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Focus: Release of exposure draft of margin lending regulation

8 May 2009

In brief: The Federal Government yesterday released the exposure draft of the Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009 and requires feedback on its proposed reforms within three weeks. This follows the announcement in January 2009 that the Government was commencing consultation with industry about its proposed margin lending reforms. Partner Warwick Painter and Senior Associate Justine Woodford provide an overview of the reforms.

How does it affect you?

  • For the first time, margin lending facilities (which are very broadly defined to catch as many margin lending-type arrangements as possible) will be subject to formal regulation under a structured legislative regime overseen by the Australian Securities and Investments Commission (ASIC).
  • Under the new regime, margin lenders will need to be licensed; will be subject to a new margin lending-specific set of 'responsible lending' rules; will be required to be members of low-cost external dispute resolution bodies; must issue Product Disclosure Statements and must clearly disclose fees and commissions before lending.
  • Unless otherwise agreed with the financial adviser, the margin lender will be responsible for notifying the borrower of a margin call, even where the primary client contact is only with the adviser.
  • The new laws will apply prospectively to all margin lending contracts including, in some cases, packaged investment arrangements where margin lending is only one element of the overall arrangement.

Timetable

The Federal Government has set a short and sharp timeframe for finalising the legislation and implementing margin lending regulation on a national basis. This reflects the fact that consultation on the legislation with a range of industry participants and consumer groups has been taking place since January 2009 (although very few details of the consultation process are known).

Submissions on the Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009 and the accompanying Regulations are due by 29 May 2009.

Following submissions, it is expected that the legislation will be finalised reasonably quickly, with the Minister, Senator Nick Sherry, announcing that the Bill will be introduced into Parliament in June. The Corporations Act 2001 (Cth) will then apply to margin lenders and advisers three months after the legislation comes into force.

Margin lenders (ie, those who deal in margin lending facilities) and advisers (ie, those who provide advice in connection with margin lending facilities) will be required to submit an application for an Australian Financial Services Licence (AFSL) (or modification to an existing AFSL) within three months after the legislation comes into effect.

Special interim arrangements will then apply during the period until ASIC issues the licence (expected to be within a further period of six months) – essentially, lenders and advisers can continue to operate without holding a licence and without being subject to the requirements of Chapter 7 of the Corporations Act, except the responsible lending and notification requirements (which will apply during that interim period).

Overview of the reforms

Although the legislation and accompanying regulations are part of a broader package which also implements certain reforms in relation to debentures and trustee companies, most attention has been focused on the fact that the legislation will make 'margin lending facilities' a financial product, fully regulated by Chapter 7 (and not regulated by the national consumer credit legislation). In general terms (except where a lender has engaged in misleading and deceptive conduct or offers linked financial products), margin loans have previously been unregulated under either the Corporations Act or existing consumer credit legislation.

The new legislation covers two broad classes of 'margin lending facility', with the ability for the Government (by ASIC declaration) to specify other types of margin lending facilities as new products emerge or products outside the existing net are identified. The defined classes are:

A standard margin lending facility, which is basically any loan or credit facility where the following elements are present:

  • the funds are intended by the client to be used wholly or partly for investment in financial products;
  • the loan is secured wholly or partly over 'marketable securities'; and
  • the client is subject to a margin call where the value of the underlying marketable securities falls below a certain ratio as against the amount of the loan (the current LVR); and

A non-standard margin lending facility where the following elements are present:

  • title to marketable securities passes from the client (similar to the securities lending arrangements used by Opes Prime and other high profile magin lending business failures);
  • the client receives 'transferred property' (being an equivalent arrangement to the cash or credit which would have been provided under a margin loan);
  • the funds are intended by the client to be used wholly or partly for investment in 'marketable securities'; and
  • the client is subject to a margin call where the current LVR exceeds an agreed threshold.

The Government has indicated that the proposed definitions are intended to catch any margin lending arrangement where the required elements are present, even where the facility has other features, such as:

  • protected equity facilities to a degree of less than 100 per cent (eg put option protected loans);
  • some 'securities lending' style arrangements where these are 'functionally similar' to a margin loan;
  • hybrid products which utilise the key features of a margin loan;
  • limited or non-recourse margin loans (where the amount that can be recovered is restricted to the underlying marketable security); and
  • margin loans where other assets form part of the secured property (eg residential property).

The Minister has flagged that there is a high level of concern with margin lending arrangements where the client is advised to take equity out of their family home (under a residential mortgage) and then use that cash to leverage further into buying shares through a margin loan. The Minister has referred to this as the double-debt trap. Clearly, those margin lenders who also provide housing loans will have to be very focused on areas where this may occur with their own clients (whether or not they are directly aware of it).

There are also questions about whether the legislation will apply (or the Government will declare it to apply) to other investment lending arrangements, for example where there is a mortgage over underlying marketable securities, but no trigger event based on a current LVR. These type of loans may still involve default and enforcement over the underlying securities, but the default (for example, default in making a required loan reduction or paying interest) is not linked to an LVR.

What will it mean for margin lenders and advisers?

Lenders and advisers will be:

  • required to hold an AFSL;
  • regulated by ASIC;
  • required to be members of low-cost external dispute resolution bodies;
  • required to clearly disclose fees and commissions before lending;
  • required to lend under a tailored margin lending-specific set of responsible lending obligations which, broadly speaking, will:
    • require a lender to assess a person's 'true' loan-to-value ratio, meaning that the lender can no longer assume the money being used by the investor isn't itself debt;
    • require advisers to provide advice that is appropriate to a consumer's needs and circumstances; and
    • mean that advisers and lenders will only be able to provide or recommend a margin loan if they are reasonably sure the borrower can afford the loan without suffering substantial hardship.

The new laws will clarify the operation of margin calls, which occur when the security provided by the borrower has fallen in value by a certain amount and the lender calls for additional security or cash to be provided, failing which the lender may sell down some or all of the investments provided by the borrower as security. (Delays in these notifications and a consequent failure by borrowers to act quickly to meet their obligations may cause borrowers to fall into 'negative equity'.) The new laws clarify the requirement that lenders must notify clients of a margin call, unless clear arrangements are in place for the financial adviser to do so.

Finally, the new laws will apply prospectively to all margin lending contracts. For existing margin lending facilitates, requirements will be triggered when the new obligations apply – otherwise, the contracts continue on foot.1

The Government also proposes to release a model short form, plain English product disclosure document for margin lending, presumably along the lines of what it has issued for the First Home Saver Accounts.

We will keep you updated on further developments in this area and provide you with further analysis of the implications and issues as the legislation progresses.

Footnotes
  1. The explanatory materials provide examples such as, where there is an increase in a credit limit, the new responsible lending requirements will apply; when there is a margin call, the notification requirements apply etc.

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