House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Minister for Human Services Minister for Financial Services, Superannuation and Corporate Law the Hon Chris Bowen Mp

Chapter 5 - Regulation impact statement - Margin loans

Commonwealth regulation of margin loans - regulation impact statement

Part 1 - Introduction

5.1 Council of Australian Governments (COAG) reached an in principle agreement on 26 March 2008 that the Australian Government would assume responsibility for regulating mortgage credit and mortgage advice, including non-deposit taking institutions and mortgage brokers, as well as margin loans. On 3 July 2008, COAG agreed that the Australian Government would also assume responsibility for regulating all other consumer credit products and requested the COAG Business Regulation and Competition Working Group report back at the 2 October meeting with a detailed implementation plan for other credit.

5.2 Against that backdrop, in September 2008 the Australian Government decided to:

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first, enact the Uniform Consumer Credit Code (UCCC) of the States and Territories and, where relevant, proposed amendments to the UCCC, as Commonwealth legislation;

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the new national framework would be administered by the Australian Securities and Investments Commission (ASIC), which would be given enhanced enforcement powers;

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secondly, to extend the scope of the current regulatory framework so that the new national consumer credit framework would:

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include consumer lending for investment properties;

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regulate the provision of margin loans;

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require all providers of consumer credit and credit-related brokering services and advice to be members of an external dispute resolution body;

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provide for a licensing regime requiring all providers of consumer credit and credit-related brokering services and advice to obtain a licence from ASIC;

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require licensees to observe a number of general conduct requirements, including responsible lending practices;

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regulate the provision of credit for small businesses; and

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introduce specific conduct obligations, where warranted, for particular credit activities or products.

5.3 On 2 October 2008, COAG agreed to an implementation plan for the regulation of consumer credit. COAG agreed to a phased approach to reform, beginning with the transfer of responsibility key credit regulation, including the Uniform Consumer Credit Code as phase one. COAG also agreed to an implementation plan for phase two, the regulation of remaining areas of consumer credit, including payday lending (for example, pawnbrokers), credit cards, store credit, investment and small business lending, and personal loans, so that the reform package is completed in the first half of 2010.

5.4 A regulation impact statement (RIS) was prepared and considered in the context of consideration of the decisions by the Australian Government in September 2008. A copy of that RIS is at Chapter 6. The September 2008 RIS includes background information, including the market and regulatory environment for consumer credit and margin lending, and consultation processes that had been carried out to that date. It also includes a diagram of the two-phased approach to implementation (see Chapter 6), that was endorsed by COAG.

5.5 This RIS should be read in conjunction with the margin loan sections of the September 2008 RIS. It focuses on analysis of key measures in the Bill that substantively change the regulatory framework.

Part 2 - Consultation

Green Paper on Financial Services and Credit Reform

5.6 On 3 June 2008, the Government released the Green Paper on Financial Services and Credit Reform: Improving, Simplifying and Standardising Financial Services and Credit Regulation.

5.7 The Green Paper discussed the regulation of mortgages, mortgage brokers and margin loans, and proposed options for the Commonwealth taking over regulation in this area. With respect to other consumer credit products such as credit cards, personal loans and micro loans, the Green Paper asked for submissions on whether these products should also be regulated solely by the Commonwealth or whether there is a role for the States and Territories in this area.

5.8 Some 150 submissions were received in response to the Green Paper, and an overwhelming majority supported the Commonwealth assuming responsibility for the regulation of all consumer credit.

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From the industry's perspective, this support was driven by the reduction in compliance burden that would be achieved by reducing the number of different regulatory regimes they are required to operate under.

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From the consumer advocates' perspective, this support was driven by the better protections and efficiencies a consistent national regime offers.

Margin loans

5.9 Some 20 submissions in relation to margin loans were received in response to the Green Paper.

5.10 There was general support for the inclusion of margin loans as a financial product in Chapter 7 of the Corporations Act 2001 (Corporations Act) (Grant Thornton, Australasian Compliance Institute, Financial Planning Association, Australian Financial Counselling & Credit Reform Association Incorporated, Australian Institute of Credit Management).

