Note: Where available, the PDF/Word icon below is provided to view the complete and fully formatted document
Treasury Laws Amendment (2016 Measures No . 1) Bill 2016
Go To First Hit

Bill home page  


Download WordDownload Word


Download PDFDownload PDF

2016

 

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

 

 

 

HOUSE OF REPRESENTATIVES

 

 

 

Treasury Laws Amendment » (2016 MeaSures « No » . 1) « Bill » 2016

 

 

 

EXPLANATORY MEMORANDUM

 

 

 

 (Circulated by authority of the

Minister for Revenue and Financial Services, the Hon Kelly O’Dwyer MP)



Table of contents

Glossary.............................................................................................................. 1

General outline and financial impact............................................................ 3

Chapter 1               « Amendment » to the scope of the Terrorism Insurance Act 2003      9

Chapter « 2 »               Improving Employee Share Schemes............................ 45

Chapter 3               Deductible gift recipients.................................................. 61

Chapter 4               Ex-gratia disaster recovery payments to New Zealand SCV holders         65

Chapter 5               Derivative money of retail clients..................................... 71

Index............................................................................................................... 137

 

 



The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation

Definition

AAT

Administrative Appeals Tribunal

AFSL

Australian financial services licensee

AGA

Australian Government Actuary

AGDRP

Australian Government Disaster Recovery Payment

APRA

Australian Prudential Regulation Authority

ARPC

Australian Reinsurance Pool Corporation

ASIC

Australian Securities and Investments Commission

ASX

Australian Securities Exchange

CASS

Client Assets Sourcebook

CFD

Contract-for-difference

Corporations Act

Corporations Act 2001

Corporations Regulations

Corporations Regulations 2001

DGR

Deductible gift recipient

DRA

Disaster Recovery Allowance

DRP

Ex-gratia Disaster Recovery Payment

DTI

Declared Terrorist Incident as defined in the Terrorism Insurance Act 2003

ESS

Employee Share Scheme

FCA

Financial Conduct Authority

Financial System Inquiry

Financial System Inquiry 2014

(David Murray AO, Chairman)

ISA

Ex-gratia Income Support Allowance

issuing company

Company which issues the ESS interests under the ESS

ITAA 1936

Income « Tax » Assessment Act 1936

ITAA 1997

Income « Tax » Assessment Act 1997

NBCR

Nuclear, biological, chemical and radiological risks

OAIC

Office of the Australian Information Commissioner

OECD

Organisation for Economic Co-operation and Development

OTC

over-the-counter derivatives

Pool Re scheme

Pool Reinsurance Company Limited scheme

pre-lodgment year

Issuing company’s most recent income year before the year in which the disclosure document is lodged with ASIC

Privacy Act

Privacy Act 1988

RIS

Regulation Impact Statement

SCV

New Zealand special category visa

(subclass 444)

Terrorism Insurance Act

Terrorism Insurance Act 2003

the scheme

Terrorism Insurance Scheme

Wallis Inquiry

Financial System Inquiry 1997

(Stan Wallis AC, Chairman)



« Amendment » to the scope of the Terrorism Insurance Act 2003

Schedule 1 to this « Bill » amends the Terrorism Insurance Act 2003 (Terrorism Insurance Act) to clarify that losses attributable to terrorist attacks using chemical or biological means are covered by the terrorism insurance scheme under the Terrorism Insurance Act.

Date of effect This measure applies from 1 July 2017.

Proposal announced The Terrorism Insurance Act Review 2015 was published on the Treasury website on 15 December 2015. 

Financial impact The « amendment » in schedule 1 does not have a financial impact.  

Human rights implications :  This Schedule does not raise any human rights issue. See Statement of Compatibility with Human Rights — Chapter 1, paragraphs 1.177 to 1.180.

Compliance cost impact There are « no » compliance cost impacts arising from this « amendment » .

Summary of regulation impact statement

Regulation impact on business

Impact This « amendment » to remove doubt about whether losses attributable to terrorist attacks using chemical or biological means are covered by the terrorism insurance scheme under the Terrorism Insurance Act could create regulatory costs for insurers, as they may need to closely consider the impact of these amendments on their business. However, these regulatory impacts are unquantifiable and are likely to be minor

Main points :

•        Under section 41 of the Terrorism Insurance Act, the Minister is required to prepare every three years a report that reviews the need for the Terrorism Insurance Act to continue in operation.

•        The latest review, which was completed in 2015, has been certified to have undertaken a process and analysis equivalent to a Regulatory Impact Statement, and is included in Chapter 1 below.

Improving Employee Share Schemes

Schedule « 2 » to this « Bill » amends the Corporations Act 2001 (Corporations Act) so that employee share scheme (ESS) disclosure documents lodged with the Australian Securities and Investments Commission (ASIC) are not made publicly available for certain start-up companies.

Date of effect : These amendments apply from the date of commencement which is the day after Royal Assent.

Proposal announced : The proposal was announced as part of the National Innovation and Science Agenda on 7 December 2015.

Financial impact : None

Human rights implications : This Schedule does not raise any human rights issue. See Statement of Compatibility with Human Rights - see Chapter « 2 » , paragraphs 2.42 to 2.45.

Compliance cost impact : None

Deductible gift recipients

Schedule 3 to this « Bill » amends the Income « Tax » Assessment Act 1997 (ITAA 1997) to add six organisations as deductible gift recipients: The Australasian College of Dermatologists, College of Intensive Care Medicine of Australia and New Zealand, The Royal Australian and New Zealand College of Ophthalmologists, Australian Science Innovations Incorporated, The Ethics Centre Incorporated and Cambridge Australia Scholarships Limited.

Date of effect : The law takes effect on commencement.

Proposal announced : The measure was announced in the 2016-17 Budget.

Financial impact : These amendments will have the following financial impact:

  2015-16

2016-17

2017-18

2018-19

2019-20

-

..

-0.1

-0.1

-0.1

- considered to be zero

.. considered not to be zero but rounded to zero

Human rights implications : This Schedule does not raise any human rights issue. See Statement of Compatibility with Human Rights — Chapter 3, paragraphs 3.20 to 3.23.

Compliance cost impact : Nil.

Ex-gratia disaster recovery payments to New Zealand special category visa (subclass 444) holders

Schedule 4 to this « Bill » provides income « tax » relief to eligible New Zealand special category visa (subclass 444) (SCV) holders who are impacted by disasters in Australia by:

•        amending the Income « Tax » Assessment Act 1936 (ITAA 1936) to provide a « tax » rebate for the ex-gratia Income Support Allowance (ISA), and

•        amending the Income « Tax » Assessment Act 1997 (ITAA 1997) to provide an income « tax » exemption for the ex-gratia Disaster Recovery Payment (DRP).

Date of effect This measure applies to ex-gratia ISA and DRP payments received for disasters occurring in the 2014-15 year and later years.

Financial impact Negligible.

Human rights implications :  This « Bill » does not raise any human rights issues. See Statement of Compatibility with Human Rights — Chapter 4, paragraphs 4.29 to 4.32.

Derivative money of retail clients

Schedule 5 to the Treasury Laws « Amendment » (2016 Measures « No » . 1) « Bill »  2016 amends the Corporations Act 2001 (Corporations Act) to provide greater protection for retail client money and property held by financial services licensees in relation to over-the-counter derivative products. These amendments align the Australian client money regime with community expectations regarding the level of protection that should be afforded to retail consumers of complex financial products and services.

Date of effect :  The amendments made by this Schedule commence on the day after the end of the period of 12 months beginning on the day the Treasury Laws « Amendment » (2016 Measures « No » . 1) « Bill »  2016 receives Royal Assent.

Certain amendments made by this Schedule apply to uses of retail client money and property on or after commencement, whether the money or property was paid to the licensee before, on or after that commencement.

Proposal announced On 20 October 2015, the Government announced that it would develop legislative amendments to improve protections for client monies held in relation to derivatives. This commitment was made as part of the Government’s response to the Financial System Inquiry.

