House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

2 Regulation impact statement

Background to proposed amendments

Financial System Inquiry

2.1 The financial sector is undergoing rapid change and development, resulting in concerns about whether existing regulation remains adequate. The FSI was established in 1996 to analyse the forces driving change in the financial system, and to recommend ways to improve current regulatory arrangements.

2.2 The FSI found that the three major forces driving change were changing customer needs (including changing demographics and an increased willingness to adopt technology), technology driven innovation, and significant regulatory change, such as the liberalisation of trade and capital. ^[F1] The Report then identified four broad changes arising from these forces: increased competition, resulting in rationalisation of pricing and costs; closer links between the Australian economy and international markets; increased conglomeration and further market widening, which would continue to challenge traditional institutional and regulatory boundaries; and increasing disintermediation in the provision of financial services. ^[F2]

2.3 The Report also considered the philosophy behind financial regulation, and concluded that specialised regulation was required to ensure that market participants acted with integrity and that consumers were protected. This was so due to the complexity of financial products, the adverse consequences of breaching financial promises and the need for low-cost means to resolve disputes. ^[F3] The principles of regulation which guided the inquiry were competitive neutrality, cost effectiveness, transparency, flexibility and accountability. ^[F4]

2.4 The FSI considered that very large efficiency gains and cost savings could be released from the existing system through improvement to the regulatory framework and through continuing developments in technology and innovation. However, markets could only deliver these outcomes where competition was allowed to thrive and where consumers had confidence in the integrity and safety of the system.

2.5 The FSI did not advocate change for its own sake, but sought an appropriate balance between achieving competitive outcomes and ensuring financial safety and market integrity. In particular, the recommendations of the FSI sought to:

•

create a flexible regulatory structure which would be more responsive to the forces for change operating on the financial system;

•

clarify regulatory goals;

•

increase the accountability of the agencies charged with meeting those goals;

•

ensure that regulation of similar financial products was more consistent, and promoted competition by improving comparability;

•

introduce greater competitive neutrality across the financial system;

•

establish more contestable, efficient, and fair financial markets resulting in reduced costs to consumers;

•

provide more effective regulation for financial conglomerates, which would also facilitate competition and efficiency; and

•

facilitate the international competitiveness of the Australian financial system.

2.6 One key issue in achieving these outcomes was market conduct and disclosure in the financial system. The FSI stated that financial markets could not work well unless participants acted with integrity, and there was adequate disclosure to facilitate informed decision-making by the consumers of financial products. The FSI identified the following problems with the existing regulatory approach ^[F5] :

Disclosure

•

financial market participants faced a range of information disclosure rules which varied greatly in their status, degree of prescription and penalties for breach; ^[F6]

•

the existence of widespread concerns that the information available did not allow prospective purchasers to compare products - consumers need to compare product characteristics, costs and expected rates of return if they are to make informed decisions;

Licensing

•

regulatory arrangements involved complex and overlapping regulation of financial market participants, with particular problems where participants are subject to more than one regime, sometimes with contradictory rules; ^[F7]

Financial markets

•

incomplete coverage by the existing Corporations Law, which did not apply to transactions falling outside strict definitions of securities or a futures contract;

•

the narrow definitions of securities and futures contract required legislative amendments to permit exchanges to trade new products; and

•

uncertainty and inconsistency in the treatment of hybrid products with both security and derivatives characteristics.

2.7 The Report therefore recommended ^[F8] that:

•

a consistent and comprehensive disclosure regime for the whole financial system be established, based on product profile statements which provided a better balance between effectiveness and cost; ^[F9]

•

a single licensing regime be introduced for all advisers providing investment advice and dealing in financial markets; ^[F10]

•

a single set of conduct requirements be developed for investment sales and advice including minimum standards of competency and ethical behaviour, requirements for the disclosure of fees, and rules for handling client property and money; ^[F11]

•

that the law covering financial markets adopt a broad definition of financial products subject to generic requirements and supplemented by specific regulation for particular classes of products - to replace existing separate Corporations Law regulation of securities and futures contracts; ^[F12] and

•

that there be a single authorisation procedure for financial exchanges. ^[F13]

Corporate Law Economic Reform Program (CLERP)

2.8 In tandem with the FSI, the Government established CLERP to review existing policy in key areas of business regulation. The purpose of the program is to ensure that current regulation is consistent with the governments economic objectives. In particular, it seeks to improve the efficiency of corporate regulation and reduce regulatory burdens on business. The reforms are aimed at facilitating a more efficient and competitive business environment.

