Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)10 Compensation regimes for markets
Summary
10.1 Proposed Part 7.5 addresses:
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- the National Guarantee Fund (NGF) and its administration (which is currently regulated under Part 7.10 of the Corporations Law) (proposed Division 4); and
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- requirements for compensation arrangements which certain other markets will be required to make (that is, cover accessible by a retail client for specified losses of property entrusted to a participant in a financial market) (proposed Division 3);
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- the comparable provisions are currently found in Parts 7.9 and 8.6 of the Corporations Law.
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- the aim of Division 3 of Part 7.5 is to provide better targeted compensation arrangements which can be provided by a market in a variety of ways.
10.2 In this regard it is necessary to separate consideration of clearing and settlement system support. This is addressed in proposed Part 7.5 only to the extent that the NGF currently provides this type of support. It is, however, referred to more generally in Part 7.3.
10.3 The aim of the compensation arrangements required by proposed Part 7.5, particularly Division 3 arrangements, is to provide investors in appropriate circumstances with protection from certain losses. They will not be required to pursue other possible avenues of redress first (and this includes those mechanisms required of financial services licensees).
Division 2 - when there must be a compensation regime
10.4 Licensed markets through which participants provide services for retail clients must have compensation arrangements where the participants hold property on behalf of those clients (proposed section 881A).
10.5 This needs to be addressed in the licence application (proposed section 881B).
10.6 The applicant may state that the market will be covered by the NGF. If the Minister is satisfied that the market will be covered by the NGF, then he or she may grant the licence (proposed section 881D).
10.7 On the other hand, the applicant may have made its own compensation arrangements which will be considered under proposed Division 3 of Part 7.5 (see proposed section 881C, 882A and 882B).
10.8 Proposed Part 7.5 will not apply to overseas markets seeking a licence under proposed subsection 795B(2) on the basis that, if appropriate, the compensation arrangements of the overseas market will be considered in reaching a decision whether to grant the licence (proposed section 880A).
10.9 The current coverage of the NGF in relation to the ASX's markets is expected to be little changed.
Division 3 - approved compensation arrangements (other than the NGF)
10.10 In brief, the differences between the compensation arrangements required under proposed Division 3 and the current requirements under Parts 7.9 and 8.6 of the Corporations Law are:
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- the proposed Division 3 arrangements require coverage only for retail clients, while the current Parts 7.9 and 8.6 of the Law do not distinguish between wholesale and retail clients;
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- the proposed Division 3 arrangements tie the loss to a transaction on the market, not to the firm's business of dealing in securities or futures contracts as the current provisions do;
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- while Parts 7.9 and 8.6 require a fidelity fund, under proposed Division 3 a greater range of mechanisms will be acceptable and it will be up to the market as to how these are funded.
10.11 The proposed Division 3 arrangements require coverage for loss arising from fraud or defalcation, as do Parts 7.9 and 8.6. Since the Division 3 arrangements are the minimum, particular market operators may wish to provide, in addition to the required coverage, coverage for loss for the client of a participant arising from the effect of the participant's insolvency on funds or financial products held on the client's behalf.
10.12 The aim of these provisions is to provide protection to retail clients, while allowing greater flexibility to markets as to how to provide the compensation.
10.13 The term retail client is defined in proposed section 761G.
10.14 It will be a matter for the business judgment of the operator as to whether the compensation arrangements are also accessible by wholesale clients.
10.15 To the extent that they are available to wholesale clients, the arrangements are not subject to this regulatory regime except to the extent, if any, to which they may impact on the adequacy of the arrangement for retail clients.
10.16 Access to the compensation arrangements may therefore be limited in the case of a retail investor whose order is passed from a financial planner to a participant in the market.
10.17 The focus on retail investors is consistent with the views expressed in the FSI Report.
10.18 As indicated above, if the relevant market needs to have compensation arrangements under Division 3, it will need to include the relevant information in its application (proposed paragraph 881B(2)(c)). It will then be considered for approval under proposed section 882A.
10.19 Proposed section 882B addresses the procedure for obtaining approval of compensation arrangements after the licence has been granted.
10.20 The Minister will also be empowered:
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- to revoke an approval (proposed section 882C); and
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- if the Minister forms the view that the licensee's approved compensation arrangements are no longer adequate, to give a written direction to do specified things so that the arrangements become adequate once more (proposed section 882D).
