Securitisation, Funds Management and other Marketing Activities

Objective

To ensure that the operations of special services providers are sufficiently free of all forms of risk, both financial and non-financial, that the likelihood of such bodies failing to meet their obligations to societies is reduced to an absolute minimum. Towards this end, to ensure that a special services provider is not exposed to undue risk (particularly moral risk) as a result of its involvement with securitisation and managed funds products and the marketing of these and other products and services provided by third parties.

General Background

Funds management encompasses the provision of investment and related financial services for the management of investors funds, whereby the investors become the beneficial owners of the assets in which their funds are invested. Securitisation involves the pooling of assets (or interests in assets), usually in a special purpose vehicle, funded by the issue of securities.

In both cases, the rate of earnings paid, and the return of capital, to investors hinges on the cash flows from the underlying assets in which the funds are invested. This can place pressure on a special services provider involved in such activities to agree to arrangements under which it is required to make payments to, or absorb losses that may fall on, the investors to compensate for poor investment performance. If this occurs, unless permitted under this standard, the special services provider will be required to hold capital in support of the assets as if they were on its balance sheet.

In considering an SSPs involvement in these areas, AFIC is concerned that these activities may introduce undue risk into its operations. In particular the concern is with moral risk, ie the possibility an SSP 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 SSP. Similar concerns arise where an SSP markets products or services which are provided by a third party. This is particularly so when the SSP badges the product or service offered to its customers.

The standard focuses heavily on securitisation and 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 relevant operations of an SSP.

If any aspect of a proposed securitisation or funds management initiative or transaction is inconsistent with, or not covered by, the guidelines set out in the standard, then an SSP should obtain prior approval from AFIC. An SSP (or its subsidiary) will be required to demonstrate that it has adequately identified the risks arising from the proposed transaction and has adequate expertise and systems in place to measure, manage and monitor the risks involved.

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

The introduction of this standard (by revising and superseding earlier standards) may see an SSP in breach of some of its requirements. Where this is the case the SSP should contact AFIC to discuss its position.

The prime responsibility for the prudent participation of an SSP and its subsidiaries in securitisation, funds management and other marketing activities rests with its board and management. An SSP should have in place clear strategies as well as board approved policies governing its participation in these areas. In addition, it must maintain appropriate systems to identify, measure, monitor and control risks arising from its participation in these areas.

This standard applies to all securitisation and funds management activities even if a trust based vehicle and the issuing of units is not involved. Unless otherwise indicated, reference to an SSP includes any subsidiaries within its consolidated group. Intermediation activities against which an SSP is required to hold capital do not constitute funds management or securitisation activities.

Prudential Standards

5.5.1.a To safeguard against investor confusion, an SSP must ensure that, where it is involved in funds management or securitisation activities, the following conditions are satisfied:

(i) Investors are given to understand clearly that the securities in which they invest do not represent deposits or other liabilities of the SSP or any of its subsidiaries.

2. investors are 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) Investors are unambiguously informed that the SSP or its subsidiaries do not in any way stand behind the capital value or performance of the securities issued by the special purpose 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.

5.5.1.b The disclosures in 5.5.1.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 AFIC.

5.5.1.c Investors must also provide a signed acknowledgment indicating that they have read and understood the required disclosures. To ensure this the disclosures in 5.5.1.a should also appear in close proximity to the signature on the application form in any document inviting investment.

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

5.5.1.e It is possible that securities could be traded in a paperless environment. Where this is envisaged an SSP must discuss with AFIC procedures for ensuring that the spirit of the disclosure requirements are met.

5.5.1.f Where an SSP has a limited involvement in a securitisation or 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 AFIC.

This concession will not be available where the SSP 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 SSP or its subsidiary or associate permits the use of its name, badge, logo or any other identifier in the marketing of the securitisation or funds management scheme.

5.5.2 Structuring Funds Management and Securitisation Schemes

5.5.2.a The main basis of the policy on funds management and securitisation is that there is a clear separation between the SSP involved and any special purpose vehicle or scheme. To this end, an SSP must not without prior approval from AFIC:

(i) Have any ownership or beneficial interest in a special purpose vehicle.

(ii) Include the word "building society" or "credit union" in the name of the special purpose vehicle or any subsidiary involved in securitisation or funds management related activities.

