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 8 - Regulation impact statement - Harmonisation of the treatment of debentures and promissory notes

Introduction

8.1 Over the past two to three years, there have been a number of high profile collapses of property development companies, starting with Westpoint and followed by Fincorp, ACR and Bridgecorp.

8.2 Consumers were able to invest in these property development companies by acquiring a debenture or promissory note issued by the company. In broad terms a debenture or a promissory note is a debt instrument.

8.3 The collapses have had significant impact with some investors losing considerable amounts of money. Total losses are estimated at around $900 million, invested by around 20,000 investors across Australia (although some of those funds will be recovered, particularly in the case of Fincorp and ACR).

8.4 There have been a range of reasons put forward to explain the collapses, other than the regulatory framework. These include poor corporate decision making; poor management; inappropriate use of funds; land banking, inexperienced personnel; high ongoing running costs; inappropriate or bad advice from financial advisers driven by higher than normal commissions; and, investors seeking higher than normal returns but not understanding the inherent high risk and unsecured nature of their investment.

8.5 Nevertheless, as a result of these corporate collapses there has been considerable discussion about the regulatory framework governing debentures and promissory notes and whether changes are appropriate.

8.6 In particular, these questions arise from the uncertainty about the Westpoint group's issue of promissory notes where clarification of whether they were regulated products was only achieved through the courts following a long and costly process. The uncertainty arose because of the belief by the issuing parties, Westpoint that the promissory notes they issued, which were valued at over $50,000, were not regulated by the Corporations Act 2001 (Corporations Act).

8.7 While the subsequent court decision made it clear that the promissory notes in question were interests in managed investment schemes and therefore were subject to regulation under the Corporations Act, it also highlighted the framework in relation to promissory notes is not sufficiently robust and doubts about its applications still exist.

8.8 Promissory notes valued at less than $50,000 are currently regulated as debentures. However, an inconsistency arises between the treatment of promissory notes valued at over $50,000 and debentures over that threshold. Given that debentures and promissory notes are broadly the same kind of financial product, this inconsistency provides a level of complexity and uncertainty in the marketplace resulting in ongoing suggestions that a regulatory gap exists.

8.9 The exclusion of promissory notes with a face value of more than $50,000 from the definition of debenture dates back to 1981. The original purpose of introducing the $50,000 threshold appears to have been to delineate between sophisticated investors and the investing public needing greater protection (similar to the retail/wholesale delineation today), but not impede normal banking and commercial dealings where that protection is not needed. Also at that time, industry participants were opposed to a definition of debentures which included negotiable instruments such as bills of exchange and promissory notes. The main reasons appear to be administrative issues and the imposition of stamp duty if the instrument was classed as a debenture.

8.10 Some 27 years later this exclusion level is out of date, particularly when compared to the $500,000 threshold which currently applies before an investor can be called sophisticated.

8.11 Further, there are circumstances where an issue of a promissory note valued at over $50,000 can escape the operation of the Corporations Act altogether:

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if a promissory note valued at over $50,000 is not issued as an interest in a managed investment scheme and does not fit within the definition of a financial product (so it would then be regulated under Chapter 7 of the Corporations Act), it would not be defined as a financial product. To be defined as a financial product, the promissory note would need to generate a return to the investor and the investor would not have day-to-day control over their investment;

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this anomaly also needs to be addressed.

8.12 Indeed, there is the possibility that promissory note issuers are already structuring their arrangements to avoid the operations of the Corporations Act.

Example 8.1 : Case study - Westpoint

Westpoint was a privately owned property development company located in Perth, Western Australia. Westpoint was active in several capital cities across Australia, including Melbourne and Sydney. Westpoint collapsed in early 2006 after insolvency proceedings were instigated by Australian Securities and Investments Commission (ASIC) in November 2005.

The difficulties experienced by Westpoint relate to a number of projects for which part of the funding was raised through the issue of promissory notes valued at more than $50,000 to retail investors. This so-called mezzanine financing promised high yields of up to 12 per cent per annum, but was secured only by second mortgages over the properties under development. Investors in these notes therefore ranked behind senior debt holders when the projects were wound up.

Promissory notes are regulated as debentures if they have a face value of less than $50,000. The Westpoint notes were issued with a face value of over $50,000 for the purpose of trying to avoid the disclosure and other requirements in law. ASIC took Westpoint to court to clarify the regulatory status of the promissory note. After appeal, in June 2006, the court confirmed that the promissory notes on issue were interests in a managed investment scheme and therefore subject to the disclosure and other requirements under the Corporations Act.