10.21 Currently, Parts 7.9 and 8.6 do not require that the property be received by the broker in connection with a transaction on the exchange which is required to pay the claim from its fidelity fund.
10.22 Subsection 907(1), for example, currently refers to property that was entrusted in the course of or in connection with that member's or firm's business of dealing in securities.
10.23 This is considered inappropriate in an age where the one person may be a participant on a number of markets and clearing and settlement facilities.
10.24 The proposed provisions therefore require that, in the case of compensation arrangements for financial markets (see proposed paragraph 885C(1)(b)), the property or authority over property was given to the participant in connection with effecting a transaction covered by provisions of the operating rules of the market relating to on-market transactions.
10.25 This will align the coverage of the compensation arrangements with the area of participants' conduct for which the market has some responsibility.
10.26 It is the intention therefore that the provisions will cover funds held in anticipation of margin calls, but not, for example, loans to participants.
10.27 The need for the necessary connection with a particular market is also addressed in proposed section 885D. In this connection, it should be noted that, even though, for example, the client may provide the one cheque to a financial service provider in connection with an arrangement that the financial service provider enter into several transactions on behalf of the client, each amount attributable to a separate transaction is considered a separate loss.
10.28 If a loss is not a Division 3 loss (and the market is not subject to Division 4 arrangements), then the client will be left to pursue the financial service provider, who is required to have adequate compensation arrangements (see proposed section 912B).
10.29 It is not necessary that the person against whom defalcation or fraud is alleged has been convicted or prosecuted; nor does it matter that the evidence on which the claim is allowed would not be sufficient to establish guilt (proposed subsection 885C(2)). This follows current subsections 911(7) and 1243(7) of the Corporations Law.
10.30 The compensation arrangements are required to cover relevant losses caused by the fraud or defalcation of certain ex-participants (see proposed paragraph 885C(1)(a)(ii)). This follows subsections 907(12) and 1239(10) of the Corporations Law.
Adequate compensation arrangements
10.31 Proposed Subdivision D of Division 3 describes what are adequate compensation arrangements (proposed 885B). They are:
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- compensation rules which provide adequate coverage for Division 3 losses, the amount of the compensation, how it is to be paid and the making and determination of claims and notification of the outcome of claims (proposed paragraphs 885B(1)(a) to (d));
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- arrangements which provide for an adequate source of funds and arrangements for administration and monitoring (proposed paragraphs 885B(1)(e) and (f));
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- under the arrangements, potential claimants have reasonable and timely access to the compensation regime (proposed paragraph 885B(1)(g)); and
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- run-off arrangements (proposed paragraph 885B(1)(h)).
10.32 The requirements referred to in proposed paragraphs 885B(1)(a) to (f) are then described in greater detail in proposed sections 885C to 885I.
10.33 In considering these matters, the Minister must also have regard to the matters mentioned in proposed section 885J (proposed subsection 885B(2)). They are:
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- the services provided by the market and by the participants in it; and
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- any risk assessment report in relation to the market given to the Minister under proposed section 892K.
10.34 Under Division 3, the compensation rules must provide that the amount of compensation to be paid is not less than the actual pecuniary loss plus reasonable costs and disbursements in making and proving the claim (proposed section 885E).
10.35 The provisions also address:
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- rights of set-off (proposed subsection 885E(2));
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- caps on payments (proposed subsections 885E(3) and (4));
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- the payment of interest (proposed subsection 885E(5)); and
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- the procedure to be adopted where there are insufficient funds (proposed subsection 885E(6)).
10.36 The compensation rules must also deal with how compensation in respect of Division 3 losses is to be paid. This may be in a lump sum or instalments (proposed section 885F).
10.37 The compensation arrangements under Division 3 may exclude losses of a kind described above. However, the compensation arrangements will not be adequate unless the Minister is satisfied that those exclusions are appropriate (proposed subsection 885C(3)).
10.38 It will be appropriate to consider under this provision arrangements which, for example, permit or require the rejection of claims by persons referred to in the definition of excluded persons in section 921 (for example, the person whose conduct has caused the loss, or his or her spouse).
10.39 Only one claim can be paid in relation to the one loss (proposed section 886A). This will ensure that a person may not make a claim in relation to a derivatives transaction and the underlying securities.
10.40 There must be an adequate source of funds available to cover the claims made (proposed section 885H). The source is not specified.