On 22 December 2015, the Government released a policy paper, ‘Enhanced Protection of Client Money’, to explain and consult on the proposed changes. An Exposure Draft of this Schedule was also released for consultation on 29 February 2016.

Financial impact The financial impact of the amendments made by this Schedule is nil.

Human rights implications :  This Schedule does not raise any human rights issue. See Statement of Compatibility with Human Rights — paragraphs 5.288 to 5.291.

Compliance cost impact The reform will deliver an overall net benefit. While licensees’ compliance costs will increase by around $517,000, the reform should promote investor confidence in the industry and its regulation and will markedly enhance retail consumer protections. The costs do not reflect the cost to business for any loss of revenue due to changes in the law.

Summary of regulation impact statement

Regulation impact on business

Impact The measure will impact Australian financial services licensees that provide retail derivatives, in particular, over-the-counter issuers.

Main points :

•        The current regulatory framework does not adequately protect retail clients, as it exposes their over-the-counter derivative client money to risks they may not be aware of.

•        Licensees have few restrictions on how they can deal with client monies connected to over-the-counter derivatives, whereas other client money (connected with other financial services and products) is generally to be held in trust.

•        Investor confidence depends on robust and responsive regulation of the financial system. Inappropriate risks can undermine the confidence in the financial system, especially where those risks are not able to be overseen by regulators or understood by investors, particularly retail investors. The Australian Securities and Investments Commission (ASIC) as the financial services regulator is unequivocal about the need for reform in this area.

•        To better protect retail clients, the Government has considered prohibiting licensees use of over-the-counter derivative client money; continuing to allow AFSLs to use over-the-counter derivative client money to hedge, provided there are safeguards in place; and maintaining the status quo.

•        The Government has consulted extensively on its reform package. In late 2015 and early 2016, the Government sought public comment on a policy paper, draft legislation and regulation. Since then, officials have met with a broad range of stakeholders - including Australian financial services licensees, regulators, and other experts - to explore and test the case for change.

•        Having considered the available options for reform, the Government has concluded that by prohibiting the use of retail over-the-counter derivative client money by Australian financial services licensees for their own and other clients’ purposes, client money will be much safer and investor confidence in the industry likely to increase.

•        Following a one year transition period for industry, the Government will seek ASIC’s assistance in monitoring the impacts of reform, and advice on mitigation as needed.



Chapter 1          

« Amendment » to the scope of the Terrorism Insurance Act 2003

Outline of chapter

1.1                   Schedule 1 to this « Bill » amends the Terrorism Insurance Act to clarify that losses attributable to terrorist attacks using chemical, biological or similar means are covered by the terrorism insurance scheme established under the Terrorism Insurance Act.

Context of amendments

1.2                   The Terrorism Insurance Act established a scheme for replacement terrorism insurance to address the market failure in the insurance sector that arose as a result of the withdrawal of cover for terrorism insurance following the terrorist attacks of September 11, 2001.

1.3                   The replacement insurance scheme under the Terrorism Insurance Act ensures holders of eligible insurance contracts will be covered for terrorist attacks. The Terrorism Insurance Act provides for this by overriding terrorism exclusion clauses in eligible insurance contracts (as defined in section 7), to the extent that the losses excluded are eligible terrorism losses arising from a declared terrorism incident (declared under section 6).

1.4                   As part of the scheme, insurance companies are able to reinsure the risk of claims for such eligible terrorism losses by paying premiums to the Australian Reinsurance Pool Corporation.

1.5                   Section 41 of the Terrorism Insurance Act provides for a statutory review every three years to assess the scheme’s effectiveness and whether it needs to continue operating. The most recent review commenced in September 2014. Following engagement with industry and other stakeholders, the findings and ten recommendations of the review were made public in December 2015.

1.6                   Recommendation ten of the 2015 review suggested an « amendment » to the Terrorism Insurance Act to clarify that the scheme covers losses attributable to declared terrorist incidents if they use chemical, biological or other similar means.

1.7                    The 2015 review recommended that the scope of the scheme be clarified to address a number of general exclusions currently provided for in many insurance contracts that would exclude losses resulting from chemical or biological explosions and pollution or contamination. As these exclusions do not use the words “terrorism” or “terrorist” to describe the event causing the losses, there is potential for confusion over whether they would be covered or not.

1.8                   Amending the Terrorism Insurance Act to clarify that the scheme applies in relation to losses attributable to declared terrorist attacks using chemical, biological or other similar means would remove this ambiguity and ensure that these events are effectively covered as was always intended.

Summary of new law

1.9                   The new law amends the Terrorism Insurance Act to clarify the scheme covers losses attributable to terrorist attacks involving acts described as chemical, biological, polluting, contaminating, pathogenic or poisoning or words of similar effect.

Comparison of key features of new law and current law

New law

Current law

The scheme covers losses attributable to acts described using the words ‘terrorism’, ‘terrorist’, or words of similar effect and to attacks described using the words ‘chemical’, ‘biological’ or words of similar effect.

The scheme covers losses attributable to acts described using the words ‘terrorism’, ‘terrorist’ or words of similar effects.



Detailed explanation of new law

1.10               The « Bill » specifies that exclusion clauses in eligible insurance contracts for acts described as ‘chemical’, ‘biological, ‘contaminating,’ ‘pathogenic’, ‘poisoning’ or acts described using other similar words have « no » effect in relation to a declared terrorist event.   [Schedule 1, item 1, subsection 8( « 2 » )]

1.11               As a result of this change, holders of eligible contracts will be covered for eligible terrorism losses that arise from declared terrorist attacks which are caused by chemical, biological or other similar means (despite any exclusions in their insurance contract).

1.12               The « amendment » is a clarification to the existing provisions to ensure the scheme operates as originally intended to provide insurance against declared terrorist attacks, including where caused by chemical, biological or other means.

1.13               Insurance providers would be able to reinsure the risks against these terrorist attacks through the Australian Reinsurance Pool Corporation in return for paying a premium. 

Application and transitional provisions

1.14               The « amendment » applies in relation to eligible contracts in force, whether made before, at or after the commencement of the Schedule on 1 July 2017. [Schedule 1, item « 2 » ]

1.15               The insurance providers affected by the « amendment » will be provided with written notification of the changes by the Australian Reinsurance Pool Corporation 3 months before the changes take effect.

1.16               The application of the « amendment » to contracts made before commencement of the Schedule is justified as the « amendment » clarifies the original scope of the law rather than changing it. Applying the « amendment » to all insurance contracts from commencement of the Schedule will also ensure a consistent treatment for all holders of eligible insurance contracts in relation to a declared terrorist attack.

Regulatory impact Statement - Terrorism insurance act review 2015

AUSTRALIA’S TERRORISM INSURANCE SCHEME

Background to Review

1.17               The Terrorism Insurance Scheme (the scheme) was intended as an interim measure to operate while terrorism insurance cover was unavailable in the private market. The scheme was set up under the Terrorism Insurance Act 2003 (the Act), and is operated by the Australian Reinsurance Pool Corporation (the ARPC). The Act requires that the Minister prepare a report that reviews the need for the Act to continue in operation at least once every three years. [1]   Previous reviews in 2006, 2009 and 2012 have concluded that there was insufficient commercial market terrorism insurance available at affordable rates and that the scheme should continue to operate.

1.18               The terms of reference for this review appear at Appendix A. It is not the purpose of this review to consider the level of risk of terrorism. That is the function of other branches of government. Nevertheless, recent events — in Sydney and Paris, for example — highlight that terrorism is an ongoing threat. The Sydney event in December 2014 gave rise to the first and only activation of the scheme since its inception.

1.19               This comes at a time when the scheme has been in operation more than a decade. Last year, the National Commission of Audit, in expressing a view on the future of a number of Australian Government bodies, said of the ARPC:

“With continued recovery in terrorism insurance markets, there is scope for a gradual Commonwealth exit over the coming years.” [ « 2 » ]

1.20               Against that background, this review has closely considered the scope for government withdrawal from the market, and whether alternative structures for the ARPC, including full or partial private ownership, would be viable.   To assist in exploring these issues, an external consultant (Pottinger) was engaged by Treasury.  In addition, in finalising this review, consultations were held with industry representatives on a draft of the Report.