It has been estimated that some 3,000 to 4,000 investors lost approximately $300 million through the promissory note issues. The majority of Westpoint's companies are now in liquidation. Various legal actions continue against the directors of the company as well as related parties. Currently 19 licensed financial planners and three unlicensed financial planners have been banned for various periods from holding an Australian financial services licence (AFSL).

Had it been clearer in law that promissory notes valued at more than $50,000 were caught under the Corporations Act and therefore subject to the disclosure requirements, then the extended and expensive court case would not have been required and investors' funds may have been better protected.

8.13 The Westpoint problem identified a shortfall in the regulatory system - both in terms of the inconsistency in the thresholds relating to how financial products are regulated ($50,000 versus $500,000) and uncertainty and inconsistency of the regulatory approach between debentures and promissory notes depending on their value.

8.14 While ASIC has now issued additional guidelines for debenture issuers and trustees which require additional disclosure, this does not address the inconsistency in the treatment of both products, nor do the guidelines apply to promissory notes.

8.15 Further, the Parliamentary Joint Committee in its oversight report on ASIC published in March 2007 recommended that an amendment to the disclosure requirements in the Corporations Act to the $50,000 threshold applying to promissory notes be sought.

8.16 ASIC also supports the Government's intention to review the regulation of debentures and promissory notes.

Current arrangements

Regulation of debentures

8.17 Debentures are regulated under the Corporations Act (Chapter 2L). Debentures are debt instruments used by the issuer or borrower to raise funds from investors in return for the payment of interest.

8.18 The features of the regulatory regime include the following:

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Debenture issues are required to be governed by a trust deed and must have a trustee. The trustee is required to undertake certain specified actions intended to safeguard the interests of debenture holders. It is also specified who can act as a trustee.

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The trust deed must provide certain rights on behalf of debenture holders and trustees must act in the interests of debenture holders as defined under the Corporations Act.

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The duties of the borrowers are defined, including the requirement to conduct their business in a proper and efficient manner and to provide certain reports with specified contents to the trustee and to ASIC.

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Different naming rules apply to debentures under the Corporations Act depending on the nature of the debenture being issued, that is, whether it is a 'mortgage debenture', 'debenture', 'unsecured note' or 'unsecured deposit note'. The rules generally reflect the type of security available over the debenture.

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Debentures are issued as a source of finance for a range of business activities, including debt capital funding, mortgage lending for residential or commercial property, participation in and ownership of commercial and residential real estate, or to facilitate membership of clubs, groups or franchise operations.

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Debenture issues can be listed or unlisted and can be secured or unsecured.

Unlisted issues of debentures

8.19 It has been identified that unlisted and unrated debentures pose an increased risk for retail investors. In particular, investors do not have the benefit of the market to provide:

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a readily available value for the debenture;

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public scrutiny of the ongoing performance of the issuer either through market forces or via listing rules, as would be the case if the issue were in the public domain; and

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an easy market for the sale of their interests, particularly where investors may have lost confidence in their investment.

8.20 Risks to investors further increase where the funds provided through the issue are on lent, often through other companies in the group for property development purposes as there is considerable uncertainty about returns until such time as the developments are completed and sold. ASIC has issued revised guidelines to immediately address these risks for consumers - see below.

Regulation of promissory notes

8.21 Promissory notes are used to raise funds, such as those issued in the Westpoint case.

8.22 The formal characteristics of promissory notes are covered by the Bills of Exchange Act 1909. However, the investor protection regime, including disclosure, licensing and conduct rules, is contained within the Corporations Act.

8.23 Promissory notes are regulated in the Corporations Act either as debentures or as financial products depending on their value:

Less than $50,000 = debenture

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Promissory notes under $50,000 are regulated as debentures (Chapter 2L):

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debenture issues are governed by a trust deed and trustee (Chapter 2L) and must be accompanied by a prospectus (Chapter 6D);

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issuers and/or financial advisers must also meet relevant disclosure, conduct and licensing requirements (Chapter 7).

$50,000 or over = financial product

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Promissory notes valued at $50,000 or over are excluded from the definition of debentures (s9) and are regulated as a financial product (Chapter 7):

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promissory note issuers must therefore provide a Product Disclosure Statement (PDS) (Part 7.9 in Chapter 7).

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Sometimes promissory notes are issued in the form of an interest in a Managed Investment Scheme:

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as such, the Managed Investment Scheme must be registered and have a licensed responsible entity in place; and

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each Managed Investment Scheme must provide a PDS (Chapter 7).