5.11 It was noted that introducing a new specific regime (as opposed to extending Chapter 7) would be costly for both government and participants, would add further regulation to a system that already suffers from inefficient regulatory overlap and increase the risk of future inconsistency (Macquarie Bank, National Australia Bank, Australasian Compliance Institute, ANZ).

5.12 Some submissions called for further research and analysis before any action was taken and cautioned against a 'knee jerk' reaction to recent failures such as Opes Prime and Lift Capital, which involved products not sold by the majority of the industry (Australian Bankers Association, Securities and Derivatives Industry Association, Investment and Financial Services Association Ltd).

5.13 Subsequent to public consultation through the Green Paper, the Industry and Consumer Consultation Group assisted in developing the details of the regulatory regime. Further details of the Consultation Group's deliberations in relation to margin loans are noted below in the 'margin loans' section. The membership of the consultative group was expanded in relation to the margin loans discussion to include margin loan expertise.

5.14 It is noted that separate consultations with the same group are being held to develop a special product disclosure document for margin loans. On the Government's side, these discussions are being led by the Financial Services Working Group (the Working Group), which is a body composed of representatives from the Australian Treasury, the Department of Finance and Deregulation and ASIC. The Working Group was established in February 2008 and is tasked with simplifying and shortening disclosure documentation in financial services.

Part 3 - Regulation impact assessment

Impact assessment methodology

5.15 Impacts can be divided between three impact groups (consumers, business and government). Typical impacts of an option on consumers might be changes in access to a market, the level of information and disclosure provided, or prices of goods or services. Typical impacts of an option on business would be the changes in the costs of compliance with a regulatory requirement. Typical impacts on government might be the costs of administering a regulatory requirement. Some impacts, such as changes in overall confidence in a market, may impact on more than one impact group.

5.16 The assessment of impacts in this regulation statement is based on a seven-point scale (-3 to +3). The impacts of each option are compared with the equivalent impact of the 'do nothing' option. If an impact on the impact group would, relative to doing nothing, be beneficial, the impact is allocated a positive rating of +1 to +3, depending on the magnitude of the relative benefit. On the other hand, if the impact imposes an additional cost on the impact group relative to the status quo, the impact is allocated a negative rating of -1 to -3, depending on the magnitude of the relative cost. If the impact is the same as that imposed under the current situation, a zero score would be given, although usually the impact would not be listed in such a case.

5.17 The magnitude of the rating of a particular impact associated with an option has been assigned taking into account the overall potential impact on the impact group. The reference point is always the status quo (or 'do nothing' option). Whether the cost or benefit is one-off or recurring, and whether it would fall on a small or large proportion of the impact group (in the case of business and consumers), is factored into the rating. For example, a cost or benefit, even though large for the persons concerned, may not result in the maximum rating (+/-3) if it is a one-off event that only falls on a few individuals. Conversely, a small increase in costs or benefits might be given a moderate or high rating if it would be likely to recur or if it falls on a large proportion of the impact group. The rating scale for individual impacts is explained in the table below.

5.18 The ratings for the individual impacts compared to the status quo are then tallied to produce an overall outcome for the option. If it is positive, it indicates that the option is likely to produce a more favourable cost/benefit ratio than the status quo. If it is zero there would be no overall benefit from adopting the option, and if negative the option would provide overall a less favourable cost/benefit ratio than the 'do nothing' option. Ordinarily, options that have the highest positive score would be the favoured courses of action

5.19 What is classed as a 'large', 'moderate' or 'small' cost or benefit depends on the nature of the problem and options being considered. Of course, the costs and benefits associated with options to address a problem costing billions of dollars per year are likely to be of a much greater absolute magnitude than the costs and benefits of options for dealing with a rather modest issue that affects only a handful of persons. However, as all the ratings are made relative to the status quo/do nothing option for a particular problem, the absolute value of 'large' or 'moderate' or 'small' is not really important. All that matters is that within a problem assessment, the impacts of each option are given appropriate ratings relative to the status quo and each other. If that occurs, it will be sufficient for the methodology to yield an overall rating that assists in assessing the relative merits of options, from a cost/benefit perspective, to address the particular problem.