1.21               For the reasons set out in detail in the chapters below, the recommendation of this review is that the current ownership and administration structure of the scheme as set out in the Act be retained, while noting that there is scope to revisit alternative structures in future if there is a significant change in market conditions.

1.22               Nevertheless, as the need for the scheme has persisted for more than a decade, the policy framework against which its operation is assessed should « no » longer be limited to one that conceives of the scheme as a short term, temporary measure. While the ongoing need for the scheme should continue to be periodically reviewed, the fact that it has matured into at least a medium-term policy response should be recognised and reflected in decisions about the nature and scope of its operation.

1.23               Reflecting the considerations outlined above, the recommendations in this report are motivated by the desire to ensure that:

•        those who benefit most from the scheme — insured parties and the insurance industry - take an appropriate level of responsibility for its sustainable operation;

•        the government and taxpayers are fairly compensated for any financial support provided to scheme;

•        the scheme operates equitably and effectively to provide terrorism cover where it is unavailable in the private market; and

•        there is an appropriate level of certainty around the operation of the scheme.

Recommendations

Structure of the ARPC

1.24               Recommendation 1 : That the Act remains in force, subject to future three yearly statutory reviews.

1.25               Recommendation « 2 » : That the current administration structure of the ARPC as set out in the Act be retained.

Retentions

1.26               Recommendation 3 : The four per cent rate of gross fire and industrial special risk premium (less any fire services levy) should be increased to five per cent.

1.27               Recommendation 4 : Current maximum retention levels for individual insurers should be removed.

1.28               Recommendation 5 : The maximum industry retention should be increased from $100 million to $200 million.

Retrocession

1.29               Recommendation 6 : That the ARPC continue to have the discretion to purchase retrocession, subject to the APRC assessing the need for, and levels of, its retrocession programme and value for money.

Fee for the government guarantee

1.30               Recommendation 7 : That the ARPC pay to the Commonwealth each year, commencing in 2016-17:

a)    a fee of $55 million in respect of the Commonwealth guarantee of the ARPC’s liabilities; and

b)    an additional amount of $35 million per annum to reflect the Commonwealth’s support in making the ARPC reserves available for payment of claims.

Premiums

1.31               Recommendation 8 : That the premiums charged by the ARPC be increased, with effect from 1 April 2016 to:

-                  16 per cent for Tier A,

-                  5.3 per cent for Tier B, and

-                  2.6 per cent for Tier C.

Scope of the scheme

1.32               Recommendation 9 : That the scope of the scheme be extended so that it applies to:

a)    buildings in which at least 20 per cent of floor space is used for commercial purposes; and

b)    buildings with a sum insured value of at least $50 million, whether used for commercial or other purposes.

1.33               Recommendation 10 : That the application of the Act be clarified by amendments that remove doubt about whether certain losses would be covered under the scheme; in particular, losses attributable to terrorism attacks that use chemical or biological means.

CHAPTER 1:  INTRODUCTION

RATIONALE OF THE SCHEME

1.34               The lack of affordable terrorism insurance following terrorism events on 11 September 2001 forced Australia’s commercial property owners, developers and investors (such as banks, superannuation funds and fund managers) to assume their own terrorism risk, as existing policies expired and renewal policies explicitly excluded terrorism cover. Effects included a substantial reduction in commercial building activity. As a result, in May 2002 the Government announced that it would act to protect the Australian economy from the negative effects of the withdrawal of terrorism insurance cover.

1.35               Subsequently, a scheme was established under the Terrorism Insurance Act 2003 (the Act) to replace terrorism insurance coverage for commercial property and associated business interruption losses and public liability claims. Under the Act, the scheme is administered by the ARPC, a Commonwealth statutory corporation. The scheme commenced on 1 July 2003.

Operation and coverage

1.36               The Act operates by overriding terrorism exclusion clauses in eligible insurance contracts to the extent the losses excluded are eligible terrorism losses arising from a declared terrorist incident (DTI). [3]   This requires insurers to meet eligible claims in accordance with the other terms and conditions of their policies.

1.37               Insurance companies can (but are not required to) reinsure the risk of claims for eligible terrorism losses through the ARPC, in which case premiums are payable to the ARPC at rates set by the Minister. Insurance companies can choose to reinsure through the private reinsurance market.

1.38               An eligible insurance contract is a contract that provides insurance coverage for:

•        loss of, or damage to, eligible property owned by the insured;

•        business interruption and consequential loss arising from loss of, or damage to, eligible property that is owned or occupied by the insured or an inability to use all or part of such property; or

•        liability of the insured that arises from the insured being the owner or occupier of eligible property. [4]

‘Eligible property’ is defined under the Act as the following property that is located in Australia:

•        buildings (including fixtures) or other structures or works on, in or under land;

•        tangible property that is located in, or on, such property; and

•        property prescribed by regulation. [5]

Note that there is a range of exclusions set out in the Terrorism Insurance Regulations 2003 .

How a claim is funded

1.39               In the event of a DTI, claims would progress along the following sequence (see also Figure 1):

1.         Losses would be met first by industry up to the level of each insurer's retention; then

« 2 » .         From ARPC capital up to the value of the deductible on retrocession cover; then

3.         From the retrocession program, (with any co contribution being made from ARPC capital and then through the government guarantee); and finally

4.         Through the government guarantee, up to the $10 billion cap.

1.40               The sum of these tiers represents the maximum claimable amount under the scheme. Should the total claimed losses exceed the capital of the ARPC, the value of retrocession cover purchased and the $10 billion government guarantee, a 'reduction percentage' would be applied and claims would be paid on a pro rata basis.

1.41               Insurers that reinsure their terrorism risks with ARPC retain part of the cost from a DTI. The retention, similar to an excess or deductible, requires the insurer to pay the first part of any claim. Retentions for individual insurers are calculated as 4 per cent of fire and industrial special risk premiums collected by the insurer, with a minimum retention of $100,000 and a maximum retention of $10 million.

1.42               The ARPC's reinsurance agreement also provides for a maximum industry retention of $100 million. If the sum of the retentions of individual insurers in respect of all eligible terrorism losses caused by a single DTI exceeds the maximum industry retention of $100 million, then each insurer's retention is reduced proportionately. [6]

Figure 1: 2015 ARPC scheme capacity



CHAPTER « 2 » :  CONTINUATION OF THE ACT

ISSUE

1.43               This chapter examines whether there is a need for the Act to continue to deem cover for losses suffered due to a terrorism incident into eligible insurance contracts and whether the government should continue to provide a reinsurance scheme for this risk. Considerations include to what extent there continues to be a market failure in the provision of terrorism insurance and what the impact would be if the Act were to be abolished.

1.44               As noted above, the National Commission of Audit, in expressing a view on the future of a number of Australian Government bodies, said of the ARPC:

“With continued recovery in terrorism insurance markets, there is scope for a gradual Commonwealth exit over the coming years.” [7]

1.45               The scope for any short term Commonwealth exit is considered below.

RECOMMENDATION

1.46               The restriction on availability of terrorism insurance and reinsurance cover in the private market remains. There is some cover available, but this falls well short of the current level provided under the scheme. This is unlikely to change in the short to medium term. As a result, it is recommended that:

Recommendation 1 : That the Act remains in force, subject to future three yearly statutory reviews.

1.47               In relation to the size of the scheme, the current capacity is considered an appropriate level of cover, in that modelling indicates it would adequately cover the cost of a single explosion event and provide a good level of cover for a multiple explosion event.

ASSESSMENT

Appropriate level of terrorism cover

1.48               The ARPC’s modelling demonstrates that, if a loss was to occur in the Sydney or Melbourne central business districts from a large blast, ARPC’s pool of funds plus the retrocession program would cover almost all probable events. [8]   Multiple explosion events have not been modelled and would lead to larger losses. Determining an appropriate capacity for the scheme is challenging due to the lack of certainty of the probability of substantial events. However, the ARPC’s conclusion that the current capacity of $13 billion is adequate to comfortably cover most foreseeable outcomes of a major explosion event in a large Australian city provides a basis on which to maintain the current level of cover under the scheme. If ARPC reserves were depleted after such an event, consideration would be given as to how best to replenish those reserves in preparation for any further event.