2.9 Under this program, the Government released policy papers containing detailed proposals and draft legislative provisions as a means of consulting widely. CLERP Paper No. 6 dealt specifically with the financial system, and sought to implement the recommendations of the FSI. This paper was published in December 1997 ^[F14] , followed by a consultation paper in March 1999 ^[F15] . The changes proposed by CLERP 6 are now embodied in the FSR Bill.

2.10 The FSR Bill also includes a 15 per cent limit on shareholdings in prescribed markets or clearing and settlement facilities, and a requirement for bidders and target companies involved in major takeovers to record telephone conversations with target shareholders. These reforms were not part of the public consultation process associated with CLERP 6.

The Financial System

2.11 The stability, integrity and efficiency of the financial system are critical to the performance of the entire economy. ^[F16] Australias strong and growing finance and insurance industry adds value through financial intermediation and support services, and is a significant employer in Australia. Over each of the last six years, in current price terms, the finance and insurance industry has grown more quickly than the economy as a whole and, in 1999-2000, both year on year growth and through year growth for this industry were much higher than for Australia as a whole. ^[F17] In 1999-00 the finance and insurance sector contributed 7.2 per cent to GDP, up from 6.8 per cent in 1998-99. The finance and insurance sector is the fourth largest sector in the Australian economy, and is larger than both agriculture (3.3 per cent) and mining (4.6 per cent) sectors. ^[F18]

2.12 The financial sector is made up of the following: the central bank and prudential regulatory bodies; depository corporations (such as banks, building societies and credit co-operatives); insurance corporations and pension funds (life insurance, general insurance, superannuation funds); other financial corporations, including financial intermediaries (such as financial unit trusts and investment companies); and financial auxiliaries (such as securities brokers, insurance brokers and flotation corporations). ^[F19]

2.13 As at 30 June 2000, the consolidated total financial assets on the books of financial institutions was $1,389.4 billion. ^[F20] The total assets on the books of Australian banks (excluding the Reserve Bank of Australia (RBA)) at the same date were $731 billion. ^[F21] Life insurance corporations held total assets of $184 billion as at 30 June 2000, while general insurance corporations held assets of $68 billion. ^[F22] Superannuation funds had total assets of $405 billion as at 30 June 2000. ^[F23] Managed funds had consolidated total assets of $590,422 million as at 30 June 2000. ^[F24] Turnover on the Sydney Futures Exchange (SFE) in 1999-00 was $10.03 trillion, up from $6.2 trillion in 1993-94. ^[F25] At the end of June 2000, the market capitalisation of domestic equities on the Australian Stock Exchange (ASX) was $682 billion, up from $163 billion in 1988-89, and the market capitalisation of overseas-based equities on the ASX (at the end of June 2000) was $210 billion. ^[F26]

2.14 The following Acts currently regulate the financial sector:

2.15 Corporations Lawand regulations (which will be replaced by the proposed Corporations Act 2001 (proposed Corporations Act) and regulations);

2.16 Australian Securities and Investments Commission Act 1989 (ASIC Act) and regulations (which will be replaced by the proposed Australian Securities and Investments Commission Act 2001 (proposed ASIC Act) and regulations);

Banking Act 1959 ;

Insurance Act 1973 ;

Insurance (Agents and Brokers) Act 1984 and regulations;

Insurance Contracts Act 1984 ;

Life Insurance Act 1995 ;

Retirement Savings Accounts Act 1997 ;

Superannuation Industry (Supervision) Act 1993 .

Consultation

2.17 The Government established the Business Regulation Advisory Group (BRAG), which represents key stakeholder organisations, so that the CLERP proposals could be developed in close consultation with business. The Companies and Securities Advisory Committee (CASAC), which provides advice to the Government from the business and professional communities, also provided detailed comments on the proposals. There has been strong support from the business community for CLERP.

2.18 Following the release in March 1999 of the CLERP 6 Consultation Paper, an extensive public consultation process took place. The Minister for Financial Services and Regulation met with key stakeholders representing the interests of consumers, financial service providers and financial markets. In addition, Treasury and the Ministers office held public consultations in Sydney, Melbourne, Brisbane, Adelaide, Perth and Darwin, with over 400 interested parties. More than 120 submissions were received in response to the Paper, and officers of the Treasury have participated in over 80 meetings with stakeholders.

2.19 The consultation process in relation to the draft FSR Bill commenced upon the release of the Bill to the public on 11 February 2000. Treasury received over 100 submissions in response. Targeted consultation sessions with stakeholders were conducted in April 2000, and representatives from approximately 30 interest groups attended these sessions. Feedback from stakeholders represented at the round-table consultations was largely positive, although a number of refinements to the draft legislation were suggested. These suggestions have been taken into account in the final drafting of the FSR Bill.