5.20 An example of the rating calculation for an option, using the seven-point scale ratings of impacts, is in the table below. The example is based on a purely hypothetical scenario that a new type of long-wearing vehicle tyre is being sold and marketed, but it has become apparent that the new style of tyres have a higher risk of exploding while in motion than conventional tyres. The example is designed merely to illustrate how the rating scale might be used to compare a proposal's costs and benefits option to the 'do nothing' option - it is not intended to be a comprehensive or realistic assessment of options to address such a problem.

Illustrative rating for the problem of a long-wearing tyre that may fail

Option A: Do nothing

Table 5.2

Option B: Ban on sale of the new tyre

Table 5.3

Option C: Industry-developed quality control standards

Table 5.4

5.21 In the above hypothetical example, Option C appears to have a better impact for consumers and a better overall cost/benefit rating than Option B.

Margin lending

Problem identification

5.22 There have been concerns that some margin borrowers are not aware of the extent to which margin lending contracts place the risk of changes to market conditions on them. The possibility of such borrowers suffering unexpected consequences is particularly high in volatile market conditions such as those experienced in the recent global financial crisis.

5.23 For example, some clients of the collapsed financial planning firm Storm Financial who had entered into margin loan arrangements borrowed funds against the equity in their homes and used them as a contribution to a margin loan. Some of these borrowers have fallen into negative equity in relation to their margin loans, and are now having to repay outstanding amounts on the margin loans as well as continuing to service the loan secured against their home. Where borrowers do not have additional sources of funds to do so, they are at risk of defaulting on their home mortgages and losing their homes.

5.24 Indications are that not all of these borrowers adequately understood the way that margin loans operate, including the potential consequences of margin calls. In addition, they may also not have been aware that they exposed themselves to the risk of losing their homes when they borrowed to fund the margin loan.

5.25 The Storm case illustrates the risks that can be attached to margin loans, and the fact that retail borrowers may not be fully aware of them when entering the arrangements.

5.26 Those factors were key considerations in the decisions of the Australian Government and COAG in 2008 to introduce a regulatory framework for margin lending. The issue being addressed in this RIS is the form of the new regulatory framework.

Objectives

5.27 The key objectives of a regulatory framework for margin lending are to achieve an outcome that: retail investors who enter into such arrangements are fully aware of the associated risks, and do not enter margin loans due to irresponsible conduct by lenders and/or inappropriate advice by financial advisers.

Options

Status quo

5.28 Currently margin loans are not treated as a specific product for regulatory purposes. Aspects of margin loan arrangements may fall under a variety of regulatory regimes, including the Corporations Act and the Code of Banking Practice. Other areas remain unregulated, such as the disclosure of key risk and other information to borrowers.

5.29 Margin loans will not be covered by the new consumer credit legislation in phase one, as that system does not cover investment loans (other than loans for investments in residential properties).

Option A: Include margin loans as a financial product under the Corporations Act and apply Chapter 7 with some modifications

5.30 Under Option A, margin loans would be defined as a financial product in Chapter 7 of the Corporations Act. As a consequence, financial services providers offering margin loans as one of their products would become subject to a comprehensive range of licensing, conduct and disclosure requirements. Providers and intermediaries would be covered by rules regarding external dispute resolution and compensation arrangements. The regulator would be ASIC.