Market failure

1.49               The report prepared by external consulting firm Pottinger considered the availability of reinsurance for terrorism risk in detail. It concludes that the availability and pricing of private sector terrorism insurance has improved over time due to the low incidence of major terrorism claims, better risk modelling and greater competition among reinsurers. Terrorism loss reinsurance prices have also fallen over time. In addition, coverage has improved for small events.

1.50               Nonetheless, there is still a partial market failure. The Pottinger report estimates that terrorism risk retrocessions available to Australian insurers at a reasonable price total around $5 billion, which is well below the approximately $13 billion of reinsurance cover provided by the scheme.

1.51               There also seems to be « no » material likelihood of market conditions changing such that adequate private sector supply of terrorism insurance becomes available over the near to medium term. The development of a private market for terrorism insurance in Australia depends on further growth in the capacity of global reinsurance markets for terrorism risk. Recent developments overseas indicate that government support of terrorism insurance arrangements continues to be required. The US Parliament, for example, recently voted to reinstate the national terrorist insurance scheme, which had lapsed in December 2014. The « Bill » passed with bipartisan support.

1.52               Current conditions do not imply the continued availability of private sector terrorism insurance at an economic price over the medium to longer term, particularly in the event of a major claim in Australia or overseas. Further, the report indicates that, while there is increasing capacity to insure the risk pool managed by the ARPC, there is « no » guarantee that the same capacity would be available to individual insurers. The report identifies the risk-pooling mechanism as a key factor in providing cost effective reinsurance of terrorism risk.

Impact on competition

1.53               A second consideration is whether continuation of the scheme is preventing the re-emergence of a private market for terrorism insurance. Again, the capacity of Australian insurers depends on the global market for reinsurance. In this context, the current government supported scheme in Australia is likely to have little effect on the development of the market. Supporting this conclusion is the Finity report’s finding that « no » market solution has emerged in relation to high rise residential and mixed use buildings not covered by the scheme.

1.54               The low impact of the scheme on the development of a market solution is consistent with the view of insurance industry stakeholders that the scheme should remain in largely its current form and is of benefit to them in a market where terrorism insurance is lacking. In fact, the successful retrocession program operated by the ARPC is viewed by stakeholders as having a positive effect on Australian insurers’ access to global reinsurance markets.

Impact of removal of the scheme

1.55               A final consideration is whether the removal of the scheme would have any negative impacts.

1.56               The likely negative economic impacts are difficult to assess. There are indications from some stakeholders that removing the scheme may not initially concern   the market more generally. However, conditions have not materially changed so that funding of large scale commercial projects would be viable without insurance. In current conditions, the pricing of the scheme suggests that insurers see little likelihood of a large-scale loss. Yet there seems to be « no » reason to think that a future large terrorist event would not have a similar effect on large commercial building activity to that in 2001.

1.57               A further issue is that, if sufficient terrorism insurance is not available in the private market, then the government may be called on to provide open-ended support in the event of a terrorist incident. Existence of an explicit guarantee provides certainty and enables the government and « tax » payers to be fairly compensated for the provision of the guarantee.

1.58               The need for the scheme was highlighted recently through the certainty it provided in the December Sydney siege events where it was activated for the first time. Although losses are predicted to be below the level of activation of the government guarantee, the scheme has provided a mechanism for communication between insurers and the government and provided certainty to claimants.

Ongoing reviews

1.59               The Pottinger report recommends making the scheme permanent given the apparent ongoing need for the Act, and posits reviews once every 5 years. While this review recognises that the temporary nature of the scheme needs to be reassessed given the persistent need for it, it is considered that triennial reviews should remain in place to ensure that the ongoing need for the scheme is closely monitored, but also to ensure that the parameters of the scheme are appropriately set.

CHAPTER 3:  OWNERSHIP STRUCTURE OF THE ARPC

ISSUE

1.60               While the Act and the ARPC are necessary and likely to be so over the longer term, there may be alternative options available for ownership of the ARPC. This chapter considers alternative options for the ARPC and whether the ownership or administration structure should be changed.

RECOMMENDATION

1.61               Recommendation « 2 » : the current administration structure of the ARPC as set out in the Act be retained.   

ASSESSMENT

1.62               The introduction of the scheme in 2003 was to counter a significant impact on economic activity due to a lack of insurance for commercial property and associated business interruption losses and public liability claims. At the time, it was recognised that creation of the ARPC, a government owned statutory corporation, would increase government involvement in the insurance market, operate as a competitor to private sector reinsurers, and increase the risk faced by the government through the provision of a government guarantee. For these reasons, the scheme was intended to be temporary until a market based solution

re-emerged.

1.63               This review finds that there is « no » near term possibility of a market-based solution emerging and that the scheme should continue.   However, the review also considers whether there is scope for alternative ownership or administration structures for the ARPC that might increase industry responsibility for the scheme’s continued operation, and facilitate a gradual withdrawal from the market by the government. An external consulting firm, Pottinger, was engaged by Treasury to provide advice on alternatives for this review (report attached as Annex A).

1.64               Pottinger’s report canvasses ownership and administration structures used for similar schemes overseas and considers costs and benefits if these options were to be adapted for use in the Australian context. Drawing on Pottinger’s work, this review considers two broad alternative options for ownership of the ARPC that would allow for significantly lower government involvement: a private sale and a mutual structure. If one of these options were to be pursued, a transition plan would need to be established to ensure the success of the transfer.

1.65               Both options presented here retain a mechanism to pool risk. Terrorism risk is different to other insurable risks as the potential loss from a single event is very high, events happen at very low frequency and are unpredictable, and the actions of the government can have an impact on the probability of an event. The Pottinger report concludes that a risk pool, such as the one operated by the ARPC, is the most cost efficient way to provide access to retrocession markets. The report concludes that the same level of retrocessions may not be available to individual insurers outside a risk pool. [9]    This view was reinforced in consultations with the industry.

1.66               Both options also contemplate the continuation of the government guarantee. The Pottinger report estimates that the private sector currently can provide only $3 billion — $5 billion in retrocession coverage for terrorism risk in Australia, below the current size of the scheme and the estimated maximum losses under a single large terrorist incident. In the event of a terrorist incident where losses exceeded those covered by the private sector, it is likely that the Government would be called upon to provide additional financial support. An explicit government guarantee reduces uncertainty, decreases insurance premiums, and ensures that the government receives adequate compensation for the risk faced in acting as an insurer. Most foreign schemes have some form of government support.

Sale of the ARPC by trade sale or initial public offering

1.67               A private sale of the ARPC has the potential to reduce government involvement and risk taken by the government, as well as realising value for the government that is currently tied up in the ARPC. The government could seek to retain majority ownership through a limited share offer or pursue full privatisation.

1.68               Establishing a likely purchase value for the ARPC is difficult without exact knowledge of how the scheme would operate after a sale. The factors to be considered include how much control the private entity would have over premiums and the ability of the purchaser to diversify risk; market sounding reports suggest that few market participants would be interested in purchasing an insurer that only covered terrorism risk. The value would also be affected by any minimum prudential capital requirements that might be applied, required provisions for charges following a major claim, and whether the Act will continue to deem insurance cover for losses caused by terrorism incidents into eligible contracts.

1.69               If the scheme settings remain as they are, Pottinger considers that private sector buyers would place little value on the ARPC. The Pottinger report estimates that the current premium and cost structure of the ARPC would generate a return on equity below that of other listed insurers. The potential purchaser may also be required to inject capital into the ARPC to meet prudential capital requirements if the ARPC was privately owned, lowering the value to a potential purchaser.

1.70               While the settings of the scheme can be changed to facilitate a sale, a clear transition plan to establish and maintain the value of the ARPC would be required.