10.41 If a market needs funds to, for example, increase its fidelity fund or assist in paying for other compensation arrangements, then it will be able to levy its participants through its rules. Such levies are supported by proposed section 883D and a proposed new levies bill which is expected to be introduced in the next sitting. The procedure which these provisions require is included for constitutional reasons.
Limitation on access to other funds to satisfy compensation claims
10.42 Proposed section 883C is comparable with section 915 of the Corporations Law which limits the source of funds for compensation claims.
The fidelity funds of defunct or merged facilities
10.43 How a fidelity fund or part of a fidelity fund (if the fund is shared) is dealt with in, for example, the event of a market merging with another market or ceasing to carry on business as such will be addressed in the regulations (proposed section 886B).
10.44 This mechanism would appear desirable given the wide range of possible situations - from the demise of a small market to the merger of major markets.
Use of rules and changes to arrangements
10.45 In order to provide markets with a greater role in defining the terms of the compensation arrangements, a number of matters are required to be included in compensation rules rather than being included in the Corporations Law (see proposed paragraphs 885B(1)(a) to (d) for a summary).
10.46 These rules are thus analogous to the operating rules of the market or facility. Provisions relating to their effect, enforcement and amendment are included (proposed sections 883A, 883B and 884B).
10.47 Proposed paragraphs 885B(1)(e) to (f) also indicate that there are other requirements which do not need to be in the rules.
10.48 These will be able to be changed in accordance with proposed section 884C. The intention is to require approval for major matters, but not minor administrative changes (see proposed section 884A).
Division 4 - National Guarantee Fund
10.49 Part 7.10 of the Corporations Law currently regulates the NGF. This Part will be replaced by proposed Division 4 of Part 7.5.
10.50 The nomination of the Securities Exchanges Guarantee Corporation (SEGC), currently in the Corporations Act 1989 , will be included in Part 7.5 (proposed section 890A). A transitional provision is expected to preserve the current nomination.
10.51 Division 4 of Part 7.5 applies in relation to markets operated by a body corporate that is a member of the SEGC (or a subsidiary of such a member) other than those that the regulations state are not covered by this Division (proposed section 887A). The purpose of the proviso is to provide flexibility in the future, not to exclude any particular market now.
Moving the heads of claim into the regulations
10.52 The proposed provisions foreshadow moving the heads of claim into the regulations (see proposed sections 888A to 888E). The regulations will provide for:
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- the situations in which compensation may be claimed;
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- the kinds of compensation available;
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- the amount of compensation available;
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- the way in which it is to be paid; and
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- the making and determination of claims.
10.53 Moving these matters into the regulations will provide flexibility to adjust the heads of claim in line with changes in the procedure of the members of the SEGC (currently only the ASX) and to reflect changes in the products that may be traded on their markets.
10.54 Many of the amendments to Part 7.10 which were put forward during the consultation process related to Divisions 6-8. These proposals will be taken into account in the drafting of the regulations. However, it is envisaged that there will be no significant changes to the actual compensation cover provided currently by the NGF, apart from those foreshadowed above.
10.55 The significant changes to the provisions currently included in Part 7.10 of the Law are summarised below.
10.56 The procedure included in proposed sections 889J and 889K is included for constitutional reasons. Consequential amendments to the proposed Corporations (National Guarantee Fund Levies) Act 2001 are expected to be introduced in the next sitting.
Payment out of NGF to prescribed body
10.57 It may be appropriate, at some time in the future, for the proportion of the NGF attributable to clearing house support to be paid to the appropriate arm of the ASX, thus confining the role of the NGF to 'investor protection' claims.
10.58 Proposed 891A will empower the Minister to make such a decision if he or she is satisfied that the relevant body had made adequate arrangements for covering all or part of the clearing and settlement system support that is provided for by Division 4 of Part 7.5 or the relevant regulations .
10.59 In considering such an application the Minister will also have regard to the adequacy of the remaining funds for the claims which remain payable out of the NGF (proposed subsection 891A(4)).
10.60 Conditions may be imposed in connection with such a direction (proposed subsections 891A(2) and (3)).
10.61 While section 928 of the Corporations Law provides for SEGC business rules, it is understood that there are currently no rules which the SEGC considers fit this description.