(iii) Provide credit support, liquidity support, other lending, treasury or transaction facilities or any other facilities or services (unless expressly provided for in this standard) to a special purpose 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 special purpose vehicle.

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

5.5.2.b Requirements i, iv and v set out above do not apply (where AFICs prior approval has been obtained to establish the relevant entity), to:

• A subsidiary involved in a scheme in the capacity of a pure "trustee" or "custodian".

• A life insurance company and its statutory funds regulated by the Insurance and Superannuation Commission.

• 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.

5.5.2.c An SSP, itself, must not act in any circumstances as a manager, trustee, custodian, responsible entity or any similar role for the purposes of managing investors funds or securitising assets. Any participation must be through stand alone subsidiaries that are adequately capitalised in their own right.

5.5.2.d Where an SSPs subsidiary or other associate acts in such a role, the SSP should ensure that a clear distinction exists between the SSP and the subsidiary or associate concerned. Any documentation or marketing of a funds management or securitisation scheme with which a subsidiary or associate is involved should not give the impression the entity is in any way backed by the SSP or any of its subsidiaries (unless a formal commitment of support has been approved by AFIC).

5.5.2.e An SSP may not subordinate, defer or waive the receipt of fee or other income associated with funds management or securitisation activities without obtaining approval from AFIC.

5.5.3 Offering Investment Advice and Sale of Securities

5.5.3.a In its operations, an SSPs subsidiary may (subject to AFICs and other appropriate regulatory approvals) offer advice to customers regarding investments (including in securitisation, 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 customers may be confused as to the relationship between an SSP and the issuer of a security (or other product), and a possibility of the SSP feeling some moral or commercial obligation to customers as a result of its actions.

To minimise such risks, an SSP 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 customers are aware they bear the risks associated with their investment decisions. The SSP 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 SSP) dealing with customers are required to be appropriately trained and to avoid misleading or confusing them concerning the risks involved or the SSPs relationship with (or support for) investments recommended or offered for sale by the SSP.

5.5.3.b Where an SSP makes investment decisions or purchases securities for customers at its own initiative or discretion (and is not required to hold capital against these assets), then the SSP will be deemed to be acting as a "manager" and the relevant provisions of this standard will apply.

5.5.4 Badging

5.5.4.a Where an SSP allows its name, logo or trade mark to be used in the marketing of products provided by a third party institution it faces risks over and above those covered in 5.5.3. In these circumstances it will also be required to ensure:

(i) The 'name' or 'badge' of the other party providing the product or service 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) For investment products, the provisions of section 5.5.1 "Disclosure" are fully satisfied.

5.5.4.b An SSP which fails to comply with these conditions may be required, by AFIC, to discontinue its association with the relevant product.

5.5.4.c In its operations an SSP or its subsidiary may provide administrative, processing and similar facilities or services to its members (eg standard documentation) which have been sourced from an external party. Where this is the case the SSP is required to ensure:

(i) The ultimate provider of the service is identified to its members and any other users.

(ii) The division of responsibility, between an SSP and the facility or service provider, for the safety and performance of the product is clearly established.

(iii) It has adequately identified the risks arising from these contracts and has appropriate policies and procedures in place to measure, monitor and manage the risks involved.

5.5.5 Purchase of Securities

5.5.5.a Unless exempted by AFIC, an SSP will only be permitted to purchase securities issued by a special purpose vehicle provided:

(i) The purchases are at the sole discretion of the SSP, are acquired on an arm's length basis on market terms and conditions (including price), and are subject to the SSPs normal credit policies.

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

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

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

(v) The securities are fully performing.

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

5.5.5.c An SSP should not purchase assets held by a special purpose vehicle. Exceptions are the purchase of liquid assets from a special purpose vehicle in the normal course of an SSPs liquidity management or trading operations and assets purchased pursuant to the exercise of representations and warranties.

5.5.5.d Should AFIC come to the view that the pattern of an SSPs purchases of securities (and/or assets), or its willingness to do so, suggests that the SSP is supporting investments in a special purpose vehicle, then the SSP may be required to hold capital against all the securities issued by the special purpose vehicle.