Problem identification and regulatory objectives

2.20 Regulation in this area can be justified from a market failure perspective. The FSI identifies the market failures, and these are summarised above, along with the relevant recommendations of the Inquiry. The objectives of the FSI review were to develop a regulatory framework that is consistent, flexible, adaptable and cost effective. ^[F27]

2.21 CLERP is also aimed at improving the efficiency of the regulatory environment, reducing costs on business and industry participants, and removing barriers to entry for service providers. CLERP 6, now embodied in the FSR Bill, is intended to achieve these objectives in relation to the financial sector.

2.22 The following section details more specific problems with existing regulation and the solutions proposed by the Government in the FSR Bill. The proposed solutions follow very closely the recommendations of the FSI.

2.23 However, the 15 per cent shareholding limit in prescribed markets or clearing and settlement facilities, and the requirement for bidders and target companies involved in major takeovers to record telephone conversations with target shareholders, both now included in the FSR Bill, did not originate in the recommendations of the FSI.

Overview of FSR Bill

2.24 The FSR Bill was originally intended to amend the existing Corporations Law. However, the High Courts decision in the Hughes case last year questioned the constitutional basis for aspects of the existing Corporations Law. Agreement was reached with New South Wales and Victoria late last year on a referral of power to address the constitutional uncertainty. Once the necessary legislation is in place, the Commonwealth will be able to introduce the Corporations Bill 2001. The FSR Bill will then amend the proposed Corporations Act. This Regulatory Impact Statement (RIS) will therefore refer to the proposed Corporations Act, where appropriate.

2.25 The three key elements of the regime proposed in the FSR Bill are:

•

product disclosure;

•

licensing and conduct of financial services providers; and

•

licensing of financial markets and clearing and settlement facilities.

2.26 These features are explained in greater detail below. However, they all rely on a new definition of financial product, which replaces definitions in existing consumer protection legislation for securities, futures, insurance, superannuation, some banking products, and managed investments. The new definition is designed to be flexible, and starts with a general definition that focuses on three key functions provided by financial products, namely making a financial investment, managing a financial risk, and making non-cash payments. There is also a list of specific inclusions in the definition, and a list of specific exclusions. A regulation-making power provides further flexibility to include or exclude particular products from the regime as appropriate. This power will ensure the continuing relevance of the legislation as new financial products emerge.

2.27 Another key definition is that of retail client. The FSR Bill draws a distinction between retail and wholesale clients. Generally, the consumer protection provisions will apply only to retail clients, as it is recognised that wholesale clients do not require the same level of protection, as they are better informed and better able to assess the risks involved in financial transactions. The new definition of retail client has several limbs.

2.28 The first limb applies only to general insurance, and is product based. An individual or small business that purchases or receives advice on one of the listed general insurance policies will be considered a retail client. The list is based primarily on the concept of standard cover in the Insurance Contracts Act 1984 (Insurance Contracts Act), plus a couple of additional categories of policies also regarded by industry as consumer policies. A regulation-making power is included for flexibility. General insurance is treated differently from other financial products for two reasons. First, it is difficult to identify a meaningful monetary limit for insurance, as either the premium or sum insured could be used. Secondly, if the premium were relied upon, few (if any) policies would exceed the product-value test outlined below, with the result that all purchasers of general insurance policies would be retail clients. It is not desirable from a policy perspective to capture wholesale products, such as marine insurance and property insurance for businesses, which are also general insurance products. Such an approach would also be inconsistent with the concept of consumer insurance policies in existing insurance legislation.

2.29 The second limb provides that a person will always be considered a retail client where the relevant financial product is a superannuation product or a retirement savings account (RSA). This will ensure that disclosure is given to all persons in relation to superannuation and RSA products. This is consistent with the long term nature and complexity of such products and will ensure the integrity of the regime in a choice of superannuation fund environment.

2.30 The third provision relates to all financial products except general insurance, superannuation and RSAs, and comprises four tests. The product-value test provides that a person is not a retail client where they purchase a financial product, or a financial service related to a financial product, and the value of the product is above the prescribed threshold (to be set initially at $500,000). Regulations may modify the application of the test where appropriate. The second test ensures that small businesses receive protection as retail clients under the regime. The third test considers individual wealth and provides that a person with net assets of at least $2.5 million or a person who had a gross income for each of the last two financial years of $250,000 or more will not be considered retail. Finally, professional investors are always considered wholesale clients. This category includes financial services professionals, listed entities, banks and friendly societies, and other entities that may be presumed to have the expertise and/or access to professional advice to justify their being treated as wholesale.