1.71               A significant policy issue is that a privately owned ARPC would likely operate as the sole provider of terrorism reinsurance in Australia. Creation of a systemically important financial institution operating as a monopoly provider of terrorism reinsurance may trigger financial system stability concerns. In particular, it may be necessary to identify how the entity would recapitalise after a large claim. Privatisation may also impact on the prudential capital requirements of insurers reinsuring with the ARPC.

Transfer to a mutual structure

1.72               A second option is for the ARPC to adopt a mutual structure.  Members could be either the property insurers or the insured property holders. An « international » precedent exists for a mutual structure owned by insurers - the UK Pool Re scheme.

1.73               Mutualisation of the ARPC offers several advantages. It could increase industry involvement and responsibility and align incentives between the administrators of the scheme and those who benefit from the availability of terrorism insurance. The private sector would also take a much larger role in operating the scheme, reducing the administrative burden on the government. However, mutualisation is unlikely to reduce the risks faced by the government. As discussed, for the capacity of the scheme to be maintained, a government guarantee would be required. Existing mutual schemes overseas also receive government support.

1.74               Again Pottinger considers that clarification of uncertain aspects of the scheme would be required before the scheme could be mutualised. This list includes clarification of the regulatory framework for the mutual structure and any regulatory capital requirements; the mutual entity’s ability to set prices; the process for recapitalisation after a large claim; the nature of the government guarantee; and the coverage of the scheme. In addition, the governance and voting rights within a mutual would need to be considered to ensure the appropriate balance of interests between stakeholders. A comprehensive transition plan would be required to ensure the success of any mutualisation.

1.75               Mutualisation would not necessarily release capital to the government. The Pottinger report argues that a mutual structure may be subject to prudential capital requirements or may wish to hold capital in a similar way to a private entity. One implication is that it may be necessary for the government to ‘gift’ the existing capital to the scheme without compensation.

Assessment

1.76               The options outlined above may be viable in the longer term but do not present as attractive short-term solutions. None of the viable options identified by Pottinger involve complete withdrawal of government support, and would require major adjustments to the scheme, including heavily increasing the burden on the users of the scheme, if they were to release capital to the Commonwealth.

1.77               The current administrative structure is well established and provides terrorism insurance that cannot be provided to the same degree in the private market. In addition, the current scheme provides a high level of cost effective access to « international » reinsurance markets for terrorism risk, with the ARPC being able to build a sizeable retrocession program. Market participants widely support the continuation of the current scheme in its structure and operation.

1.78               Following the events at the Lindt Café in Sydney in December 2014, the scheme provided certainty to claimants and allowed for effective communication between industry and the government. Government control of the scheme ensures that the scheme will continue to be operated in the public interest, including in the event of a large claim.

1.79               Against this background, there appears to be « no » compelling case for a major change in the ownership or administration structure of the ARPC in the short term. If market considerations change, further consideration could be given to these options. The appropriate next step would be to undertake a comprehensive scoping study to further consider the viability of alternative options and set out an implementation plan for a preferred option. In the meantime, greater private sector participation can be encouraged by adjustments to the scheme parameters as set out in this review.

1.80               The Northern Australia Insurance Premiums Task Force is assessing the feasibility of a reinsurance pool for cyclone risk, among other options.  Its interim report notes that the ARPC could potentially be used to offer a cyclone reinsurance contract (although the cyclone and terrorism pools would need to be completely segregated from each other).

Chapter 4:  Ensuring Financial Sustainability of the Scheme

1.81               Although introduced on a temporary basis, the Act has been required to operate over a longer period than initially contemplated. The current pricing of the government guarantee and premiums, as well as settings relating to the purchase of retrocession and retention levels, should be reviewed to ensure the scheme is sustainable over the medium term and that industry takes an appropriate level of responsibility.

1.82               This chapter considers:

•        the level of industry retentions;

•        the purchase of retrocession by the ARPC;

•        the fair level of compensation received by the government for the provision of the $10 billion guarantee and the retention of capital by the ARPC; and

•        the appropriate level of premiums.

INDUSTRY RETENTIONS

Issue

1.83               Whether:

•        the current level and structure of retentions that apply to individual entities that reinsure with the ARPC are appropriate;

•        the overall industry retention per incident is appropriate; and

•        increasing this retention would encourage insurers to seek out reinsurance privately.

Recommendations

1.84               Recommendation 3 : The four per cent rate of gross fire and industrial special risk premium (less any fire services levy) should be increased to five per cent.

1.85               Recommendation 4 : Current maximum retention levels for individual insurers should be removed.

1.86               Recommendation 5 : The maximum industry retention should be increased from $100 million to $200 million.

Background

1.87               When the scheme began in 2003, the Act required insurers who bought reinsurance from the ARPC to retain risk at a minimum of nil and a maximum of $1 million, with the maximum industry wide retention set at $10 million. Retentions were based on 4 per cent of the reinsured’s gross fire and industrial special risk premium less any fire service levy. The 2006 review of the Act recommended that, as the insurance industry had developed, retentions under the scheme should increase to a minimum of $100,000 and a maximum of $10 million, with an industry retention of $100 million. Retentions were gradually increased as a result. The 2012 review of the Act recommended « no » change to retention levels.

Assessment

1.88               An analysis of ARPC’s portfolio indicates that five insurers benefit from the $10 million maximum retention and many insurers would have a retention of less than $100,000 if the minimum was not applied. That is, smaller insurers are made to retain more than 4 per cent of relevant premiums, yet large insurers have their retention capped under the current arrangements at less than 4 per cent.

1.89               Further, some consolidation of insurance licenses has led to a situation where some insurance groups have effectively reduced their maximum exposure under the scheme by reducing the number of insurance companies they own that are subject to an individual cap of $10 million.

1.90               The ARPC advises that insurer’s retentions under the ARPC’s terrorism reinsurance « agreements » are much lower than those used in natural catastrophe reinsurance, even though the ARPC retentions are more generous in that they are the maximum retention per year rather than per event.

1.91               Based on the above, the case can be made for increasing the retention level and removing the maximum individual retention in ARPC « agreements » to ensure that the insurance industry takes an appropriate level of responsibility in the event of a major claim under the scheme. Removing the maximum retention will also ensure a more even distribution of retention burden. Minimum retentions should be maintained to ensure that insurers retain a non-trivial level of responsibility under the scheme.

1.92               One of the underlying principles of the scheme is that it should be designed to allow the re-emergence of the commercial market for terrorism risk cover. Raising retention levels requires insurers to retain a greater amount of terrorism risk, for which they can self-insure or seek to commercially reinsure. Either course of action increases private sector involvement in the provision of terrorism risk cover. Increasing retentions also increases the relative attractiveness of commercial terrorism reinsurance.

CONTINUATION OF RETROCESSION PROGRAM

Issue

1.93               Whether the ARPC should continue to have the discretion to purchase retrocession in the private market.

Recommendation

1.94               Recommendation 6: That the ARPC continue to have the discretion to purchase retrocession, subject to the APRC assessing the need for, and levels of, its retrocession programme and value for money.

Background

1.95               For the first six years of the scheme, the ARPC did not purchase retrocession. Instead, premiums were used to build capital within the ARPC to extend the size of the scheme and provide a buffer before the unfunded government guarantee was called upon. However, once sufficient capital had built up within the scheme, the ARPC was given the discretion to purchase additional retrocession cover from the private market.

1.96               The ARPC has purchased retrocession every year since 2009. It initially provided cover of $2.3 billion, but this amount has increased over time to a maximum of $3.2 billion in 2014. In 2015, retrocession cover was slightly lower at $2.9 billion.

Assessment

1.97               The purchase of retrocession creates a role for the private market in providing terrorism insurance under the scheme and ensures that the insurance of private sector assets is provided to the greatest degree possible by the private market. A strong argument can be made in support of continuing the retrocession program, in that it:

•        supports the private sector provision of terrorism insurance and reinsurance;

•        provides an indication of both the market price for terrorism insurance and the availability of terrorism reinsurance in the private sector;

•        increases the overall capacity of the scheme (currently by around $3 billion); and

•        reduces the risk that the government guarantee will be called upon.

