial investment [9.50] making a [9.270] financial market [9.410] market for a financial product, making [9.400] financial product [9.50], [9.250], [9.310] deal in a [9.390] financial product advice [9.370] financial risk, managing [9.280], [9.375] financial service [9.50], [9.360] fixed interest securities [9.70] holding out [9.220] investment [9.40] lifting the corporate veil [1.90] liquidation [5.300] managed investment scheme [6.40] margin lending [9.105] Product Disclosure Statement (PDS) [10.360]-[10.460] real property [9.90] retail client [9.440] securities [9.320] solvency [5.50] Statement of Advice (SoA) [10.280]-[10.310] trustee company [9.50] uncommercial transaction [5.490] unfair preference [5.490] unreasonable director related transaction [5.510] unsecured note [3.240] winding up [5.300]

307