5.5.6 Servicing

5.5.6.a A funds management or securitisation scheme may involve the participation of an entity acting as a "servicer" or "servicing agent". An SSP or its subsidiary may undertake the role of servicing a pool of assets held by a special purpose vehicle provided:

(i) There is a formal written servicing agreement in place which specifies the services to be provided and any required standards of performance. Those standards should be reasonable and in accordance with normal market practice. There should be no recourse to the SSP beyond the fixed contractual obligations specified. The servicer should be under no obligation to fund payments, absorb losses on assets, or otherwise recompense investors for losses.

(ii) The services are provided on an arm's length basis, on market terms and conditions (including remuneration), and subject to the SSPs normal approval and review processes.

(iii) The servicing agreement is limited as to a specified time period (ie the earlier of the date on which all claims connected with the issue of securities are paid out or the SSPs replacement as servicer). A fixed termination date need not be specified provided the SSP is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.

(iv) Subject to reasonable qualifying conditions, the special purpose vehicle and/or investors have the clear right to select an alternative servicer.

(v) The servicing agreement is documented in a fashion which clearly separates it from any other service provided by the SSP. An SSPs obligation under each facility must be stand-alone.

(vi) The SSPs operational systems are adequate to meet its obligations as a servicer.

5.5.6.b Unless approved by AFIC, an SSP acting as servicer should be under no obligation to remit funds to the special purpose vehicle or investors until they are received from the underlying assets.

5.5.6.c An SSP may receive a performance-related payment (or benefit from any surplus income generated) for its role as servicer, 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 SSP to any additional obligations. This payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.

5.5.6.d Where a servicing agreement does not meet the conditions above an SSP may be required to hold capital against the assets it is servicing as if they were held on its balance sheet.

5.5.7 Managing Investors Funds

5.5.7.a A subsidiary of an SSP may act as a manager of funds placed in a funds management or securitisation 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 prior approval is received from AFIC) obligate an SSP or any subsidiary to buy back securities or units issued, or assets held, by the vehicle.

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

(iii) The agreement is limited as to a specified time period (ie. the earlier of the date on which all claims in connection with the issue of securities are paid out or the SSPs replacement as manager). A fixed termination date need not be specified provided the SSP is able, at its absolute discretion, to withdraw from its commitments at any time with a reasonable period of notice.

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

(v) The management agreement is documented in a fashion which clearly separates it from any other facilities provided by the SSP. An SSPs obligations under each facility must be stand-alone.

5.5.7.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 SSP to any additional obligations. Such payment should be recognised for profit and loss (and capital) purposes only if it has been irrevocably received.

5.5.8 Representations and Warranties

5.5.8.a Where an SSP undertakes to provide facilities and services, or provide assets to a special purpose vehicle, it is customary to make representations and warranties concerning those functions or assets. Where all of the following conditions are satisfied, an SSP will not be required to hold capital as a result of providing representations and warranties. Otherwise, it will need to hold capital against the full value of securities issued by the special purpose vehicle. The conditions are:

(i) Any representations and warranties are provided only by way of a formal written agreement and are in accordance with market practice.

(ii) The SSP undertakes appropriate due diligence before providing or taking on any representations and warranties.

(iii) The representations and warranties refer to an existing state of facts that the SSP can verify at the time services are contracted or assets sold.

(iv) Representations or warranties are not open-ended and, in particular, do not relate to the future creditworthiness of assets or the performance of the special purpose vehicle or the securities it issues.

(v) The exercise of any representation or warranty requiring the SSP to repurchase or replace assets sold to the special purpose vehicle, or any part of them, must be undertaken within 120 days of their transfer to the vehicle and any transfer should be conducted on the same terms and conditions as the original sale. This time limit does not preclude the subsequent payment of damages by an SSP as a result of breaches of representations and warranties.

5.5.8.b Any agreement by an SSP to pay damages as a result of a notice of claim being made must be conditional on:

(i) There being documentary substantiation of the negotiation of the agreement to pay damages in good faith.

(ii) The onus of proof for a breach of a representation or warranty resting with the other party.

(iii) Damages being limited to the loss incurred as a result of the breach.

(iv) The written notice of claim specifying the basis for the claim.

AFIC should be notified of any instance where an SSP has agreed to pay damages arising out of any representation or warranty.