Financial product disclosure

Problems/options

2.30 There are two major problems with existing regulation of financial product disclosure. First, functionally similar products are governed by disparate Acts and non-legislative instruments. In particular:

•

securities, futures and managed investments are covered by the proposed Corporations Act;

•

insurance is governed by the Insurance Contracts Act and codes of practice;

•

superannuation is governed by the Superannuation Industry (Supervision) Act 1993 (SIS Act); and

•

many retail banking products are subject to the Code of Banking Practice.

2.31 These instruments impose differing levels of disclosure in relation to the various products. It is therefore very difficult for consumers to compare different, but functionally similar, financial products.

2.32 Secondly, developments in the financial services industry have led to organisations now offering a range of financial products and services in relation to those products. The fragmented and product-specific nature of the existing legislation is hampering this development by imposing inconsistent standards and high compliance costs.

2.33 The proposed solution is to apply consistent disclosure requirements to all financial products, although with flexibility in the legislation to allow for significant differences between products. The requirements comprise point of sale disclosure through a Product Disclosure Statement, ongoing disclosure and periodic reporting requirements, advertising requirements, and an obligation to provide confirmation of transactions.

2.34 This disclosure regime will replace a range of existing disclosure regimes for financial products, such as those under the SIS Act and regulations, the Retirement Savings Accounts Act 1997 (RSA Act) and regulations, life insurance circulars, codes of practice governing deposit-taking institutions, and existing Corporations Law requirements for managed investments and futures. The new regime will also supplement, but not replace, requirements under the Insurance Contracts Act.

2.35 The new disclosure requirements will generally only apply to dealings with retail clients.

Costs/benefits

2.36 Industry will benefit from the introduction of consistent disclosure standards. Many entities that now offer several financial products, currently subject to different regulatory regimes, will benefit from having the same disclosure requirements apply to all products. This will ultimately decrease compliance costs, although industry will probably incur some costs in the initial stages associated with preparing the new disclosure documents required under the new regime. These costs are difficult to quantify and will vary between different product issuers. However, costs will be limited by the fact that the new disclosure regime is broadly in line with existing industry legislation, codes and practice. Further cost minimisation is assisted by transitional provisions which allow product issuers up to two years in which to move to the new regime. Most product issuers would need to update their disclosure documents over that two year period in any event as, under a number of existing regimes, existing disclosure documentation has a mandated shelf life of around 12 months. For example, life insurance disclosure documents must be updated every 12 months, the key features statement for superannuation funds is only current for 12 months, and prospectuses for managed investments last for 13 months.

2.37 Consumers will benefit from the new regime, as a consistent standard of disclosure will allow consumers to compare functionally equivalent financial products, and lead to increased consumer confidence and participation in the financial sector.

Feedback from consultations

2.38 Submissions are generally supportive of consistent disclosure standards, although there has been debate over the role of industry codes under the new regime. These comments have been taken into account in refining the FSR Bill.

Conclusion

2.39 The introduction of a consistent disclosure standard to apply to all financial products addresses consumers need for comparable information on products, while increasing industry efficiency and lowering compliance costs.

Licensing and conduct of providers of financial services

Problems/options

2.40 As with financial product disclosure, existing regulation of providers of financial services is product-specific and contained in a number of different Acts and non-legislative instruments. Again, this creates problems in a sector that is rapidly consolidating, where banks now offer stockbroking services and financial advisers provide advice on a broad range of financial products. These entities are obliged to obtain multiple licences and to comply with a range of legislation and non-legislative instruments that may be inconsistent in conduct and disclosure standards. Potential competitors are discouraged from entering the market by these complexities, and those involved in offering a range of services and products incur high compliance costs and an increased administrative burden.

2.41 Consumers are also disadvantaged by the current regulatory framework as they cannot be certain that the conduct of the financial service provider meets minimum standards. Consumers may also be confused by persons acting in several capacities, and therefore holding several licences. Further, consumers may not receive sufficient information in relation to certain matters, such as commissions on products.

2.42 The proposed solution is to introduce a single licensing regime applying to all persons providing a financial service, whether as principals or as authorised representatives. Financial services is defined in the FSR Bill as providing advice, dealing in, or making a market in financial products; operating a managed investment scheme; or providing a custodial or depository service.

2.43 The financial service provider and authorised representatives provisions will apply to the following classes of existing participants:

•

securities dealers and investment advisers;

•

futures brokers;

•

life insurance companies, general insurance companies;

•

superannuation funds;

•

life and general insurance brokers;

•

deposit taking institutions; and

•

their agents and employees.

