Funds Management Alert

In brief

• From 1 July 2009, margin lending will be regulated under the financial services provisions in Chapter 7 of the Corporations Act.
• Providers of margin loans will need to hold an Australian financial services licence (AFSL) and provide a short-form Product Disclosure Statement (PDS). They will also be subject to responsible lending conduct provisions.
• The new legislation will be contained in the Corporations Amendment (Financial Services Modernisation) Bill, to be introduced into Parliament by June. This forms part of the Federal Government’s overall reform of consumer credit under which it will be assuming responsibility for its regulation from the states and territories.

Margin lending in the spotlight

With equity markets having fallen 50% since November 2007, margin lending has become a regular feature in the press. During the first few months of the financial crisis, stories abounded of margin calls and distressed selling, including by directors in companies whose share prices were in freefall such as ABC Learning and Babcock & Brown.

The effect of the crisis on “mum and dad” investors that took out margin loans became only too apparent when reports emerged late last year of nearly 500 clients of Storm Financial receiving margin calls and owing the Commonwealth Bank amounts exceeding the values of their portfolios. Storm Financial is now in voluntary administration, under investigation by ASIC and facing the threat of legal action from its former clients. It has been alleged that not only were loans provided to some clients with low incomes and minimal assets, but many clients were encouraged to “double leverage” their share investments by borrowing against their home.

The Federal Government flagged its intention to reassess the regulation of margin lending in its “Green Paper on Financial Services and Credit Reform” issued in June 2008 (Green Paper).[1] The Green Paper highlighted the dramatic growth in margin lending in Australia over the past several years as equity markets boomed. The total value of margin loans increased from under $7 billion in September 2000 to over $32 billion in March 2008 (down from a high of $37 billion in December 2007), and in that period the number of clients with margin loans more than doubled from 84,000 to 202,000. [2]

The Government is concerned that consumers may not be aware of the risks of margin loans, and the ability of lenders to unilaterally withdraw the facility, change loan to value ratios or withdraw a particular security from the list of approved investments.

How is margin lending currently regulated?

At present margin lending is largely unregulated by any consumer protection legislation.

As a margin loan involves a “credit facility”, it is excluded from being a financial product for the purposes of Chapter 7 of the Corporations Act. [3] Accordingly, a margin loan provider is not required to hold an AFSL, and disclosure of the terms and conditions of the loan is simply made in the loan agreement signed between the parties.

By excluding credit facilities from the Corporations Act, the Commonwealth has (until now) left it to the states and territories to regulate credit, under the Uniform Consumer Credit Code. However, the UCCC does not cover margin lending, as the legislation excludes credit provided for investment purposes. [4]

Margin lending is regulated in some residual ways. For example, if a financial planner gives any advice to the borrower about the shares or other financial products being financed by the margin loan, the planner must have an AFSL (or be a representative of a licensee), and give a Statement of Advice to the borrower.

Misleading and deceptive conduct in relation to margin loans is regulated under the Australian Securities and Investments Commission Act. [5]. For example, ASIC can take action against financial planners for misleading advice about margin loans.

The proposed reforms

Under amendments to the Corporations Act to be contained in a bill called the Corporations Amendment (Financial Services Modernisation) Bill, the Government proposes to make margin loans a Chapter 7 financial product.

All margin loan providers will have to:

• have an AFSL;
• comply with general conduct standards, including the requirements to deal with investors efficiently, honestly and fairly;
• provide a short-form PDS that includes disclosure of all fees and charges, including commissions paid by the margin loan provider to advisers who sell the product;
• provide a Statement of Advice (if personal financial product advice is provided) and ongoing reporting;
• have adequate arrangements for the management of conflicts;
• ensure representatives are adequately trained and competent to provide those services; and
• have internal dispute resolution procedures, and be members of an approved external dispute resolution scheme.

Importantly, lenders will also be subject to new responsible lending conduct provisions. Under these provisions, lenders will be required “to know whether the capital being brought to the table by the retail borrower is in fact their own, or whether it is itself debt, such as equity from a home”, and “in such cases the lender will be required to assess … ‘the true loan to value ratio’”. [6]

As always, “the devil will be in the detail”. For example, it is unclear at present what margin lending arrangements will be covered. Will the new provisions be limited to “standard” margin loans where the borrower retains beneficial ownership of the investments? Or will they extend to the type of arrangement used by Opes Prime, where borrowers transferred beneficial ownership of the investments to the lender through securities lending agreements?

What happens next?

The Government’s Financial Services Working Group has been consulting with industry on the proposal since January 2009. The group is also working on a new short-form, plain English PDS for margin loans, to be modelled on the four-page PDS for First Home Saver Accounts produced by the group.

To achieve a 1 July start date, the Bill will need to be introduced into the Parliament in the May or June sittings. The next sitting starts on 12 May.

Once the Bill is introduced, the DibbsBarker Financial Services team will provide further guidance on the new law and its implications.

For further information, please contact:

1. “Green Paper on Financial Services and Credit Reform”, Treasury, Corporate and Financial Services Division, 3 June 2008, pages 27 to 33
2. Page 28, Green Paper
3. Section 765A(1)(h)(i) and regulation 7.1.06
4. Section 6(4) of the UCCC. As part of the Government’s consumer credit reforms, the UCCC will be re-enacted as a Commonwealth Act and applied by each state and territory.
5. A credit facility is a financial product under the ASIC Act: section 12BAA(7)(k)
6. Luncheon address by Nick Sherry, Minister for Superannuation and Corporate Law on 3 March 2009 to the ASIC Summer School, Sydney

The material contained in this publication is no more than general comment. Readers should not act on the basis of the material without taking professional advice relating to their particular circumstances.