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Focus: Funds Management – Discounted issues to associates: ASIC amends Class Order 05/26

12 February 2007

In brief: ASIC has amended the Class Order that regulates discounted issues by registered managed investment schemes. Senior Associate Penny Nikoloudis reports on the changes.

• Background to Class Order 05/26
• Pricing relief under Class Order 05/26
• How has Class Order 05/26 been amended?
• Associate underwriting – placements and rights issues
• Placements to associates as fiduciaries
• Equal treatment – jumbo offerings
• Clarification of 'related issue'
• Interaction between sections 601GAA and 601GAB
• Some unresolved issues

Background to Class Order 05/26

Class Order 05/26 provides conditional relief from the following provisions of the Corporations Act 2001 (the Act) that apply to registered managed investment schemes:

• paragraph 601GA(1)(a) of the Act, which requires the constitution of a registered scheme to make 'adequate provision' for the consideration that is to be paid to acquire an interest in the scheme; and
• subsection 601GA(4) of the Act, which provides that if members of the scheme have the right to withdraw, the constitution must specify that right and set out 'adequate procedures' for making and dealing with withdrawal requests.

The Australian Securities & Investments Commission (ASIC) has interpreted the expression 'adequate' in these provisions to mean that it must be possible to objectively test the determination of the issue and redemption price from the terms of the constitution. In other words, the scheme's constitution must specify an 'independently verifiable' issue and redemption price.

Pricing relief under Class Order 05/26

Class Order 05/26 provides conditional relief from these provisions by allowing the responsible entity to:

• issue units in a registered scheme at a discount in specified capital raising situations, including placements, rights issues and distribution reinvestment plans (referred to as the capital raising relief) – see AAR's Focus: Funds Management, May 2005; and
• exercise limited discretions when calculating unit prices, such as 'standard' discretions relating to transaction costs, valuation methodologies, rounding policies, and so on (referred to as the pricing discretions relief) – see AAR's Focus: Funds Management, February 2006 and Client Update: Funds Management, April 2006.

As we have previously reported, there were several gaps and ambiguities in the Class Order, often resulting in individual relief applications having to be made to ASIC. The recent amendments to Class Order 05/26 aim to address the most significant of these concerns.

How has Class Order 05/26 been amended?

The amendments to Class Order 05/26, which came into effect on 23 January 2007, relate principally to those aspects dealing with the 'capital raising relief'. However, some technical changes have also been made to the 'pricing discretions relief' under the Class Order. The more significant amendments are summarised below.

It is also timely to remind responsible entities that ASIC's 'no-action' position on compliance with the 'pricing discretions relief' expires on 1 May 2007 (see AAR's Client Update: Funds Management, April 2006). By this date, responsible entities must have in place documented 'pricing discretion' policies and comply with the associated member notification and product disclosure statement (PDS) obligations. With this deadline fast approaching, responsible entities who have not yet implemented measures to comply with the 'pricing discretions relief' should begin to take appropriate action to ensure that the Class Order conditions will be satisfied before 1 May 2007.

Associate underwriting – placements and rights issues

The previous position

Class Order 05/26 allows the responsible entity of a listed scheme to issue units at a discount in a placement or rights issue, provided certain conditions are satisfied. Previously, the Class Order did not extend to placements or rights issues that were underwritten by an associate of the responsible entity. In these circumstances, it was necessary to apply to ASIC for individual relief.

What has changed?

ASIC has modified the Class Order to permit underwriting (or sub-underwriting) of rights issues and placements by an associate of the responsible entity of a listed scheme. The relief is subject to certain conditions designed to address the potential conflict between the best interests of members and the interests of the responsible entity and its associates. In summary:

• the underwriting (or sub-underwriting) agreement must be on arm's length terms; and
• the associate must hold an Australian Financial Services Licence (AFSL) that authorises it to deal as an underwriter or sub-underwriter in interests in managed investment schemes. The AFSL must contain conditions to the effect that, where the licensee is an associate of the responsible entity of the scheme:
  • the licensee must not exercise voting rights of units that it acquires as an underwriter or sub-underwriter; and
  • the licensee may only dispose of units that it acquires as an underwriter or sub-underwriter (i) in the ordinary course of trading on the ASX; or (ii) to a person who is not an associate of the responsible entity; or (iii) to a person who is an associate of the responsible entity that acquires the interests in an 'eligible fiduciary capacity' (as defined – see below).

These conditions are similar to conditions that ASIC has recently imposed on case-by-case relief. However, unlike recent examples of case-by-case relief:

• the Class Order does not impose a condition requiring the disposal of shortfall interests within a fixed time period (which could have the potential to impact on the market price of units in the scheme and, in turn, the value of scheme members' investments); and
• the voting and sale restrictions described above are imposed as AFSL conditions, rather than requiring entry into a deed poll. Importantly, this means that licensees wishing to take advantage of the relief must apply for a variation to their AFSL. This will need to be factored into the capital raising timetable. ASIC has not yet updated the AFS Licensing Kit or Pro Forma 209 to include these standard conditions.

Also:

• the relief does not extend to a foreign financial services provider who is exempt from holding an AFSL for underwriting under one of the Class Orders that apply to wholesale foreign financial service providers. Where a placement or rights issue is underwritten by an associate of the responsible entity who is a foreign financial service provider relying on one of those Class Orders, an individual relief application may need to be made to ASIC; and
• the associate underwriting relief is restricted to placements and rights issues. It does not extend to the underwriting of issues of interests under distribution reinvestment plans or interest purchase plans.

Placements to associates as fiduciaries

The previous position

Previously, the Class Order did not allow interests to be issued in a placement to a person who was the responsible entity's associate.

What has changed?