2.44 The single licensing regime will therefore replace licensing requirements in the:

•

Proposed Corporations Act - applying to securities dealers, investment advisers, futures brokers and futures advisers, and their proper authority holders;

•

Insurance (Agents and Brokers) Act 1984 (IABA) - providing for the registration of general insurance and life insurance brokers and the regulation of insurance agents; and

•

Banking (Foreign Exchange) Regulations - applying to foreign exchange dealers.

2.45 The single licensing regime will also apply to product issuers (such as life insurance companies, friendly societies, general insurance companies, banks, superannuation funds) who carry on a financial services business and who:

•

engage agents to provide advice on and/or sell products to clients;

•

sell products directly to clients through direct response campaigns (irrespective of the medium through which these transactions occur, for example, direct mail campaigns, telephone sales or internet sales); or

•

sell products directly to clients over the counter.

2.46 Provisions in current insurance and superannuation regimes and the relevant parts of the SIS Act and the IABA will be repealed. In addition, the licensing provisions in Chapters 7 and 8 of the proposed Corporations Act will be replaced by these new provisions.

2.47 A licence will be required where services are provided to either wholesale or retail clients. Consistent conduct and disclosure standards will then apply to all licensees, but with some flexibility to tailor requirements to different services, and with additional obligations placed on licensees who provide services to retail clients. Examples of the conduct standards imposed on licensees include: a requirement to provide financial services in a competent and honest way; a requirement to comply with any conditions imposed by the Australian Securities & Investments Commission (ASIC) on the licence; obligations in respect of the handling of clients funds; and an obligation to maintain competence, skills and experience to provide financial services.

Costs/benefits

2.48 Industry will benefit from the new licensing regime in several ways. Both compliance costs and the administrative burden relating to conduct and disclosure will be reduced due to the new uniform standards, particularly for entities that offer several different financial services and would have required multiple licences under existing regulation. An example is life insurance advisers who also advise on or deal in securities, who are currently required to comply with requirements under both the insurance and securities regimes. This requires the adviser to be either a licensed securities dealer or proper authority holder under the existing Corporations Law and either a registered life insurance broker or life insurance agent under the life insurance regime.

2.49 However, there will be some costs associated with the move to the new licensing regime, although these are difficult to quantify. In particular, industry may incur costs in bringing their conduct and disclosure practices in line with the new regime, although in many instances the new requirements mirror or build on existing requirements in legislation or industry codes. The regime provides for a two year transitional period, which should also assist in the reduction of compliance costs. In fact, the submission from the Investment & Financial Services Association Ltd concludes that the FSR Bill will have a positive impact on the costs associated with the licensing and distribution of financial services. ^[F28]

2.50 The simplified procedures will also increase competition in the financial services sector, by encouraging existing participants to broaden the range of products and services offered by them to the public. Consumers will benefit from the increase in competition, through lower costs and a greater range of products and services, and from the more thorough conduct and disclosure regime. There will also be reduced risk of confusion due to participants holding several different licences to act in different capacities.

Feedback from consultations

2.51 Market participants generally support the introduction of a single licensing regime, recognising the benefits it will provide to industry.

Conclusion

2.52 In order to increase efficiency and competition, and to decrease the regulatory burden on providers of financial services, a single licensing regime will apply to providers of financial services.

Markets and clearing and settlement facilities

Problems/options

2.53 The primary problem in relation to Australian markets is the lack of competition in this sector, for the reasons outlined below.

2.54 Currently, there are only two approved securities exchanges operating in Australia - the ASX and the Stock Exchange of Newcastle Limited - and two approved futures exchanges - the SFE and the Australian Derivatives Exchange Limited. Similarly, there are only two approved clearing houses ^[F29] , the Securities Clearing House (SCH), which is associated with the ASX and is expressly recognised in the proposed Corporations Act, and the SFE Clearing House.

2.55 The problems in respect of exchanges arise largely from the distinction made in the proposed Corporations Act between securities and futures, which are currently regulated in separate Chapters. There are some inconsistencies between the two regimes as they were written at different times, and as separate Acts, prior to being included in the existing Corporations Law. Under existing law, exchanges can trade in only securities or futures contracts. The licensing regime is also complicated, as there are seven avenues of authorisation for operating a securities or futures market. Further, the distinction between securities and futures has become unsustainable due to the emergence of financial products bearing features of both securities and futures, which are very difficult to categorise as one or the other. Such products must currently be categorised as one or the other by means of regulations, which is complicated and cumbersome. Current arrangements therefore allow scope for regulatory arbitrage.

2.56 Competition in relation to clearing and settlement facilities is discouraged by the significant advantages conferred on the SCH under the existing provisions, such as its unique access to provisions which facilitate electronic transfer of legal title. While a person is not prevented from offering a competing service, the advantages enjoyed by the SCH would make the new facility uncompetitive in practice.