(a)

Westpoint mezzanine/promissory note issues were characterised as Managed Investment Schemes by the Western Australian Supreme Court.

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Some promissory notes may not satisfy the definition of either a debenture or a financial product;

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however, most promissory notes are likely to fall under one of these two categories.

8.24 The current regime is summarised in the Table below.

Table 8.1 : Summary of the current regulatory framework for promissory notes

ASIC's work

8.25 In analysing some of the reasons for the various property development company collapses, since early 2007, ASIC has prioritised the area of unlisted and unrated debentures as a high risk sector. To date, ASIC has released two sets of guidelines addressing the two areas of immediate concern, to improve disclosure in relation to the unlisted unrated debentures market and setting out guidelines on the way these products are advertised.

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The guidelines set out specific measures to provide better quality information to retail investors about the risks of such investments.

8.26 ASIC also established a Retail Investor Task Force to undertake research into the retail investment sector, focusing on improving retail investor education generally to assist retail investors better understand their investment options and the risks they may incur.

8.27 ASIC has now issued a Guide for investors in unlisted debentures to assist them in making better informed decisions about this type of product and the risks involved. The work of the Retail Investor Task Force also informed the strategic restructure of ASIC which has established a structure it feels is better placed to undertake its regulatory role, including a specific team to deal with retail investors and consumers.

8.28 However, again, these guidelines do not address the area of promissory notes valued at over $50,000.

Systemic risks with collapses in this sector

8.29 Even after the fallout from the collapses which attracted significant media attention, studies suggest that retail investors still have a high degree of confidence in their own ability to make appropriate investment decisions. Westpoint promissory notes were issued without any disclosure documents and with the promise of high returns, leaving investors to make decisions without the level of disclosure that applies to other financial products - however investors were happy to make the decision to invest regardless at that time.

8.30 However, following the collapse of Westpoint and other companies, investors have been quick to complain to the Government and ASIC about their losses.

8.31 Low investor confidence can lead to a general loss of confidence in the high yield finance sector and potentially may result in investors withdrawing funds from companies active in the sector. In a worst case scenario this could lead to further collapses through a snowball effect. This happened in New Zealand where over 20 finance companies have collapsed, leading to a general loss of liquidity in the sector.

8.32 The current financial crisis has compounded this impact on investor confidence.

8.33 Collapses can therefore have systemic implications, impacting:

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individual savings, leading to increased reliance on Government pensions, with a corresponding Budget impact;

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general confidence levels in debenture issues, which may lead to viable companies collapsing due to liquidity shortfalls, as has happened in New Zealand; and

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the financing of fundamentally viable projects, which may not be able to proceed with potential wider consequences for employment and economic growth.

8.34 It is therefore important to ensure the investor protection regime is sound and robust and that retail investors investing in these products are provided with sufficient resources to make informed decisions.

8.35 Any action also needs to be balanced against the risk of increasing costs for business.

Objectives of Government action

8.36 The Government aims to provide a robust system where investors are provided with appropriate protective mechanisms. Where perceived or real regulatory gaps exist, it is appropriate for the Government to undertake a review.

8.37 Eliminating uncertainty about the regulation of promissory notes in the marketplace would be the main current objective.

8.38 Given the $50,000 cut-off level dates back to 1981, it is timely to reconsider whether this threshold is still appropriate. This is particularly so given that a person who invests $500,000 or more for a financial product is considered to be a sophisticated investor and the same protections therefore do not apply.

Consultation

8.39 In this context, in June 2008, the Government issued the Financial Services and Credit Reform Green Paper. The Green Paper addressed six issues in the financial services sector for possible reform, including the debentures sector. The Green Paper was made available on the Treasury website and a media release was issued.

8.40 Four potential changes to the regulation of the debentures sector were proposed in the paper, relating to:

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harmonisation of the regulation of promissory notes;

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licensing of debenture issuers;

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licensing of trustees; and

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review of trustee duties.

8.41 However, subsequent to the issue of the Green Paper, it was agreed that while the harmonisation issue should be addressed now, consideration of the three remaining reforms be deferred until the conclusion of ASIC's debenture review project. This will allow the considerable work already commenced by ASIC to improve the consumer protection framework in this area to be thoroughly assessed before any further changes, which may not prove necessary, are implemented.

8.42 ASIC's review will look into the effectiveness of its recently revised (2007) guidelines on improved disclosure and advertising of unlisted, unrated debentures. Once completed a further assessment of the remaining three items will be undertaken.