1.98               During consultation, industry stakeholders did not express particular views on the ARPC’s retrocession program. Insurers generally benefit under current arrangements; the purchase of retrocession by the ARPC increases the size of the scheme and, therefore, the amount of reinsurance cover purchased by insurers.

1.99               On balance, it is prudent for the ARPC to maintain its retrocession programme, at a level that represents the best value for money having regard to the ARPC’s other commitments, to ensure that the private reinsurance market for terrorism cover continues to operate in Australia, and to give information about the availability and price of private terrorism reinsurance. This approach would assist in a government withdrawal from the market in future if conditions improved.

COMPENSATION TO GOVERNMENT

Issue

1.100           Whether and to what extent the government should be compensated for the financial benefits it provides to the ARPC.

Recommendation

1.101           Recommendation 7 : That the ARPC pay to the Commonwealth each year, commencing in 2016-17:

a) a fee of $55 million in respect of the Commonwealth guarantee of the ARPC’s liabilities; and

b) an additional amount of $35 million per annum to reflect the Commonwealth’s support in making the ARPC reserves available for payment of claims.

Background

1.102           The ARPC is not a mutual pool. It is a government owned reinsurance agency that provides reinsurance cover to industry on the same basis as that provided by commercial reinsurers. The premiums charged by the ARPC represent compensation for the risk of a claim occurring during the period of insurance.  The government bears considerable risk in the event of a claim. In the first instance, the government’s equity in the ARPC would be reduced as claims are paid out of its pool. Further, in the event of a large claim that exhausts the capital retained in the ARPC and any retrocession purchased by the ARPC, the government will be called upon to cover losses.

1.103           Since its inception, the ARPC has been backed by a government guarantee of the ARPC’s liabilities to the amount of $10 billion. From the scheme’s commencement, it was intended that the Commonwealth be compensated for the risk it assumed in providing its guarantee. As outlined in the Revised Explanatory Memorandum to the Terrorism Insurance « Bill » 2002, the intention was “that risk transferred to the Commonwealth is appropriately priced and that the Commonwealth is compensated by those benefiting from the assistance”.

1.104           Initially « no » charge was made for the Commonwealth’s assistance to the scheme, allowing income from premiums to be used to build up capital within the ARPC as a reserve fund to act as a buffer against a claim on the government guarantee.

Nature of Government Support

1.105           In determining a fair amount of compensation for government support to the ARPC, it is instructive to consider the nature of that support. It is open to the government to raise premiums at any time, including following a DTI and subsequent claim on the scheme. This does not, however, have the consequence that the scheme is intended to be a ‘post-funded’ one in the sense that stakeholders would be required to ‘repay’ funds expended by the Commonwealth as a result of the guarantee. The ARPC provides reinsurance to insurers and is not able to demand repayment of any claims made on it. Similarly, the support provided by the Commonwealth as guarantor is in the nature of reinsurance rather than temporary liquidity.

1.106           Post-funding would be similarly complicated by the fact that the scheme as it currently stands is not compulsory, so that any increase in premiums following an event may result in insurers looking for retrocession cover outside the ARPC scheme. In this regard, the terrorism insurance scheme stands in contrast to the Financial Claims Scheme, for example, which imposes a levy on industry, if required, in the aftermath of the failure of a financial sector entity. While flexibility remains for ARPC premiums to increase following a large claim, insurers are not compelled to reinsure with it.

1.107           The result is that the support provided by the government guarantee is akin, if not identical to, retrocession cover, and this is an appropriate starting point for assessing the amount of compensation that should be paid to the Commonwealth.

Assessment

1.108           From the 2012 13 fiscal year, the ARPC began to compensate the government for the guarantee and this has continued to the time of this review. The current compensation arrangements are split into a fee and dividend: the fee represents a reasonable annual charge for the guarantee ($55 million), while the dividend ($57.5 million) provides retrospective compensation for the years that taxpayers were not compensated for providing the guarantee. The dividend is set to cease after 2017-18. A study by the AGA put the value to the ARPC (and those it reinsures) of the guarantee over this period (having regard to the background as set out above) at least $800 million. The task of this review is to assess an appropriate and sustainable level of compensation for the ARPC to pay to the Commonwealth on an ongoing basis.

1.109           Pottinger estimates that, if the ARPC was to replace the government guarantee with private retrocession of $10 billion in the private market (if it was available), this would cost around $200 million annually. This estimate assumes the premium paid by the ARPC would be equal to the marginal rate on line for the ARPC’s retrocession program in 2014. Pottinger argues that this rate is the minimum rate at which the private sector could provide retrocession.

1.110           The AGA provides an intentionally more conservative estimate of the value of the guarantee to the ARPC of around $55 million, significantly below the charge the Pottinger report estimates would be applied by a private sector reinsurer. This estimate assumes the first dollar of cover provided under the guarantee could be priced at the marginal rate on line of the retrocession programme, but that reasonable fee falls for each additional dollar of the guarantee provided. In effect, the AGA’s valuation implies zero charge for the last $3 billion of the guarantee. The end result is a fee below the private sector charge as the government does not have to achieve ‘market returns’.

1.111           To date, the government has received « no » compensation for allowing the ARPC to retain capital to fund a potential claim, even though the ARPC has built up a significant pool through its reinsurance operations. Pottinger estimates that the cost to the ARPC to reinsure the first $360 million of losses in the private market, which would currently be funded using the capital retained by the ARPC, would be between $30 million and $70 million. A similar value of $35 million is obtained by the AGA based on the ARPC holding a capital pool of $500 million. Both of these calculations draw on actual premiums paid by the ARPC for retrocession.

1.112           Given the principle that the government should be fairly compensated for taking on the risk, a fee or dividend consistent with the AGA’s more conservative estimate of $35 million is considered more appropriate than a full commercial rate. This fee represents fair compensation for the provision of around $500 million in government funds in the form of the pool and reserves.

1.113           Coupled with the fee of $55 million for the $10 billion guarantee, this equates to an ongoing annual compensation amount of $90 million payable by the ARPC to the Commonwealth.

1.114           Compensation at this level still allows the ARPC to offer cover at below the rate that could be provided by the private sector. This is considered appropriate unless or until there is evidence that suggests this impedes the return of the private market to provide reinsurance cover for terrorism.

1.115           The assessment of the value of the government guarantee set out above assumes retrocession cover continues to be purchased at around the current level. If the retrocession program were reduced in size, the value of the guarantee would rise in line with the increasing risk that the guarantee would be called upon and the fee would need to be reviewed.

1.116           An implication of the higher compensation to the government is that the ARPC will need to raise additional premiums. This is discussed in more detail below.

PREMIUM PRICING

Issue

1.117           Whether current premiums:

•        adequately reflect the cost of providing the terrorism reinsurance scheme; and

•        in any way impede a competitor from providing terrorism reinsurance in Australia.

Recommendation

1.118           Recommendation 8 : That the premiums charged by the ARPC be increased, with effect from 1 April 2016, to:

-                  16 per cent for Tier A,

-                  5.3 per cent for Tier B, and

-                  2.6 per cent for Tier C.

Background

1.119           Insurers who seek terrorism reinsurance through the ARPC pay premiums to the ARPC, although insurers may choose to reinsure with other providers. Insurers may pass on the cost of reinsurance to their policy holders through premiums, although this is a commercial decision for the insurer.

1.120           When the scheme was first established, it was considered that reinsurance premiums of between « 2 » and 12 per cent of underlying commercial property insurance premiums would be adequate to build the pool (reserves for claims) and would not be a significant cost to smaller commercial property owners if passed on by insurers. The premium levels (as a percentage) have remained unchanged since 1 October 2003. [10]  

Assessment

1.121           Two broad questions emerge in relation to whether the current premiums adequately reflect the cost of providing terrorism insurance: firstly, is the level of the premium sufficient and, secondly, is the mechanism for calculating the premiums appropriate?