Costs/benefits

2.57 The Government aims, with the new regulatory regime, to increase competition in these areas by lowering the barriers to entry and encouraging new participants to operate competing markets and facilities. First, the new regime ends the current distinction between securities exchanges and futures exchanges by introducing a single licensing regime for financial markets. The single licensing regime will replace the seven avenues for authorisation as operators of various financial markets under the proposed Corporations Act. This will greatly simplify licensing procedures. Further, a suitably qualified market will be able to trade in any financial product, and in particular both securities and derivatives.

2.58 The new regime will enhance competition in respect of clearing and settlement facilities by extending the ability to carry out electronic transfers of trades to all prescribed facilities, ending the SCH competitive advantage in this regard.

2.59 The new regulatory framework is not intended to increase regulation, but will harmonise the legislation relating to securities and futures contracts.

2.60 The new regime also facilitates the participation of overseas markets and facilities in Australia. The Minister will be able to grant a licence to operate a market or facility in Australia, to the operator of an overseas market or facility where the operator satisfies certain criteria, such as being subject to a regulatory regime at least equivalent to that in Australia, and undertaking to co-operate with ASIC. Again, this measure should enhance competition by removing barriers to the entry of overseas facilities.

Feedback from consultations

2.61 Feedback on the proposals relating to markets and clearing and settlement facilities was largely positive, although some refinements were suggested. These have been taken into account in the drafting process, and modifications made where appropriate.

Conclusion

2.62 Competition will be greatly facilitated by the ending of the distinction between securities and futures contracts, by the extension of electronic transfer and title provisions to any prescribed clearing and settlement facility, and by the greater participation of overseas markets and facilities in Australia.

Problem/options

2.63 Another problem in relation to financial markets and clearing and settlement facilities is the 5 per cent shareholding limitation that currently applies to the ASX. The shareholding limitation, inserted when the ASX demutualised in 1998, by applying only to the ASX, does not provide regulatory neutrality, limits the manner in which the ASX can enter into partnerships with overseas exchanges, entrenches management control and lessens pressure for accountability to shareholders. Rigid ownership controls have the potential to weaken apparently strong existing market operators, such as the ASX, by making it difficult or slow to restructure to take advantage of strategic partnerships or otherwise adapt to changing circumstances (such as advent of the Internet). This problem was not identified in the FSI.

2.64 It is therefore proposed that shareholdings in prescribed markets or clearing and settlement facilities under the proposed Corporations Act be subject to a 15 per cent limit. Further, a person may apply in respect of their shareholding in a prescribed entity to the Minister for approval of a percentage limit higher than 15 per cent. Consideration of an application by the Minister will be separate from the licensing procedures in respect of markets and clearing and settlement facilities and approval will depend on the Minister deciding that holding a higher percentage of the voting power would be in the national interest.

2.65 This licensing regime will include a probity check requirement in the form of a 'fit and proper person test for persons involved in the management or control of a market or clearing and settlement facility. This test will apply to persons, who directly or through corporate entities, control 15 per cent of the voting shares (including shares held by associates); and persons who are the directors, secretary and executive officer of a company which operates a financial market or a clearing and settlement facility.

2.66 A person would not be 'fit and proper' if he or she is disqualified from managing a corporation under section 206B of the proposed Corporations Act; their name appears on the register kept by ASIC for the purposes of section 1274AA (persons whom a Court or ASIC has ordered not to manage a corporation); he or she has been declared by ASIC not to be fit and proper after notice has been given by ASIC, a hearing conducted and a report made to it (ASIC would make such a decision on a case by case basis). Decisions of ASIC are subject to review by the Administrative Appeals Tribunal.

2.67 Another option in relation to the shareholding limitation is self-regulation. However, a self-regulatory approach is likely to be criticised as lacking public transparency and accountability and leaving the integrity of Australia's prime securities markets and clearing and settlement facilities to decisions of the market or facility itself which clearly has limits on its ability to take action to prevent a particular party from gaining control. Legislation is required to put a limitation on the acquisition of shares and to give time for an assessment of the acquirer to occur. Quasi-regulation and co-regulation also appear unsuitable for similar reasons.

Costs/benefits

2.68 The proposal will involve some minor costs to the relevant financial markets and clearing and settlement facilities (including the ASX) in providing additional information to the Minister. It is not expected to have any significant cost to ordinary shareholders. Substantial shareholders may incur some minor additional costs in disclosing the required information and run the risk of being unable to obtain a larger shareholding. The ASX management may be disadvantaged by the proposal as it would lose some of the protection afforded by the current fixed shareholding limitation (but directors who hold significant parcels of shares in the ASX may benefit from an increase in their value). The cost to government of the proposal is considered to be negligible, and no additional funds are sought from Consolidated Revenue.

