Funds Management And Other Marketing Activities

Objective

To protect and promote the financial integrity and efficiency of the State-based financial institutions scheme and to ensure that depositors are adequately protected from the risks that building societies incur in the process of financial intermediation. Towards this end, to ensure that a society is not exposed to undue risk (particularly moral risk) as a result of the provision of managed funds products and the marketing of these and other products as an agent for third parties.

General Background

Funds management involves the provision of financial services to an investor or group of investors who retain beneficial ownership of the assets in which their funds have been invested. Generally the assets are pooled in a trust funded by the issue of units. The trust is established pursuant to a deed which sets out the permissible investments. The trustee is charged with enforcing the deed and will usually engage a custodian as safekeeper of the assets and a manager to exercise its discretion in making investment decisions consistent with the trust deed.

The rate of earnings paid, and the return of capital, to investors hinges on the cash flows from the underlying assets in which the manager invests the funds. This can place pressure on the manager to make payments to the trust to compensate for poor performance or to offer a guarantee (explicit or implicit) regarding performance. If this occurs when a societys subsidiary acts as manager, then the society will be required to hold capital in support of the assets of the funds as if they were on its balance sheet.

With their extensive customer base, building societies have large scope to market products and services to their customers. They are well placed to offer funds management products, either as managers of pools of funds or as agents on behalf of other funds managers. The agency arrangements may include the badging of products in either the societys or industrys name. As well as funds management products such marketing could involve areas such as the sale of securities and insurance and other financial services and products.

In considering societies involvement in these areas, AFIC is concerned that these activities may introduce undue risk into the societys operations. In particular the concern is with moral risk, ie the possibility that a society will feel a moral obligation or commercial need to absorb any loss to a customer that arises from investments offered, marketed by or recommended by the society.

If a building society is to avoid holding capital against funds managements activities it must not use the word building society in the name of a funds management vehicle unless prior approval has been obtained from its SSA (following consultation with AFIC). It is envisaged that such approval will only be given in very exceptional circumstances. In particular it will not be forthcoming simply on the basis of it being an industry scheme or product.

The standard focuses heavily on funds management activities. It is intended, however, that the sections on the "offering of investment advice and sale of securities" and "badging" will apply to all operations of the society, not just funds management.

The standard envisages a societys involvement in funds management activities will be restricted to the sale of products for which a subsidiary acts as manager or for which the society acts as an agent for a third party. Any society intending to be active in other aspects of funds management such as: providing credit support, liquidity support, underwriting, other lending facilities, treasury or transaction facilities to a funds management vehicle (whether its own or an unrelated third party vehicle), or funding investor purchases of securities/units issued by a vehicle, should consult with its SSA. It will need to be able to satisfy its SSA that the risks involved in the proposed activities have been adequately identified and that it has the expertise, and adequate policies, procedures and systems in place to measure, monitor and control the risks involved.. We would generally expect an SSA to discuss any approach with AFIC.

Despite its detailed nature, this standard cannot encompass every aspect of a societys funds management activities. Where a society may have plans for a particular initiative that may raise issues not covered in the standard, it should discuss them with its SSA as early as possible.

The introduction of this standard (by revising and superseding earlier standards) may see a society in breach of some of its requirements. Where this is the case a society should contact its SSA to discuss a timetable for achieving compliance with the new standard. Any transitional period should be kept as short as possible whilst recognising the need to avoid imposing excessive compliance costs on the society.

The prime responsibility for the prudent participation of a society and its subsidiaries in funds management rests with its board and management. A society should have in place clear strategies and board approved policies governing participation in this activity. In addition, it must maintain appropriate systems to identify, measure and control risks, including potential conflicts of interest, arising from its participation in funds management. A societys SSA will need to be satisfied of this before it will endorse participation in a scheme.

Specific breaches of the standard will be handled on a case-by-case basis. It is likely however that following consultation with AFIC, an SSA will require a society to hold capital against the assets held by the funds management scheme as if they were held on its balance sheet.

This standard applies to all funds management activities even if a trust based vehicle and the issuing of units is not involved. Securities issued by a securitisation scheme will also fall within the ambit of the standard. Unless otherwise indicated, reference to a society includes any subsidiaries within its consolidated group.