1.122           The Pottinger report concludes that premium rates currently charged under the scheme are materially lower than implied by the cost of terrorism risk retrocessions purchased by the ARPC from the private sector. It estimates that, if the ARPC set premiums in line with the price of retrocessions, premiums could rise by over 100 per cent of current levels. The report further notes that the current premiums were set before there was a reasonable estimate of the cost of reinsurance (or retrocession) in the private market.

1.123           Pottinger’s assessment could therefore underpin a doubling of current reinsurance premiums charged by the ARPC. This is not, however, the result recommended in this review.  The principal determinant of the marginal price for reinsurance/retrocession in the private market is the cost of capital of the reinsurers concerned. Given that the government does not need to achieve ‘market returns’, it is not considered unreasonable that the charges levied by the government through the ARPC are lower than those that would be set by the private sector for reinsurance.

1.124           At this stage, it is unlikely that the premium settings are currently restricting competition or the development of a private market for terrorism risk (see Chapter « 2 » ), although the potential for a private market to re-emerge, and any effect ARPC premium rates have on this, should continue to be monitored.

1.125           Nevertheless, the ARPC must generate sufficient premiums to cover its ongoing costs and ensure that those who benefit from the scheme share an appropriate burden of the cost. At current levels, the premiums appear sufficient to cover operational costs, to cover the fee for the government guarantee and to purchase a degree of retrocession cover while maintaining the capital pool at around current levels. However, the current level of premiums is not enough to provide a return on the equity held by the ARPC that will be used as the first tier of funding in the event of a claim. An increase in the premium pool is, therefore, recommended.

1.126           The second question is whether the mechanism for calculating the premium is appropriate. This is the practice of setting premiums as a percentage of gross fire and industrial special risk premiums charged by the insurer and of using a community rating. Potential alternatives exist, including pricing premiums based on a larger number of criteria than only location and setting premiums as a proportion of the sum insured.

1.127           The Pottinger report considers that some level of community rating is appropriate in the context of the terrorism insurance scheme. The current system balances the need to take into account certain risks, such as geographical location, while maintaining a simple system that is well established and understood by stakeholders. Setting premiums for properties using a more complex calculation of the risk attached to each property would raise costs significantly, without necessarily implying that the premiums charged would accurately reflect the risk taken on by the ARPC. Setting premiums as a proportion of the gross fire and industrial special risk premiums links the ARPC’s premiums to conditions in the wider insurance market and is a simple mechanism to allow premiums to increase over time with property values.

1.128           It is, therefore, proposed that the ratios between the premiums under the current tiered structure be maintained, but that the level of premiums be increased with effect from 1 April 2016 to ensure the ARPC can remain self-funded over the medium term while reasonably compensating the Commonwealth and maintaining an appropriate level of capital.

1.129           In consultations with the insurance industry on premiums, a number of parties expressed a view about calculating premiums as a percentage of the insured value of the asset.  Adoption of this method of calculation would give the ARPC a more stable funding base as it would overcome the cyclical nature of insurance premiums and make ARPC’s funding smoother. 

1.130           Further consultation should be undertaken with insurers to assess the likely impact of such a change, including compliance costs, on their systems and processes, with a view to considering the adoption of this methodology at a later date.

Chapter 5:  Clarifying the coverage of the scheme

Mixed-use and high-rise residential building cover

Issue

1.131           Whether the scheme should be extended to cover ‘mixed use’ buildings and high value residential buildings.

Recommendation

1.132           Recommendation 9: That the scope of the scheme be extended so that it applies to:

a) buildings in which at least 20 per cent of floor space is used for commercial purposes; and

b) buildings with a sum insured value of at least $50 million, whether used for commercial or other purposes.

Background

1.133           The scheme set up by the Act was intended to cover commercial property. The rationale for confining the scheme to commercial property is set out in the Explanatory Statement to the Terrorism Insurance Regulations:

An assessment of the Australian insurance market by Trowbridge Consulting, assisted by Chiltington « International » , in June and July 2002 found that virtually « no » terrorism related insurance cover is available for commercial property and business interruption. The Government therefore decided that its replacement terrorism insurance scheme should cover commercial property. [11]  

1.134           This decision was given effect by excluding policies that cover losses to property that is used wholly or predominantly for personal, domestic or household purposes by the insured. [12]

1.135           At each review of the Act, the scope of the scheme has been reviewed. One consistent call from stakeholders has been that consideration should be given to extending the scheme to certain classes of residential buildings. Most recently, the question was considered in the 2012 Review, which declined to recommend that the scope of the scheme be extended. It did, however, recommend that the issue be re-examined at a later stage.

1.136           Past reviews have come to the conclusion that the scheme should not be extended to any class of predominantly residential building primarily because there was « no » evidence to suggest that the lack of coverage for that kind of property was not having an acute economic effect in the same way the lack of coverage for commercial property had in the lead-up to the establishment of the scheme. Against a background where the scheme was established to address that specific economic effect and was intended to exist only for as long as needed, the conclusion in past reviews has been not to extend the scheme. That view is re-examined in this review.

Assessment

1.137           This review has concluded that, after more than a decade in operation, the scheme should continue for the foreseeable future. As the need for the scheme persists, arguments that appeal to its temporary nature become less convincing, and the need to deal with potentially inequitable results if a major terrorist act were to occur becomes more pressing.

1.138            A study by Finity Consulting, undertaken for the purposes of this review (Annex B), has indicated that there are still classes of buildings for which terrorism cover is unavailable in the private market (and currently unavailable under the terrorism insurance scheme). These are buildings with between 20 per cent and 50 per cent commercial floor space, and buildings with a sum insured value of at least $50 million, whether used for commercial or other purposes.

1.139           If a major terrorist event were to occur, the result could be that buildings in close proximity were treated differently under the Act due to variations in the nature of the buildings’ use. The result would be that owners of some buildings would be dealt with in an orderly fashion under the scheme, while others would be left to appeal to governments for assistance in a less structured way.

1.140           The government currently recovers « no » compensation for the risk that it may be called upon to cover those outside the scheme. Expanding the scheme enables the government and « tax » payers to be suitably compensated for bearing that risk.  

1.141           A large majority of respondents to the market soundings exercise conducted by Pottinger recommended broader coverage of predominantly residential mixed use buildings by the terrorism insurance scheme. Respondents indicated that they considered the exclusion of these buildings from the scheme to be inequitable. The view was expressed that, should a terrorist attack cause material damage to a building that is not covered by the scheme, the government would be likely to come under pressure to provide financial support to the affected parties. It was thought that including such buildings in the scheme would allow the government, through the ARPC, to collect insurance premiums in advance of such an event.

1.142           Finity’s 2014 analysis of the impact of including mixed use and high rise residential buildings in the scheme focused on buildings located in Sydney and Melbourne Tier A postcodes. Finity found that including existing mixed use and high rise residential buildings in these locations in the scheme would increase the total sum insured by the ARPC in those locations by approximately 1.2 per cent and 9.7 per cent, respectively. Finity examined the impact on the premiums received by the ARPC of including mixed use and high rise residential buildings in the scheme. It was found that, across all Tier A postcodes in Australia, including existing mixed use buildings would increase premium income by between $100,000 and $200,000 per annum, while including existing high rise residential buildings would increase premium income by between $700,000 and $1.4 million per annum.

1.143           Finity also concluded that, while including mixed use buildings in the scheme would not significantly change the government’s exposure, the inclusion of high rise residential buildings would generally increase the government’s exposure; for some key risk locations, including high rise residential buildings would significantly increase the government’s exposure to losses from a declared terrorist incident.

1.144           This review recommends that the scheme be extended to cover buildings of those classes where terrorism insurance is unavailable in the private market.

IMPACT OF EXCLUSIONS IN INSURANCE POLICIES

Issue

1.145           There is some uncertainty in the insurance and reinsurance markets as to the effect of some exclusions in eligible insurance contracts. For example, some stakeholders expressed the view that general exclusions in insurance contracts may, despite the application of the Terrorism Insurance Act, remain effective to exclude liability to pay claims.

Recommendation

1.146           Recommendation 10: That the application of the Act be clarified by amendments that remove doubt about whether certain losses would be covered under the scheme; in particular, losses attributable to terrorist attacks that use chemical or biological means.