Submissions

8.43 Twenty submissions were received in relation to the debentures chapter in the Green Paper. Fourteen out of the 20 submissions received were in favour of the harmonisation proposal. The general feeling was that this option was a positive step as the regime needed to be more consistent to ensure better investor protection.

8.44 Of the remaining submissions, some did not comment specifically on the harmonisation option, and only one party, a law firm, set out any concerns. They argued that increasing the regulation of promissory notes regardless of their value was inconsistent with the rest of the Corporations Act which makes a distinction between the nature of the offering and the level of risk. For this reason, it considered the change was discriminatory without sufficient basis.

8.45 Further targeted consultation will be undertaken in relation to the harmonisation proposal, to establish whether a change to the regulation is appropriate and to assess the level of any impact.

Options

Option 1 - No change

8.46 This option would leave the current regulatory framework in place, thereby retaining the threshold levels between a debenture and a promissory note valued at over $50,000.

Option 2 - Harmonise the regulation of debentures and promissory notes

8.47 Regulate promissory notes valued at over $50,000 in the same way as debentures. This would be achieved by removing the exclusion of promissory notes from the definition of debentures in section 9 of the Corporations Act.

Option 3 - Self regulation

8.48 Issuers of promissory notes valued at over $50,000 would be required to manage their own actions in regard to the issue of promissory notes and apply in the relevant regulatory framework that issue including appropriate disclosure.

Impact analysis

Impact group identification

8.49 The groups affected by the amendments are investors/consumers, the promissory notes industry and issuers of promissory notes, the Government and ASIC.

Assumptions

8.50 In assessing the impact of the options, the following assumptions have been used based on some research undertaken by ASIC and submissions received from the earlier Green Paper consultation process.

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The estimated total value of debentures currently on issue in Australia is around $25 billion, down from $34 billion at June 2006.

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The number of issuers is estimated to be 146, compared with 154 previously at June 2006.

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The numbers of investors holding interests in promissory notes or who intend to acquire interests in promissory notes valued at more than $50,000 is likely to be lower again.

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The majority of investors had invested between $20,000 and $499,999 (representing 49 per cent of those surveyed). The higher end is more likely to reflect investment property ownership.

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In the case of the Westpoint collapse, over 3,000 investors were affected.

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Our understanding is that there are only a limited number of promissory note issuers.

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There appear to be more investors in promissory notes in the over $500,000 sector, but these would be classed as wholesale investors and any changes would not impact on this sector.

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In the then Financial Literacy Foundation's 2007 survey of 7,500 people, approximately 46 per cent said they had investments other than property. However this survey did not differentiate between retail and wholesale investors. The survey group also comprised around 550 participants who were under 18 years of age.

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According to ASIC's annual report for 2006-07, the number of licensed financial advisers were 4,625. However, it is unlikely that the proposed change would have any impact on advisers. In the assessment below, financial advisers are included under the category of 'industry'.

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Costs can take many forms including: setting up trustee arrangements, including a trust deed and trustee, court costs, or in the form of lower confidence in the marketplace.

8.51 Further consultations on the options will better determine the overall impact and associated costs and benefits.

Assessment of costs and benefits

Conclusion and recommended option

8.52 Promissory notes valued at over $50,000 are currently regulated differently to debentures for reasons that are no longer relevant. The original reasons for creating the discrepancy in 1981 appear to have come about because at that time industry participants and stakeholders opposed the broad definition of debentures including negotiable instruments such as bills of exchange and promissory notes. This appears to relate to administrative issues and the imposition of stamp duty if the instrument was classed as a debenture. Those concerns appear less relevant now.

8.53 Additionally, the $50,000 threshold has remained unchanged since 1980 and is out of date compared to the current thresholds differentiating between retail and sophisticated investors.

8.54 The current arrangement creates an inconsistent approach between the regulation of debentures and a promissory note valued at more than $50,000. This inconsistency does not appear to be warranted any longer.

8.55 Indeed, 14 of the 20 submissions from the Financial Services and Credit Reform Green Paper issued in June this year on debentures supported this option. Only one submission was against the proposed change, and its further views will be sought as part of the next round of targeted consultations.

8.56 Allowing the industry to address the problem itself (Option 3) is less likely to satisfy industry and investors in particular that they will be protected. Nor does this option meet the objective of providing clarity in the regulation of promissory notes.

Discussion of Options

8.57 Option 1 offers no real solution to the problems existing in the current regime, particularly the uncertainty that exists and the threshold anomaly.