5.31 Most of the participants (as lenders or providers) engaging in the margin lending market would already be familiar with the Chapter 7 obligations as they also supply and deal in other financial products that are covered by the Chapter 7 framework. That requires participants to:

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have an Australian financial services licence (AFSL);

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comply with general conduct standards, including the requirement to deal with investors efficiently, honestly and fairly;

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have appropriate compensation arrangements in place for losses suffered by retail clients due to breaches of the law;

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be members of an ASIC approved External Dispute Resolution (EDR) Scheme;

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provide disclosure to their clients before and after a product is purchased, including providing a Product Disclosure Statement (PDS), a Statement of Advice and periodic statements on an ongoing basis;

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have in place adequate arrangements for the management of conflicts;

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ensure that they (and their employees) have adequate resources and are competent to provide the services; and

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be subject to the enforcement provisions surrounding market manipulation, false or misleading statements, inducing investors to deal using misleading information, and engagement in dishonest, misleading or deceptive conduct.

5.32 Some modifications to Chapter 7 would be needed to adapt it to a margin loan context. In particular, there would be tailored obligations regarding the notification of margin calls, and the requirements would be expanded to cover a 'responsible lending' component (see Part 3.5 for details of the responsible lending requirements).

Option B: Incorporate margin loans in the new Commonwealth credit legislation

5.33 Under Option B, margin loans would be covered under the new Commonwealth credit legislation. This legislation will incorporate the current uniform State legislation covering consumer credit, the Uniform Consumer Credit Code (UCCC).

5.34 Under that regime, providers of credit for margin loans, and persons who suggest such facilities or assist consumers to enter them, would be subject to the following key obligations:

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Persons who engage in credit activities would, initially, have to be registered with ASIC, and subsequently hold an Australian credit licence.

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Entry standards for registration and licensing would be imposed which enable ASIC to refuse an application where the person does not meet those standards.

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Registered persons and licensees would be required to meet ongoing standards of conduct while they engage in credit activities. Specific requirements would apply to both lenders and persons providing advice and assistance to consumers in relation to obtaining credit. Licensees would be subject to responsible lending requirements, under which an assessment must be made whether a proposed credit facility is unsuitable for a client.

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Registered persons and licensees would have to be members of external dispute resolution schemes and have appropriate compensation arrangements in place.

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ASIC would have the power to suspend or cancel a licence or registration, or to ban an individual from engaging in credit activities.

Impact analysis

5.35 The groups affected by the new regime for margin loans would be consumers of credit; industry participants including lenders and advisers; and the Government/ASIC.

5.36 It is estimated that there are between 1,000 to 2,000 financial planners active in margin loans, and many of them would not otherwise need to comply with the credit framework (though they would already be covered by Chapter 7 with respect to their other business lines). The number of lenders is much smaller, and is estimated not to exceed 15. Most lenders are authorised deposit-taking instructions which are already in possession of an AFSL for other parts of their business.

5.37 The main benefits of the two options are similar, and consist mainly of significantly improved consumer protection arrangements. Consumers will be the main beneficiaries under either option, as the licensing requirements will ensure that they will be dealing with lenders and other services providers that are properly trained and resourced. The new responsible lending requirements also operate under both options, and will mean that consumers are less likely to be given a margin loan which they cannot service. A very important benefit will be the requirement under both options for licensees to be members of external dispute resolution schemes, as access to the schemes will provide consumers with fast and free resolution of disputes and compensation claims where losses have been incurred.

5.38 Benefits to industry and government are of a lesser nature, but would also be similar under either option. For government, the improved consumer protection levels available under both options will in particular reduce the incidence of consumers requiring government assistance due to the provision of loans they cannot afford.

5.39 The main difference between the two options lies on the costs side. Most of the margin loan services providers are already holders of AFSL with respect to the other services they provide. This is in particular true for financial planners, which constitute the clear majority of services providers with respect to margin loans. These entities are therefore already familiar with the Chapter 7 regime, and have already established systems and processes that are tailored to that regime. The new credit regime, while in some aspects similar to the Chapter 7 requirements, also has some areas where significant differences occur. This is true in particular for the requirements relating to the provision of advice, which constitutes the main activity of financial planners. Option B would therefore require licensees to become familiar with a new regulatory regime, and to establish new systems and processes in parallel to what they have already put in place in order to comply with the Chapter 7 regime. Costs associated with Option B are therefore considered to be higher for industry than for Option A.