2.69 The benefits of the proposal are significant. The proposed amendment is regulatory neutral and will improve competition. The ASX will benefit as a flexible ownership limitation will allow it to adapt to the rapidly changing environment in which it is operating. It is undesirable that the ASX be subject to limitations not imposed on its competitors, in an era of increased competition when particularly wholesale investors can, in many instances, easily arrange for their instructions to be executed through overseas markets which are evolving rapidly. The possibility of persons acquiring more than a 15 per cent shareholding will subject the ASX management to increased business pressures to perform. This is likely to result in a more competitive and efficient market, with advantages for participants and shareholders. ASX shareholders may also be advantaged by implementation of the proposal as it is expected that the current fixed limitation has a downward effect on the price of the shares in the ASX.

2.70 The shareholding limitation provides an appropriate safeguard to the national interest. It will be possible to stop a dominant shareholder emerging if this were not in the national interest. Otherwise, the cost to the community of an unscrupulous operator gaining control of prescribed entity could be high, as it would present a serious threat to market participants and cause significant damage to Australia's international reputation for fair and orderly financial markets.

Feedback from consultations

2.71 The ASX opposes retention of the current 5 per cent limitation.

Conclusion

2.72 The increase in the ownership limitation from 5 per cent to 15 per cent (with the ability to increase this limit with approval of the Minister), and its application to other prescribed entities regulated under the proposed Corporations Act will provide commercial flexibility in a rapidly changing competitive environment while ensuring the national interest is preserved.

2.73 The fit and proper test will provide assurance that only persons of probity are involved in the management and control of financial markets and clearing and settlement facilities and assist in maintaining the reputation and confidence in Australia's markets.

Market Misconduct

Problems/options

2.74 Existing market misconduct provisions cover market manipulation, false trading and market rigging, dissemination of information about illegal transactions, false and misleading statements, and fraudulently inducing persons to deal. There are currently two sets of provisions - one for securities and one for futures contracts. As discussed above, the FSR Bill ends the legislative distinction between securities and futures contracts. Moreover, the two sets of provisions were drafted at different times and are inconsistent in some respects.

2.75 A similar problem arises in relation to existing insider trading provisions. These are contained in Chapters 7 and 8 of the proposed Corporations Act, and in the SIS Act. Again, the provisions are not entirely consistent in their application to the different financial products.

2.76 Further, the general market misconduct provisions and the insider trading provisions do not apply to all financial products that may be traded on a financial market. This leaves open the possibility that the same conduct may be an offence only in relation to certain financial products. This is undesirable from a policy perspective, and contrary to the aim of the FSR Bill to regulate functionally similar financial products in a consistent manner.

2.77 It is therefore proposed to consolidate the different sets of provisions, and then extend the single set of provisions to cover all financial products that may be traded on a financial market. In light of the changes that will be made by the FSR Bill, there does not appear to be any other viable option but to amend the market misconduct and insider trading provisions as proposed above.

2.78 Another major problem that exists in relation to the market misconduct and insider trading provisions, is the difficulty ASIC has in successfully prosecuting a breach of the provisions. As the existing provisions are offence provisions, the criminal burden of proof (beyond reasonable doubt) applies. ASIC has found it difficult to prove elements of the offences beyond reasonable doubt, as many elements refer to the defendants state of mind. This difficulty may result in cases not being pursued even where there has been a breach of the provisions. This is undesirable as it casts the law into disrepute, and also threatens the integrity of financial markets.

2.79 It is therefore proposed to make the market misconduct and insider trading provisions civil penalty provisions. The application of the civil burden of proof (balance of probabilities) will facilitate the bringing of actions for breaches of the provisions. The application of civil penalties is likely to act as a deterrent to market misconduct.

Another option is to redraft the offence provisions to make them easier to prosecute. However, significant objections to such a proposal may be anticipated given that criminal sanctions would apply to contraventions.

Costs/benefits

2.80 There are no obvious costs associated with the proposed changes.

2.81 Consumers and industry will benefit from the consistent regulation of functionally similar products, as they can be certain about the type of behaviour that is prohibited in relation to all relevant financial products.

2.82 The high reputation enjoyed by the Australian financial markets, and consumer confidence in the integrity of the markets, will benefit from the application of civil penalties to market misconduct and insider trading provisions.

