Draft rules and more consultation for the Asia Region Funds Passport

In brief

APEC's Working Group on the proposed Asia Region Funds Passport has issued a second consultation paper on the rules and operational arrangements for the Passport, and seeks views from the public on a limited number of issues. Managing Associate Janna Vynokur and Senior Associate Matthew Symmons report on the proposed rules and remaining consultation items, and outline some of the outstanding hurdles to the establishment and success of the Passport regime.

• If the Passport is implemented, Australian fund managers will be able to rely on the streamlined regulatory processes to market their eligible managed funds to investors in the Asia region.
• Only Australian fund managers and their registered schemes which satisfy the prescriptive eligibility criteria will be able to use the Passport. Funds operated by smaller fund managers, unlisted property funds and hedge funds will not be able to participate in the Passport regime.
• The requirement for Australian fund managers to comply with the foreign host Passport economy licensing requirements for financial product advice and local product disclosure requirements may make the Passport regime unattractive and burdensome to use.
• A second round of public consultation regarding a limited number of issues has just commenced, and will close on 10 April 2015.

Are we there yet?

The main public consultation process for APEC's proposed Asia Region Funds Passport closed in July 2014. APEC's Working Group, which consists of Australia, South Korea, New Zealand, the Philippines, Singapore and Thailand, has now released its second consultation paper.

The Passport aims to facilitate cross-border distribution of managed funds products across Asian economies where collective investment products offered in one Passport economy can be sold to investors in another Passport economy. Currently, funds are manufactured, distributed and administered within each jurisdiction, with no transferability across borders (apart from a limited number of bilateral arrangements such as between Australia and New Zealand and Australia and Hong Kong).

If the Passport is implemented, Australian fund managers may rely on the streamlined regulatory processes to market their eligible funds to Asian investors in participating economies. However, the draft rules and operational arrangements for the Passport indicate that only some Australian fund managers, and only some registered schemes that meet the prescriptive eligibility criteria, will be able to use the Passport. Restrictive criteria covering permitted asset classes, gearing, short selling, use of derivatives, redemption and minimum funds under management requirements mean that many funds that are offered by fund managers to retail investors in Australia (including those operated by smaller fund managers, unlisted property funds and hedge funds) will not be able to use the Passport.

In addition, the proposed licensing requirements for the provision of financial advice and the offering of financial products, and product disclosure requirements of the host Passport economy that will apply to Australian fund managers, may make it unattractive and burdensome for Australian funds to be offered in some participating economies, and difficult to compete with more familiar passport arrangements such as the European UCITS regime.

Finally, the remaining reforms on the investment management regime, removing tax uncertainties and creating competitive tax settings will need to be fully implemented to attract foreign investment to Australia, promote the export of Australian fund management services and make the Passport a success.

New timeline

The Initial Statement of Intent for the Passport envisaged commencement in January 2016. The second consultation paper provides for the following revised milestone implementation dates:

When at least two economies give effect to the Passport arrangements, eligible collective investment schemes in these economies can access the Passport arrangements.

Which Australian funds will qualify as eligible funds?

To participate in the Passport regime, an Australian fund will need to be a registered managed investment scheme under Chapter 5C of the Corporations Act 2001 (Cth) and satisfy all of the applicable eligibility criteria set out in the final version of the MOU.

As mentioned in our first article on the Passport, unlike the Australian approach, where the Australian Securities and Investments Commission (ASIC) concentrates on ensuring adequate disclosure is made in relation to funds to be offered to retail investors, many Asian jurisdictions require that their funds meet particular investment criteria or restrictions (such as investment concentration limits or gearing prohibitions) before they can be offered to the public. The latter approach is reflected in the draft Passport rules, which list the following key criteria that Australian fund managers should be aware of in considering whether to have their funds admitted to the Passport regime.

• Permitted asset classes: A Passport fund may only acquire and hold the following assets: currency, deposits, depository receipts over gold, transferrable securities (including shares, bonds and interests in collective investment schemes, but not transferrable securities that are partly paid) and money market instruments. In addition, all assets will be subject to a geographical test such that Passport funds can only hold assets that are issued and offered in a jurisdiction whose securities regulator is an ordinary or associate member of the International Organization of Securities Commissions (IOSCO).
• Restrictions on portfolio allocation: A Passport fund will be subject to seven very detailed portfolio allocation limits (with corresponding exceptions). These are based on those that apply to the European UCITS regime. They are: a 'graduated' single entity limit restriction; a group limit; a collective investment scheme limit; a limit on unquoted shares, stocks and interests in investment schemes (other than regulated collective investment schemes); a limit on conferring significant management influence; a limit on the share of securities or money market interests on issue; and a limit on depository receipts over gold.
• Limited use of derivatives and securities lending: The draft rules allow for limited use of certain types of derivatives by Passport funds and impose restrictions on securities lending arrangements.
• Limited gearing: In general, a Passport fund could not borrow money or other assets or obtain finance. However, borrowing is expected to be allowed for limited purposes and where a series of other conditions are met, including that the amount raised is no more than 10 per cent of the Passport fund's net asset value.
• No short selling: The draft rules do not currently allow Passport funds to short sell for investment purposes (either synthetically or physically) – although the Working Group is seeking supplementary feedback on this restriction.
• Redemption requirements: Subject to limited suspension rights, a Passport fund must always pay redemption proceeds within 15 days from receipt of the redemption request.
• Complaints: Certain requirements will apply to enable foreign investors and foreign regulators to take legal action in their home economies against Australian responsible entities. We expect that these requirements will necessitate amendments to constitutions of Australian registered schemes wishing to use the Passport.
• Limits on performance fees: A fund manager will not be able to charge a fee that is based on any returns of the Passport fund unless specified circumstances are satisfied (including that the basis for the fees charged does not result in excessive risks being taken by the responsible entity).