10.62 Rather than omitting the concept, it has been retained and brought into line with the comparable market/clearing and settlement facility provisions by including provisions relating to the effect and enforcement of the rules (proposed sections 890D to 890H).
10.63 It is possible that, at some future time, it may be appropriate for the procedural aspects of handling to claims to be included in the rules, rather than in the regulations (see proposed section 888E).
10.64 Proposed subsection 888E(4) will ensure that, to the extent of any inconsistency, the regulations override the rules.
Other changes in the NGF/SEGC provisions
10.65 Many of the provisions relating to the SEGC and the operation of the NGF are not changed in any significant way. However, proposed Division 4 does include various minor amendments - for example:
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- elaborating the provisions relating to SEGC business rules;
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- providing greater flexibility in the payment of costs;
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- omitting the purposes for which payments are to be made out of the interest and profits on the NGF;
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- providing greater flexibility in relation to delegation by the SEGC; and
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- drafting improvements.
10.66 Proposed Division 4 retains the possibility that additional bodies corporate will become members of the SEGC (proposed sections 891B).
Common provisions
10.67 Division 5 of proposed Part 7.5 addresses some issues which are of relevance both to the NGF provisions and the Division 3 arrangements.
10.68 They include:
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- how regulated funds (a term defined in proposed section 892A) are to be kept (proposed section 892B);
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- investment of money in regulated funds (proposed section 892C);
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- the powers of relevant authorities to require production or delivery of financial products, documents or statements (proposed section 892D);
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- accounting and reporting in relation to regulated funds and where the compensation does not come out of a regulated fund (proposed sections 892H and 892I);
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- the relevant authority's right of subrogation when compensation has been paid (proposed section 892F);
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- the capacity to require a risk assessment report to be prepared (proposed section 892K);
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- the nature of the report required would be specified in the notice;
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- the issues addressed below.
10.69 The SEGC and those with relevant responsibilities in relation to Division 3 compensation arrangements will be empowered to require assistance from the relevant market (proposed section 892E).
10.70 The power in relation to the SEGC relates to dealing with a claim or the assessment of risks to the NGF. A comparable power is provided in relation to Division 3 arrangements.
10.71 Division 5 of Part 7.10 currently provides for the Securities Industry Development Account. Funds which exceed the minimum amount in the NGF may be paid by the SEGC Board to the ASX. The ASX is required to keep the money in a separate account designated as a securities industry development account and may only make a payment out of it for a purpose approved by the Minister (or back into the NGF).
10.72 Under proposed section 892G, such a mechanism will be available in relation to any fidelity fund, as well as the NGF.
10.73 Rather than including detailed provisions in the Corporations Law, proposed section 892Gprovides that the regulations:
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- may determine or provide a method for determining when there is excess money in a regulated fund;
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- may make provision in relation to how excess money in a regulated fund may be dealt with.
10.74 The regulations may make different provision in relation to different funds.
10.75 It is expected that the regulations will indicate that excess money in a regulated fund may be used:
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- for financial industry development purposes;
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- such payments will only be able to be made for a public benefit and must not be used to promote the profitability of commercial operations of any market;
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- examples are investor education activities that improve awareness of the functions of particular financial products and the functioning of Australias financial markets;
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- to pay premiums for fidelity insurance or other compensation arrangements of the relevant market.
10.76 Qualified privilege is provided in limited circumstances under current Parts 7.9, 7.10 and 8.6 see, for example, subsections 910(3), 969(4), 982(3) and 1242(3).
10.77 Proposed section 892J empowers the making of regulations for specified persons to have qualified privilege in respect of specified things done under compensation rules forming part of Division 3 arrangements, or under regulations for the purpose of Division 4 (NGF).
10.78 It is anticipated that the regulation-making power will be used to provide protection comparable to that currently provided.
10.79 In addition, the SEGC has qualified privilege under proposed subsection 888J(3) in respect of the publication of a statement about the coverage of an insurance contract.
10.80 The Minister is empowered to require the operator of a financial market to cause a risk assessment report to be prepared in relation to the market and to provide that report to the Minister (proposed section 892K). Such a report would be relevant to an assessment of the adequacy of the compensation arrangements proposed or in place.
10.81 Part 7.8 of the Corporations Law (deposits with stock exchanges) will be repealed and its provisions not re-enacted. Proposed Part 7.8 addresses the obligations of financial services licensees relating to dealing with clients money.