ASIC has relaxed the prohibition on associates participating in placements. Associates of the responsible entity may now participate in a placement where the following conditions are met:

• before the interests are issued, the associate holds interests in the scheme in an 'eligible fiduciary capacity' (see below). This means that only associates who are existing members of the scheme before the placement may participate;
• the associate acquires the interests in the 'eligible fiduciary capacity'; and
• the proportion of the interests that are issued to the associate does not exceed the proportion of interests in the scheme that the associate held immediately before the issue occurred. According to ASIC's commentary, this is intended to ensure that associates may only participate in the placement to the extent necessary to preserve their proportionate holding of interests in the scheme. However, the drafting of the condition (particularly the expression, 'the proportion of the interests issued') is not clear, as it seems to assume participation in a rights issue rather than a placement. We would welcome further clarification from ASIC on the drafting of this condition.

For the purposes of the Class Order, a person acquires interests in an 'eligible fiduciary capacity' if the interests are held or acquired by the person as:

• a trustee or custodian for a professional investor who is not the responsible entity or an associate of the responsible entity; or
• a responsible entity of another registered scheme; or
• a life insurance company, or an agent of a life insurance company, in the investment, administration and management of the assets of a statutory fund under the Life Insurance Act 1995 (Cth); or
• an approved trustee of a regulated superannuation fund under the Superannuation Industry (Supervision) Act 1993 (Cth).

Equal treatment – jumbo offerings

The previous position

Class Order 05/26 provides relief from paragraph 601FC(1)(d) of the Act, which requires the responsible entity to treat members who hold interests of the same class equally and members who hold interests of different classes fairly. The Class Order permits some unequal treatment by the responsible entity as between wholesale and retail investors participating in a rights issue undertaken in accordance with the Class Order. The relief is intended to facilitate pro rata rights issues that are structured as 'jumbo' offerings and involve an accelerated offer to institutional investors over a very short period followed by an offer to retail investors.

Previously, the Class Order permitted the responsible entity to treat professional investors differently from other investors by giving them a shorter period to consider the offer and/or by issuing interests to them before they were issued to some other members.

What has changed?

The Class Order now permits the responsible entity to treat investors who are 'wholesale clients' differently from other investors by requiring them to notify the responsible entity of their acceptance of the offer by a date that occurs before another date, specified in the PDS for the offer, by which other members are to notify their acceptance.

Importantly, the Class Order specifies that relief is only available provided that interests are not issued to the wholesale investors before the earliest date on which they may be issued to other members of the scheme. The note accompanying this provision of the Class Order says that this exemption 'allows the responsible entity to treat institutional and retail investors differently to the extent of the period that they are given to notify their acceptance of the offer. It does not permit the responsible entity to issue interests to institutional investors before any of the retail investors'.

We believe this is a substantive amendment to the Class Order. However, ASIC has classified this change as being of a 'technical' nature, 'intended to make the operation of the exemption clearer'.

In practical terms, these amendments mean that a 'jumbo' offering requires a deferred institutional settlement in order to enable retail investors to participate in the initial allocation at the same time as institutional holders.

Clarification of 'related issue'

The previous position

Under the Class Order, interests can only be issued in a placement without member approval if the interests issued, together with any 'related issue' in the previous year, do not comprise more than 15 per cent of the interests in the scheme.

Previously, under the definition of 'related issue', it could be argued that a placement issue that had not been approved or ratified by members in accordance with the Class Order conditions was not a 'related issue' and, therefore, did not count towards the 15 per cent cap.

What has changed?

The revised definition of 'related issue' makes it clearer that an issue of interests under a placement that has not been approved or ratified by members is a 'related issue' that counts towards the 15 per cent-in-12 months threshold.

Interaction between sections 601GAA and 601GAB

The previous position

As noted in AAR's Focus: Funds Management, February 2006, the previous drafting of section 601GAB(11) of the Class Order 05/26 was very confusing. According to ASIC's information release at the time, s601GAB(11) was intended to clarify the interaction between the 'capital raising relief' (in s601GAA of the Class Order) and the 'pricing discretions relief' (in s601GAB of the Class Order).

What has changed?

Section 601GAB(11) of the Class Order has been redrafted. The purpose of this section is to prevent a responsible entity from circumventing the specific s601GAA requirements that apply in the case of a discounted issue (that is, the 'capital raising relief') by limiting the application of s601GAB.

In practice, this means that s601GAB does not apply to the discretion exercised by the responsible entity in applying a discount to the 'market price' (or other 'starting price') under the s601GAA 'capital raising relief'. However, s601GAB does apply to the extent that it complements s601GAA – for example, in calculating the 'market price' (or other 'starting price') against which the discount is to be applied.

Some unresolved issues

While the amendments to the Class Order represent a significant step in improving and clarifying the 'capital raising relief' under the Class Order, there are still a number of technical issues in relation to the 'pricing discretions relief' that have not yet been addressed. The following issues, highlighted in AAR's Focus: Funds Management, February 2006, remain unresolved:

• the drafting of subsection 601GAB(2)(b) of the Class Order, which may require existing scheme constitutions to be modified to specify a maximum discount in relation to interest purchase plans and negotiated fees;
• the manner in which the Class Order applies to listed schemes;
• the broad scope of discretions covered by the Class Order, which could potentially capture discretions that affect the structure and operation of a scheme; and
• the compliance costs of documenting pricing discretions and policies and implementing procedures to meet the requirements of the Class Order.

For further information, please contact:

• Penny NikoloudisPartner, Sydney
  Ph: +61 2 9230 4805
  Penny.Nikoloudis@allens.com.au
• John BeckinsalePartner, Brisbane
  Ph: +61 7 3334 3520
  John.Beckinsale@allens.com.au