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Focus: Funds Management – September 2004

The regulation of managed discretionary account services

In brief: Senior Associate Penny Nikoloudis outlines the action that needs to be taken by MDA operators to comply with the new regulatory framework.

The Australian Securities & Investments Commission (ASIC) has recently introduced a tailored regulatory regime for managed discretionary account (MDA) services offered to retail funds management clients. The regime provides conditional relief from the managed investment and product disclosure provisions of the Corporations Act.

What are MDA services?

In broad terms, MDA services are arrangements that involve a person (an MDA operator) managing a portfolio of assets for a retail client on an individual basis. This may include arrangements that are commonly marketed in the industry as separately managed accounts, individually managed accounts, investment advisory programs, managed discretionary portfolio services and discretionary portfolio accounts.

MDA services differ from investor-directed portfolio services (IDPS) because MDA services involve the MDA operator making investment decisions about financial products acquired for the client's portfolio. By contrast, in an IDPS, the client, rather than the operator, makes the investment decisions.

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The ASIC definition

In March 2004, ASIC issued Policy Statement 179 (PS 179) that establishes a tailored regulatory framework for MDA services. PS 179 defines an MDA service as a service with the following features:

  • clients give to the MDA operator money or money's worth, or access to and control of money or money's worth (eg through a power of attorney) (client contributions).
  • the MDA operator has the discretion to invest in financial products using client contributions without prior reference to the client for each transaction;
  • each client agrees with the MDA operator that assets derived directly or indirectly from that client's contributions are managed as a discrete portfolio belonging to the client, and may not be pooled with the assets of another client;
  • each client has an understanding that they will derive benefits from the MDA service, including benefits from the MDA operator's expertise in investment selection and possible cost reductions (eg consolidated reporting and bulk ordering); and
  • the clients include 'retail clients' (as defined in section 761G of the Corporations Act).

If an arrangement displays these characteristics, the new regulatory framework established by PS 179 will capture it. As the definition is new, its application to particular arrangements is not always straightforward.

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How are MDA services regulated?

Before the release of PS 179 in March 2004, certain managed discretionary account services (such as those operated by participants of the Australian Stock Exchange (ASX) or the Sydney Futures Exchange (SFE)) were subject to specific ASIC policy and class order relief. However, there was no regulatory policy that applied generally to all MDA services.

ASIC considers that MDA services fall within the definition of both a 'managed investment scheme' (s9 of the Corporations Act) and a 'facility for making a financial investment' (s763B of the Corporations Act). However, in PS 179 and accompanying Class Order 04/194, ASIC has granted relief from s601ED of the Corporations Act (the requirement that certain managed investment schemes must be registered) and from Part 7.9 and Chapter 6D of the Corporations Act (the product disclosure statement and prospectus provisions). The exemption is granted subject to the MDA operator:

  • complying with conditions set out in ASIC Class Order 04/194; and
  • holding an Australian financial services licence (AFSL) that expressly authorises it to operate MDA services.

In essence, ASIC's tailored regulatory regime treats MDA operators as providers of financial services rather than issuers of financial products. To have the benefit of relief from s601ED, Part 7.9 and Chapter 6D, MDA operators must comply with the licensing and conduct provisions in Parts 7.6 and 7.7 of the Corporations Act and some additional conduct requirements designed to promote consumer protection.

PS 179 and the relief in Class Order 04/194 came into effect on 11 March 2004. However, there are transitional arrangements for existing MDA operators, as discussed below.

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The conditions of relief under Class Order 04/194

To qualify for relief, the MDA operator must comply with a number of conditions specified in Class Order 04/194. These conditions are flexible to accommodate the different arrangements that may be involved in the operation of MDA services. For example, in some cases the MDA operator may provide all financial services (ie dealing, custodial services and financial product advice) directly to clients. In other cases, the MDA operator may outsource the provision of certain financial services (eg custody or advice) to an external licensee. There are also cases where the client, rather than the MDA operator or an external custodian, holds legal title to the portfolio assets. The conditions of relief operate differently, depending on the particular structure of the MDA service.

In most cases, the key conditions of relief for the MDA operator include the following:

  • The MDA operator must give each retail client a financial services guide (FSG) that covers particular issues relating to the MDA service.
  • The MDA operator must enter into an MDA contract with each retail client that, among other things, clearly specifies the nature and scope of the discretions that the MDA operator will be authorised and required to exercise and any investment strategy that is to be applied in exercising those discretions.
  • The MDA contract must include an investment program prepared by the MDA operator (or an external licensed adviser) that complies with certain requirements and includes an opinion that the MDA contract is suitable for the client's relevant personal circumstances. ASIC takes the view that the investment program constitutes personal advice and, therefore, the preparer of the investment program must comply with the requirements of the Corporations Act relating to the provision of personal advice (including the requirement to provide a statement of advice). The MDA operator must ensure that it, or an external licensed adviser, gives each retail client, at least once every 13 months, personal advice about whether the MDA contract for that client is suitable in light of the client's personal objectives, needs and relevant circumstances. The MDA operator must also ensure that each client's portfolio assets are managed as a separate portfolio belonging to that client.
  • The MDA operator must, at all times, maintain professional indemnity insurance and insurance covering fraud by its officers and employees that meets certain requirements.
  • The MDA operator must comply with the quarterly and annual client reporting obligations set out in the Class Order.