Table 5.5 : Status quo

Option A

Table 5.6

Option B

Table 5.7

Consultation

5.40 The issue of how margin loans should be regulated was discussed with the Industry and Consumer Consultative Group, as noted in the general consultation section above. Members of the group include:

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government and the ASIC;

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key industry associations representing lenders and financial planners;

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key lenders, including both banks and brokers; and

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representatives of the main EDR Schemes.

5.41 The first meeting of the group to discuss margin loans was held on 20 January 2009 and a number of further meetings were also held.

5.42 Main issues discussed at the meetings include:

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whether the regulatory regime in Chapter 7 of the Corporations Act is suitable for margin loans, and if not what amendments are necessary to eliminate gaps and shortcomings;

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what the appropriate definition of a margin loan should be;

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what responsible lending requirements are appropriate in the context of margin loans; and

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what the appropriate transitional arrangements should be, especially for licensing matters.

5.43 One of the main concerns raised by stakeholders was the need to limit the regulatory burden placed on business, and in particular to avoid unnecessary duplication of requirements for businesses already subject to licensing and regulation under the Corporations Act.

5.44 In the consultation meetings a range of issues were raised for Government to consider. The main issues include:

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Developing an appropriate definition of a margin loan in order to ensure that a level playing field applies to all types of margin loans in the market. The key concern was to capture products offered by providers such as Opes Prime which are based on stock lending agreements rather than loan agreements. Additional members of the consultation group with specialised expertise in this area were recruited in order to ensure that an appropriate definition is provided.

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Drafting responsible lending requirements that meet Government's policy objectives while minimising the regulatory burden on industry. This issue is being addressed in a variety of ways. While the obligation to assess the possible unsuitability of a margin loan is made clear, certainty on how to conduct the assessment is being provided to industry by listing a number of key matters that must be considered. Consideration is also being given to allowing lenders to rely on information or a recommendation provided by a licensed financial planner. Further guidance will also be provided in the explanatory material attached to the legislation, and ASIC may issue further guidance where appropriate.

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Including transitional arrangements that give sufficient time to industry and ASIC for making adequate preparations, in particular for meeting the new licensing requirements, while addressing the Government's objective of a speedy introduction of the new regulatory regime. The draft legislation proposes a preparatory period during which lenders and services providers can prepare for submitting their licensing applications, and an additional period during which reduced regulatory requirements will apply in order to give industry time to meet all the requirements of the full Chapter 7 regime. ASIC is also considering ways of facilitating the licensing process, in particular in relation to meeting the training and competency requirements.

5.45 Taking account of this concern has been one of the key drivers in developing analysing the options relating to the regulatory treatment of margin loans.

Conclusion and recommended option

5.46 Options A and B would both provide overall benefits over the status quo, most of the benefits being in favour of consumers.

5.47 The main difference between Option A and B lies in the costs it imposes on business. Financial planners involved in margin loans would become subject to regulation under both Chapter 7 and credit regulation under Option B.

5.48 The recommended option is Option A, under which margin loans would be regulated by including them as a financial product in Chapter 7 of the Corporations Act with some adjustments to the legislation to take account of their special characteristics.

Part 4 Implementation and review

5.49 The recommended options would be implemented primarily through the introduction of the Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009. Associated regulations would also be required.

5.50 There will be an opportunity to refine the margin loan regime established in phase one of the general credit project in the course of developing phase two, which is proposed to include investment credit.

5.51 The new margin loan regime would, like the regulatory framework for regulation of corporate regulation and financial services, be the subject of ongoing monitoring and review by the Australian Government.