Prudential Standards

3.7.1 Disclosure

3.7.1.a To safeguard against investor confusion, a society must ensure that, where it is involved in funds management activities, sufficient disclosures are made so that investors in any funds management vehicle or scheme are:

(i) Given to understand clearly that the securities in which they invest do not represent deposits or other liabilities of the society or any of its subsidiaries or controlled entities.

(ii) Made aware that their holdings of securities are subject to investment risk, including possible delays in repayment and loss of income and principal invested.

(iii) Unambiguously informed that the society or its subsidiaries or controlled entities do not in any way stand behind the capital value or performance of the securities issued by the funds management vehicle or of the assets held by the vehicle except to the limited extent allowed under this standard and as specified in the documentation provided to investors.

3.7.1.b The disclosures in 3.7.1.a. must be provided in a conspicuous manner to prospective investors, and appear in any marketing document. A document inviting investment should include the disclosures as a prominent (and preferably stand alone) item on the inside front cover. It is recognised that variations in the location and form of the required disclosures could be appropriate where regulatory or statutory requirements restrict the presentation or content of disclosures. Any proposal to modify the requirements set out above must be agreed with an SSA.

3.7.1.c Investors must also provide a signed acknowledgment indicating that they have read and understood the required disclosures. To ensure this the disclosures in 3.7.1.a should also appear in close proximity to the signature on the application form in any document inviting investment.

3.7.1.d More generally, a society must ensure that the marketing or promotion of a vehicle with which it is associated does not give any impression that could be construed as being contrary to the disclosure requirements.

3.7.1.e It is possible that securities could be traded in a paperless environment. Where this is envisaged a society must discuss with its SSA (who will be expected to consult with AFIC) procedures for ensuring that the spirit of the disclosure requirements are met.

3.7.1.f Where a society has a limited involvement in a funds management scheme, its ability to ensure the required level of disclosure (and signed acknowledgments) may also be limited. In such cases, compliance with the disclosure requirements may be relaxed by its SSA (following consultation with AFIC).

This concession will not be available where the society or its subsidiary is the sponsor, manager, trustee or responsible entity of the scheme. It will also be unavailable (except in exceptional circumstances) where the society or its subsidiary or associate permits the use of its name, badge, logo or any other identifier in the marketing of the funds management scheme.

3.7.2 Structuring Funds Management Schemes

3.7.2.a The main basis of the policy on funds management is that there is a clear separation between the society involved and any funds management vehicle or scheme. To this end, a society must not without prior approval from its SSA after consultation with AFIC:

(i) Unless provided for in the standard have any ownership or beneficial interest (otherwise than may arise via its equity in an SSP) in a funds management vehicle.

(ii) Include the word "building society" in the name of the funds management vehicle.

(iii) Provide credit support, liquidity support, other lending, treasury or transaction facilities to a funds management vehicle, or underwrite the issue of units or securities by a vehicle.

(iv) Have any of its directors, officers or employees on the board of a funds management vehicle.

(v) "Control" the funds management vehicle such that it would need to be consolidated in accordance with Australian Accounting Standards.

3.7.2.b Requirements i, iv and v set out above do not apply, however, to:

• A subsidiary involved in a scheme in the capacity of a pure "trustee" or "custodian".
• An "approved trustee" or "custodian" established under the provisions of the Superannuation Industry (Supervision) Act 1993 (Cth).
• "Common trust funds" established pursuant to legislation and complying with Australian Securities Commission Policy Statement 32.
• A "responsible entity" established under proposed changes to the Corporations Law dealing with collective investments.

3.7.2.c A society, itself, must not act in any circumstances as a manager, trustee, custodian, responsible entity or any similar role. Any participation must be through stand alone subsidiaries.

3.7.2.d Where a societys subsidiary or other associate acts in such a role, the society should ensure that a clear distinction exists between the society and the subsidiary or associate concerned. Any documentation or marketing of funds management schemes with which a subsidiary or associate is involved should not give the impression that those entities are in any way backed by the society or any of its subsidiaries.

3.7.3 Managing

3.7.3.a A subsidiary of a society may act as a manager of funds placed in a funds management vehicle by investors, provided:

(i) There is a written management agreement in place specifying the functions which the manager is required to perform and any performance standards placed on the manager. Such standards should be reasonable and in accordance with normal market practice. The agreement must not (unless approved by its SSA, following consultation with AFIC) obligate a society or any subsidiary to buy back or otherwise purchase securities or units issued by the vehicle.

