In brief
Written by Partner Geoff Sanders and Senior Associate Jo Ottaway
The Government has recently registered the Financial System Legislation Amendment (Resilience and Collateral Protection) Regulation 2016 which, among other foreshadowed changes, helps clear the way for trustees of regulated superannuation funds to charge fund assets in order to enter into a broad range of exchange-traded and Over-The-Counter derivative transactions. The changes are intended to facilitate better access to international derivative markets in the post-GFC environment and will no doubt be welcome news for the superannuation industry.
Background
Regulation 13.14 of the Superannuation Industry (Supervision) Regulations 1994 (the SIS Regulations) prohibits a trustee of a superannuation fund from giving a 'charge' (which is broadly defined to include a mortgage, lien or 'other encumbrance') over, or in relation to, fund assets.
This general prohibition has long been subject to an exception for charges in relation to certain narrowly defined exchange-traded 'derivatives contracts', required to be given in order to comply with the rules of an 'approved body'. As highlighted in our earlier Client Update, this exception was problematic, largely because it was outdated and too limited in its scope; problems which have only worsened in light of the G20 derivative reforms.
New Derivative Charging Rules
The amendments to Regulation 13.15A of the SIS Regulations have addressed the bulk of the issues arising out of the previous exception, while at the same time, arguably creating a few new ones for super fund trustees to deal with, as outlined below.
Expanded definition of 'derivative'
As expected, the existing definitions of 'derivative' and 'derivatives contract' have been replaced with a much broader and more inclusive definition of 'derivative', which incorporates the concepts of:
- a 'derivative' and a 'foreign exchange contract' (within the meaning of Chapter 7 of the Corporations Act 2001 (Cth)); and
- certain commodity derivative arrangements, which are excluded from the Corporations Act definition of a 'derivative'.
This new, enhanced definition of 'derivative' should be sufficient to cover the vast majority of derivative contracts that super fund trustees may wish to enter into in order to manage risk.
Updated list of approved bodies
The list of 'approved bodies' in Schedule 4 of the SIS Regulations has also been updated to reflect current domestic and international exchanges and clearing houses. In total, 143 bodies have been designated as 'approved bodies', with a catch all for 'a body that performs clearing house functions, in relation to an approved body that does not itself perform those functions, in accordance with the rules of the approved body or a law of the country where the approved body is situated.'
It had been anticipated that this list would be maintained separately from the SIS Regulations, which would have facilitated more timely updates. However, to date, this has not eventuated.
Expanded circumstances in which a charge may be given
Regulation 13.15A now contains three circumstances in which a charge may be given in relation to derivatives, namely:
- Sub regulation 13.15A(1A): where the charge is given in order to comply with a requirement that the performance of obligations relating to a derivative be secured under either:
- a rule governing the operation of an 'approved body'; or
- a law of the Commonwealth, a state, a territory or a foreign country that applies to dealing in derivatives.
This first category essentially expands on the old requirement in former Regulation 13.15A(1)(b) to include relevant domestic and international laws. Clearly, this category would apply to exchange-traded derivatives. However, it will also now apply to Over-The-Counter (OTC) derivatives that are centrally cleared, to the extent that the transaction documents are consistent with the rules governing the operation of the clearing house (which we would hope to be the situation in the majority of cases).
- Sub regulation 13.15A(1B): where the charge is given to an agent to secure the performance of obligations under a derivative, in circumstances where the agent:
- enters into the derivative on behalf of the trustee; and
- is obliged (under the rules of an 'approved body' or a relevant law) to keep the property of the trustee separate from the property of the agent; and
- is obliged (subject to netting-off) to transfer property to another entity.
This second category is designed to facilitate compliance with foreign margining requirements, where the segregation of client assets is required, eg when dealing with FCMs (Futures Commission Merchants) in the US. This exemption would also apply to both exchange-traded derivatives and OTC derivatives that are centrally cleared.
- Sub regulation 13.15A(1C): where the charge is given over 'financial property' (as defined in the Payment Systems and Netting Act 1998 (Cth)) to secure certain obligations of the trustee relating to a derivative (including interest obligations and the obligation to pay costs and expenses associated with enforcing a charge over such obligations), where the financial property is transferred or otherwise dealt with so as to be in the possession or control of the secured person, or another person on behalf of the secured person under a written arrangement.
This third category aims to accommodate circumstances where, although there may not be a legal requirement (ie at law or under the rules of an approved body) to grant security relating to an exchange-traded derivative, or a cleared or uncleared OTC derivative, it is nevertheless required for contractual or other commercial purposes.
The concepts of 'possession' and 'control' will clearly be crucial here and the amended regulation details certain circumstances where the requirements will, or will not, be deemed to be complied with (see sub regulations 13.15A(1D)-(1G)). The United Kingdom has grappled with similar concepts in the Financial Collateral Arrangements (No. 2) Regulations 2003. Sub regulation 13.15A(1G) has been introduced to clarify some issues raised in the UK, namely the fact that the trustee retains a right to:- receive and withdraw income in relation to a financial property;
- receive notices in relation to a financial property;
- vote in relation to a financial property;
- substitute other financial property that the parties agree is of equivalent value for the financial property;
- withdraw excess financial property; and/or
- determine the value of financial property,
such rights are not inconsistent with the trustee having transferred or otherwise dealt with a financial property so as to be in the 'possession or control' of the secured person or another person on the secured person's behalf.
Where to from here?
The amendments commenced on the 11 May 2016 and we have already started advising clients on the application of the provisions. While the amendments are broadly facilitative of exchange-traded derivatives and centrally-cleared OTC derivatives (whether under sub regulation 13.15A(1A) or (1B)), super fund trustees will still need to undertake due diligence to ensure that the exchanges and clearing houses that they intend to transact through are 'approved bodies' and that the terms of the agreements entered into are in fact consistent with the rules of such approved bodies or other domestic or international laws.
In addition, in the context of OTC derivatives that are not centrally cleared, careful analysis of the transaction documents will be required to ensure that the arrangements put in place for dealing with collateral are not inconsistent with the requirements for 'possession or control'. For example, one issue that has surfaced already, is how the concepts of 'possession' and 'control' interact with the rights of a secured counterparty to 're-use', 're-pledge' or 're-hypothecate' posted collateral. For those unfamiliar with derivative transaction documents, this is likely to be a somewhat painful process.
Finally, it is important not to overlook the requirement for the fund to have a derivatives risk statement as required by Regulation 13.15A(1)(c), especially as the derivative to which the charge relates must be made in accordance with that statement. To date, it is likely that this statement has only covered exchange-traded derivative contracts, so it is anticipated that most, if not all, super funds will need to revisit and update these documents.