8.58 Option 2 is the option put forward by the Government in its Green Paper released in June 2008. Implementation of this option will mean those promissory notes governed under the Corporations Act currently valued at greater than $50,000 would be regulated as debentures. This approach is seen to address the perceived regulatory gap and inconsistent regulatory framework between promissory notes and debentures.

8.59 Consequently, new issuers of promissory notes valued at more than $50,000 will have to meet the requirements of Chapters 2L and 6D - requiring the establishment of trustee arrangements and the issue of a prospectus.

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This change will affect the issue of promissory notes to retail clients only and will provide a clearer framework to which issuers must adhere.

8.60 From our understanding of the market, the majority of promissory notes (commonly termed commercial paper) on issue are valued at over $500,000. We also understand that the majority of issuers are the major banks. Any increased costs as a result of the proposed change would therefore be expected to be low relative to their overall operations.

8.61 The greatest impact from this change is likely to be felt by issuers of promissory notes in the range of $50,000 to $500,000. Issuers in this range (who may or may not already be licensed depending on their business operations) will be required to establish trustee arrangements for the issue of promissory notes and comply with the prospectus disclosure requirements. It is noted that most of these issuers are currently subject to other disclosure requirements, depending on the nature of the promissory note issue, including the obligation to provide a Product Disclosure Statement. While the Product Disclosure Statement requirements differ from those applying to prospectuses, they result in a similar level of information being provided to retail investors.

8.62 While affected entities may object to any changes being imposed on them in complying with the new disclosure and trustee arrangements, that number is expected to be relatively low and the costs not onerous. Further targeted consultation will provide information in this regard.

8.63 Option 2 offers a sensible approach to address an inconsistent legislative framework where many feel a regulatory gap exists.

8.64 Option 3, self-regulation by the industry, may go some way to protecting investors provided that industry participants issue promissory notes as a regulated financial product and do not attempt to fight the system again as Westpoint did. However it does not provide a complete answer.

8.65 Through Option 2, issuers of promissory notes would be regulated like any other debenture issuer. This framework would also provide a consistent approach.

8.66 Currently, when a promissory note is issued valued at over $50,000, it may even be regulated as a financial product under Chapter 7 more as an interest in managed investment scheme. Yet a promissory note valued at less than $50,000 would be regulated under the framework for debentures. This provides a level of complexity in the issue of promissory notes. It makes sense therefore to include promissory notes valued at over $50,000 in the same regime as debentures.

8.67 Under the debentures regime, all promissory notes issuers would therefore be required to establish trustee arrangements, including setting up a trust deed and appointing a trustee. Amongst a range of duties, the trustee is required to protect the interests of debenture holders including to actively monitor the financial position and performance of the issuer. This role has been further enhanced by the recently released ASIC guidelines for debenture issues.

8.68 Trustees are also required to look after the interests of debenture holders by exercising reasonable diligence in monitoring the issuer's ability to repay the debentures - this is not required under the current framework for promissory notes. Issuers are required to report regularly to the trustee and the trustees are also required to ascertain whether the issuer has committed any breach under the trust deed of Corporations Act and this includes general obligations to carry on their business in a proper and efficient manner.

8.69 Additionally, ASIC has also issued a separate guide for retail investors interested in investing in debentures and this provides an additional level of additional information for investors to make appropriate decisions about their investments.

Conclusion

8.70 The inconsistency in the regulation of debentures and promissory notes has raised a number of questions about whether this discrepancy could be exploited again. The proposed harmonisation option would create more consistency in the regulation of both while also providing an opportunity to remove the anachronistic $50,000 threshold.

8.71 Therefore, the preferred way forward is to remove the exclusion of promissory notes valued at over $50,000 from the definition of a debenture, resulting in debentures and promissory notes being consistently regulated as debentures under the Corporations Act.

Implementation and review

8.72 Further targeted consultation will confirm whether this option is appropriate and identify any potential unexpected consequences, particularly within the commercial market.

8.73 Targeted consultation will involve a six week consultation period. Those consulted will be based on the submissions on this subject received from the Green Paper.

8.74 It is proposed that any proposed changes will be added to another Bill due to be tabled in the winter sittings next year.

8.75 It is likely that no transitional period will be required as issuers will be well aware of the changes before final implementation and the impact would not be sufficient to warrant a transition phase. This would also be subject to further review following final submissions.

8.76 Any future review will be undertaken as deemed necessary and subject to the long-term effects on the marketplace and the regulator's advice.

8.77 Ongoing enforcement and monitoring would be undertaken by the financial services regulator, ASIC.