(ii) The management agreement is undertaken on an arm's length basis and is subject to the societys normal approval and review processes. The agreement must be undertaken on market terms and conditions (including remuneration to the manager).

(iii) A society may not subordinate, defer or waive the receipt of fee or other income associated with funds management activities without obtaining approval from its SSA.

(iv) The agreement is limited as to a specified time period. A fixed termination date need not be specified provided the society is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.

(v) Subject to reasonable qualifying conditions, the funds management vehicle and/or investors have the clear right to select an alternative party to provide the management services.

3.7.3.b The manager may receive a performance-related payment (or benefit from any surplus income generated) for its role as manager, in addition to its base fee, provided that the base fee is on market terms and conditions and any performance-related payment does not commit the society to any additional obligations. Such payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.

3.7.4 Offering Investment Advice and Sale of Securities

3.7.4.a In its general operations, a society may (subject to appropriate regulatory approvals) offer advice to customers regarding investments (including funds management schemes and other products such as life and general insurance policies) act as a broker in obtaining securities (and other products) on behalf of customers or market such products directly to customers.

In conducting such business, there is a risk that investors may be confused as to the relationship between a society and the issuer of a security (or other product), and a possibility of the society feeling some moral or commercial obligation to investors as a result of its actions.

To minimise such risks, a society should ensure that where it undertakes such activities:

(i) They are conducted with investors on an arms length basis and on market terms and conditions.

(ii) Any decision to invest in particular securities (or acquire other products) is clearly taken by the customer alone and that the customer is aware they alone bear the risks associated with their investment decisions. The society should be careful to ensure that customers are aware of the level and type of risks they face on the investments.

(iii) Policies and procedures are in place to ensure that staff (and any agents of the society) dealing with customers are required to be appropriately trained and to avoid misleading or confusing them concerning the risks involved or the societys relationship with (or support for) investments recommended or offered for sale by the society.

3.7.4.b Where a society makes investment decisions or purchases securities for customers at its own initiative or discretion, then the society will be deemed to be acting as a "manager" and the relevant provisions of this standard will apply.

3.7.5 Badging

3.7.5.a Where a society allows its name, logo or trade mark to be used in marketing products of third party institutions it faces risks over and above those covered in 3.7.4. In these circumstances it will also be required to ensure:

(i) The 'name' or 'badge' of the other party providing the product also features prominently in all advertising material, marketing documents and any documents inviting investment or participation in a product.

(ii) The respective roles of the parties should be explained clearly and prominently in any document inviting investment or participation in the product - including the extent to which each party is responsible for the safety and performance of the product.

(iii) The provisions of section 3.7.1 "Disclosure" are fully satisfied.

3.7.5.b A society which fails to comply with these conditions may be required, by its SSA, to discontinue its association with the relevant product.

3.7.6 Purchase of Securities

3.7.6.a Unless exempted by its SSA after consultation with AFIC, a society will only be permitted to purchase securities issued by a funds management vehicle provided:

(i) The purchases are at the sole discretion of the society, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the societys normal credit approval and review processes.

(ii) Purchases are completed within a short time period (less than one week as a guide) from the time the society commits to purchase the securities.

(iii) Any holding is less than 10 per cent of the class of units issued by the vehicle.

(iv) They do not represent subordinated securities issued by the vehicle.

(v) The securities are fully performing.

3.7.6.b A society should have in place adequate systems and controls to ensure that it does not accumulate disproportionate exposure (vis a vis the group's asset portfolio and capital) to securities issued by funds management vehicles, eg large aggregate exposures arising from holdings of securities issued by associated funds management schemes or schemes holding similar or related assets.

3.7.6.c A society should not purchase assets held by a funds management vehicle without first obtaining approval from its SSA. An exemption to this is the purchase of Prime Liquid Assets (PLA) from a funds management vehicle in the normal course of a societys liquidity management or trading operations.

3.7.6.d Should an SSA come to the view that the pattern of a societys purchases of securities (and/or assets), or its willingness to do so, suggests that the society is supporting investments in a funds management scheme, then the society may be required to hold capital against all the assets of the scheme as if they were held on its own balance sheet.

3.7.7 Transitional Provisions

3.7.7.a The introduction of this standard may see a society in breach of some of its requirements. Where this is the case a society must contact its SSA to agree a strategy and timetable for achieving compliance. We would expect an SSA to discuss any proposal with AFIC.