Feedback from consultations

2.83 There were very few comments on the proposed changes to the market misconduct and insider trading provisions, and no objections to the proposal to make a single set of provisions apply to all financial products that may be traded on a financial market.

2.84 ASIC is very keen to have the market misconduct and insider trading provisions become civil penalty provisions, on the grounds that this will enhance its ability to safeguard the integrity of Australian financial markets.

Conclusion

2.85 The consolidation of the different sets of market misconduct and insider trading provisions, and their application to a broader range of financial products, is necessary in light of the changes brought about by the policy objectives of the FSR Bill.

2.86 Breaches of the market misconduct and insider trading provisions must be punished to ensure the integrity of Australian financial markets. ASICs ability to enforce these provisions will be enhanced by making them part of the civil penalty regime.

Telephone monitoring

Problem/options

2.87 The use of the telephone to communicate with individual shareholders during major takeover bids is becoming commonplace. Professional communications consultants are often used by both the bidder and the target company to contact target company shareholders by telephone. There is the possibility that during these telephone conversations breaches of the proposed Corporations Act could take place, particularly in relation to misleading or deceptive conduct. However, it would currently be difficult to establish that such breaches had occurred as it is unlikely that either party would have a record of the conversation. This problem was not identified in the FSI.

2.88 It is proposed that the law be amended to require bidders and target companies to record telephone conversations with target shareholders. The policy objective is to provide a greater level of protection for small shareholders from these potential breaches of the proposed Corporations Act. It is proposed to insert new provisions into Chapter 6 of the proposed Corporations Act (in Division 5, Part 6.5) requiring the recording of these communications. The provisions will only apply to major takeovers, where the target company is either a listed company or an unlisted company with more than 50 members as these are these are the kinds of takeovers that are regulated under the proposed Corporations Act.

2.89 ASIC put forward an alternative proposal, under which bidders, target companies and their agents would be prohibited from communicating by telephone with target company shareholders during the course of a takeover bid, other than with the consent of ASIC. However, this proposal is contrary to one of the basic principles of takeover regulation, that target company shareholders are given enough information to enable them to assess the merits of the bid.

Costs/benefits

2.90 If the proposed provisions are introduced, bidders and target companies will incur costs associated with the training of staff in the requirements of the new provisions, the provision of appropriate recording devices, and costs involved in identifying and storing recordings.

2.91 However, the provisions will benefit small shareholders by ensuring that bidders and target companies comply with the Law in their dealings with these shareholders. The provisions will also benefit the bidders and target companies by protecting them from costly legal disputes in the event of any accusation by shareholders of misleading and deceptive conduct arising from telephone canvassing.

Feedback from consultations

2.92 These provisions were not included in the exposure draft FSR Bill and therefore have not been subject to extensive public consultation. However, given the privacy implications, the Attorney-Generals Department and the Federal Privacy Commissioner were consulted. The Privacy Commissioner has expressed concern that the proposed provisions have not been subject to public consultation, and has recommended the inclusion in the FSR Bill of an alternative method for providing shareholders with information if they do not wish to participate in a monitored telephone call, and a sunset clause subject to a trial period and review of the proposal. In relation to the second point, it should be noted that all shareholders are provided with the relevant takeover documents as required by existing takeover provisions. The telephone calls are generally not intended to provide further information, but to canvass the opinions of shareholders in relation to the proposed takeover.

2.93 ASIC was also consulted and advised that it currently deals with this potential problem by reviewing the scripts provided by bidders and target companies to telephone canvassers to make the relevant calls to shareholders. ASIC suggested several refinements to the proposed provisions that have been taken into account in the drafting process. As noted above, ASIC also put forward an alternative proposal that all telephone communications during a takeover bid be banned.

2.94 The telephone monitoring provisions were also forwarded to the BRAG and to the Ministerial Council on Corporations (MINCO) for their consideration. BRAG and MINCO have not commented on the proposed provisions.

Conclusion

2.95 As more Australians become shareholders, the risk that some shareholders will be misled or deceived by bidders or target companies during a takeover bid becomes greater. The most straightforward and cost effective means of dealing with this problem is to introduce the proposed provisions requiring the taping of all telephone conversations to shareholders initiated by bidders and target companies.

Implementation and review

2.96 The reforms are being implemented through changes to the proposed Corporations Act. The FSR Bill introduces a new Chapter 7 into the Act.

2.97 The reforms contained in the Bill will be reviewed after the two year transition period for their implementation. The review of the Bills new licensing regimes will be conducted by Treasury and ASIC, and will assess the effectiveness of the associated administrative arrangements, and the longer-term resource requirements for ASIC in administering the licensing regimes. The new financial product disclosure regime will be reviewed by CASAC.