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Transitional arrangements

Generally, under the transitional arrangements, existing MDA operators who provided MDA services before 11 March 2004 must comply with the new MDA policy by no later than 10 December 2004 (with the new regime coming into full effect on 11 December 2004). However, they must take all reasonable steps to make the transition from 10 June 2004. To complete the transition, the MDA operator must self-certify that they can comply with the conditions set out in Class Order 04/194 and must lodge a reliance notice with ASIC. (There is currently no prescribed form for the reliance notice.)

Existing participants of the ASX or the SFE, and ex-associate participants of the SFE, are subject to separate transitional arrangements. Generally, they also have until 10 December 2004 to move to the new regime.

New MDA operators who start to provide MDA services after 11 March 2004 must comply with the conditions in Class Order 04/194 before offering the MDA services.

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The need for specific AFSL authorisation

From 11 December 2004, MDA operators must have a specific AFSL authorisation to operate MDA services.

MDA services comprise a bundle of financial services, each of which separately triggers the licensing requirement. Therefore, in addition to the specific AFSL authorisation to operate MDA services, MDA operators must have AFSL authorisations to:

  • deal in the underlying financial products;
  • give financial product advice (normally, personal advice); and
  • operate a custodial and depository service,

unless any of these financial services are outsourced to a third-party licensee.

MDA operators will not be able to provide MDA services after 10 December 2004 if they do not have the appropriate AFSL authorisations.

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How to apply for the MDA authorisations

ASIC recently announced that, from 30 September 2004, new and existing MDA operators will be able to apply for the relevant AFSL authorisations enabling them to provide MDA services. It is a good idea to apply early, to ensure that the 10 December deadline is met.

Applicants will need to answer a new series of questions in Part C of the application and complete a new Part C proof relating specifically to the operation of the MDA service. Additional proofs (eg B1 Pro Forma Table of organisational expertise) will also be required. ASIC proposes to release an updated licensing kit to assist new and existing licensees who need to obtain the appropriate MDA authorisations.

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MDA services provided exclusively to wholesale clients

If MDA services are provided exclusively to 'wholesale clients' (as defined in the Corporations Act), the regulatory framework in PS 179 and the conditions of relief in Class Order 04/194 will have no application. (Note, however, that although the MDA operator will not require a specific AFSL authorisation to provide MDA services, it may still require AFSL authorisations relating to the ancillary financial services provided in connection with the MDA service, eg dealing in the underlying financial products.)

If an MDA operator provides MDA services to both retail and wholesale clients, it will be subject to the new regulatory framework. However, some of the conditions of relief will need to be satisfied only in relation to the retail MDA clients (eg the requirement to enter into an MDA contract).

Whether a client is 'retail' or 'wholesale' is not always clear, particularly in the context of MDA services. Given the significance of this question, a careful review of each MDA client should always be undertaken before it can be assumed that MDA services are provided exclusively to clients who are 'wholesale'.

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Some unresolved issues

The implementation of PS 179 and Class Order 04/149 has not been without some teething troubles. This is not surprising, given that PS 179 represents a fundamental change to regulatory policy in this area.

The application of the new policy to particular arrangements has given rise to a number of anomalous results and seemingly unintended consequences. Many of these have been referred to industry bodies such as the Investment and Financial Services Association for further consideration. Some of the key unresolved issues include the following:

  • The impact of PS 179 on typical wholesale investment management agreements. There is an argument that a wholesale investment management agreement falls within ASIC's definition of 'MDA service' and that, as such, it constitutes an unregistered managed investment scheme. This would mean that, unless such agreements became registered schemes, responsible entities would be prohibited by s601FC(4) from entering into them.
  • If MDA services are regulated as financial services, rather than financial products, there are a number of concerns arising from the application of the retail/wholesale test in s761G of the Corporations Act.
  • The degree of trading discretion that is required to bring an arrangement within the definition of 'MDA service', and the extent to which that discretion is limited, may be unclear in practice.
  • The overlap between IDPS and MDA requirements.
  • The impact for those who have a broad authorisation but do not exercise it.
Any queries?

We will continue to monitor developments in ASIC's policy on MDA services. If you have any questions, please feel free to call us.

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For further information, please contact:

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