In addition to the fund eligibility criteria, Australian fund managers will need to meet the following requirements in order for any of their funds to qualify to participate in the Passport regime:

• Operator requirements: Responsible entities will need to ensure that they satisfy the requirements relating to the responsible entity's experience (including its track record and the qualifications of its officers), capital adequacy requirements (there will be a minimum equity requirement of US$1 million), good standing and to have at least US$500 million under management.
• Annual compliance review: Passport funds will be required to appoint an auditor to conduct an annual compliance review.
• Home country public offer: For Australia to be the home country for a particular Passport fund, there will need to be a nexus between the responsible entity's business activities and Australia. One way of satisfying this requirement is for there to be an ongoing bona fide public offer of interests in the relevant Passport fund in Australia and for the offer to be subject to the Australian registered scheme legal and regulatory regime.

The process for offering Passport funds in participating Asian economies – not straightforward

The first step for an Australian fund manager wishing to have one of its funds admitted to the Passport regime will be for it to lodge an application with ASIC. Once a Passport fund is authorised by ASIC, its responsible entity will then have to make separate applications to each host economy regulator of those jurisdictions in which it wishes to make offers.

While the Working Group has acknowledged the concerns of some stakeholders about the need to go through a host economy approval process, rather than a notification process (of the sort that applies under the European UCITS regime), the Working Group has stated that it believes that this more cumbersome process is necessary in order to facilitate the establishment of the Passport, given the diversity of the rules and regulation within the different economies.

In its approval process for an Australian fund, a foreign host regulator will be entitled to request other documents that are required to be prepared under the host economy's laws that apply to the Passport fund and would apply to local regulated collective investment schemes offered to the public in the host economy. For example, some economies require point of sale disclosure documents to be submitted to the regulator at the time of application.

While a number of submissions for the main consultation process requested standardised disclosure and key investor information, as exists for the European UCITS regime, the laws of a host economy will apply to offers made in that jurisdiction, such that Australian fund managers are likely to need to prepare separate disclosure documents for each jurisdiction, and offshore operators will have to prepare product disclosure statements in order to make offers to Australian retail investors. Host economy laws will also apply to fund labelling, annual and periodic reporting, distribution and the licensing of fund managers operating in the host economy (although Australian fund managers will be able to market their Passport funds through qualified distributors in the foreign host economy without needing to obtain a local licence).

In formulating the Passport's rules, the Working Group is having to balance the commercial reality and the public and economic policy objectives of regional governments (including investor protection). Even so, 'duplicative' requirements (such as those that will mandate multiple disclosure documents) raise concerns about the attractiveness and commercial viability of the Passport regime compared with other systems, such as the European UCITS regime, which already attracts substantial investments from Asian investors.

Further consultation

For the final public consultation process that is currently underway, the Working Group is seeking feedback from interested parties only for the 10 consultation questions (compared with the 41 questions for the previous main consultation process). These new questions ask:

• whether there are adequate avenues through which an operator is able to market a Passport fund without obtaining a licence in a foreign economy;
• whether or not it is appropriate to set the currency as the US dollar for the purposes of assessing a fund operators' capital adequacy requirements, given possible fluctuations in exchange rates;
• whether physical or synthetic short selling should be restricted and, if so, what safeguards would be appropriate to mitigate risks associated with short selling;
• a number of questions in relation to the detailed portfolio allocation restrictions (including the graduated single entity limit);
• whether the proposed rules regarding the charging of performance fees will be unduly burdensome;
• whether the proposed rules over the suspension of redemptions will be too restrictive; and
• whether the proposed approach to calculating the value of particular derivative arrangements is appropriate.

We would be delighted to discuss any particular concerns or comments that you have in relation to the Passport and its proposed rules, or to assist you in making a submission to the final consultation process, which closes on 10 April 2015.