Assessment

1.147           Once a terrorism incident has been declared, the Act operates to render terrorism exclusions in eligible insurance contracts of « no » effect. Section 8 of the Act defines a terrorism exclusion as: an exclusion or exception for acts that are described using the word ‘terrorism’ or ‘terrorist’ or words of similar effect; or other acts that are substantially similar to terrorist acts as defined in Section 5 of the Act.

1.148           Many insurance contracts contain a range of exclusions (general exclusions) that exclude cover for losses from things like: chemical, biological and nuclear explosion, pollution or contamination; the destruction of electronic data; or the effects of microorganisms. Doubt has arisen as to whether such exclusions constitute terrorism exclusions as defined by the Act.

1.149           This is because these exclusions do not use words like ‘terrorism’ or ‘terrorist’ or other words that specifically refer to events like terrorism, but rather merely exclude losses of a particular class of event.

1.150           If this view is correct, losses of a particular class could be effectively excluded even where they came about as the result of events declared to be terrorist incidents under the Act.  Take, for example, the release of a toxic chemical agent in such circumstances that caused the event to be declared a terrorist incident under the Act. On one view, a clause that purported to exclude damages caused by the release of chemical agents, but made « no » mention of terrorism or like terms, would remain effective to exclude the insurer’s liability to pay claims for losses caused by the event.

1.151           The uncertainty over whether general exclusions would be voided by the Act has created a lack of clarity over the coverage afforded by the terrorism insurance scheme.

1.152           When the scheme was introduced in 2003 it was the intention of the (then) Government that a terrorist event using chemical and biological means should be covered.

1.153           Chemical and biological attacks are covered in most « international » pools.

1.154           In its report, Pottinger recommended that the government provide clarity in relation to any restrictions that apply to the cover provided by the scheme, as uncertainty over the extent of cover may create both economic and political risks. [13]

1.155           In the market soundings exercise conducted by Pottinger, there was strong support from respondents for clarifying the coverage of the scheme in relation to chemical and biological means of attack. Some responses from reinsurers to this exercise also highlighted the lack of clarity over the impact of general exclusions on the coverage of the scheme. Some reinsurers indicated that they would expect losses from biological and chemical hazards associated with terrorist attacks to be excluded from the scheme’s coverage, through the operation of general exclusions in insurance contracts, while others expressed the opposite view. Should such an event occur the uncertainty surrounding the extent of cover provided by the ARPC would potentially create both economic and political risks. [14]

1.156           If the government was to clarify, through legislation, the coverage of the terrorism insurance scheme, this would require careful consideration of both the operation of general exclusion clauses, and whether losses from certain types of declared terrorist incidents should be explicitly excluded from coverage in the same manner as losses from nuclear hazards. Detailed consultation with stakeholders would be needed on these issues.

1.157           The Review recommends that the lack of clarity surrounding exclusion for terrorist attacks using chemical or biological means be resolved as soon as possible.

APPENDIX A:  TERMS OF REFERENCE

1.158           Treasury will report to the Minister on:

•        Whether there continues to be market failure in the private sector supply of terrorism insurance and, consequently, whether there is a need for the Act to continue in operation;

•        Options on the future of the Act, including if there are possible alternative modes of ownership of the ARPC available to the Government and the costs and benefits of each alternative;

•        Whether the pricing of the scheme (the premium rates and tier structure), the level and structure of insurer and industry retentions, and the purchase of retrocession cover (including its level and cost) continue to be appropriate and do not distort demand for insurance;

•        Whether the operation of the scheme should be extended to include mixed commercial and residential use buildings, and high-rise residential buildings; and

•        Whether refinements to the scheme are necessary to clarify coverage for biochemical attacks, having regard to the effect of insurance policy exclusion clauses such as Chemical, Biological, and Pollution exclusions.

1.159           In conducting the review, Treasury will incorporate input from an expert external consultant. The consultant will be instructed to provide a written report to Treasury.

APPENDIX B:  « INTERNATIONAL » APPROACHES

1.160           Many developed countries have national terrorism insurance systems in place. Countries with a history of terrorism tend to have long standing government run terrorism insurance schemes. For example, the Spanish scheme was established following the Spanish Civil War; the South African scheme was set out following the political unrest of the 1970s; and the Israeli scheme was started early in Israel’s statehood.

1.161           In the early 1990s, the UK Government and the UK insurance industry set up the Pool Reinsurance Company Limited (Pool Re) scheme. The scheme was designed to deal with a market failure for the provision of terrorism insurance following terrorism incidents related to the troubles in Northern Ireland and the flow-on effects of a lack of insurance on the UK economy.

1.162           A large number of schemes were set up following the September 11 terrorist attacks, including in Austria, France, Germany, India, the Netherlands, Switzerland, the United States and, of course, Australia.

RECENT DEVELOPMENTS IN THE UNITED KINGDOM AND UNITED STATES

1.163           In the English speaking world, there has been a push to make the insurance industry pay more for government guarantees, as well as to increase the amount of risk borne by the industry.

1.164           The UK Government recently announced changes to the UK scheme that push their scheme’s costs towards the insurance industry and away from taxpayers. For example, it will charge Pool Re (the UK scheme) a fee for the UK Government guarantee of the equivalent of 50 per cent of premiums, in addition to a dividend payment of 50 per cent of any surplus generated, half of which will go to the UK Government and half of which will be paid to members of Pool Re. The UK Government also recently announced that Pool Re will be permitted to seek retrocession cover.

1.165           In the US, the federal terrorist risk insurance scheme was recently reinstated after the scheme briefly lapsed due to delays in getting the « bill » passed in Congress. Some changes to the scheme push more of the responsibility onto industry in the event of a terrorist attack. The changes raise industry retentions in the event of a claim, for example, by 2020, the amount of an incident that triggers the government scheme will need to be $200 million, with co-insurance from the insurance industry increased to 20 per cent. [15]  

1.166           Towards the end of 2014 and into early 2015, the US scheme faced uncertainty because it was not clear whether the US Congress would extend the scheme. Full effects on the US economy and businesses were not felt in this short lapse as many businesses did not wish to publicise the nature of their vulnerability in the absence of TRIA. [16]   However, « no » major cancellations of building projects or events are known to have occurred. [17]  

1.167           Part 3.8 of the attached report by Pottinger discusses some of the recent developments in « international » terrorism schemes.

HOW THE AUSTRALIAN SCHEME COMPARES WITH OTHER SCHEMES

1.168           The Australian scheme is similar to terrorism insurance schemes in other Organisation for Economic Cooperation and Development (OECD) countries, with some combination of a pool, reinsurance and a government guarantee, especially those established after the 2001 terrorist attacks (for example, Belgium, Denmark, France, Germany, and the Netherlands).

1.169           Schemes established after September 2001 were generally set up as immediate responses to market failure in terrorism insurance, and were expected to be temporary in nature. Reflecting this, some schemes, such as those in Germany and the United States, include sunset clauses. Similar to the Australian scheme, they exist on a temporary basis with the intention that they only continue to operate while sufficient terrorism insurance cover remains commercially unavailable on reasonable terms. As with the Australian scheme, these two schemes are also subject to periodic review. Both the United States and German governments have extended their respective schemes.

1.170           Internationally, many terrorism schemes are public sector schemes, owned by the government. However, some are public private partnerships run by an administrator operated as a mutual on behalf of insurance companies, but backed by a government guarantee.

1.171           Private sector provision of terrorism insurance around the world is limited. In most countries, the private sector does not provide terrorism insurance, even in countries where there is « no » terrorism insurance scheme. In India and Singapore, limited terrorism reinsurance is provided by industry consortiums.

1.172           While the Australian scheme covers property that has predominantly commercial floor space, a number of schemes among other OECD countries go further, covering all commercial property, residential property and their contents. The German, UK and US schemes resemble the Australian scheme most, focussing on cover for commercial property and business interruption.

1.173           Similarly, while the Australian scheme excludes cover for nuclear and radiological risks, they are covered by a number of other schemes. The Danish scheme was established specifically to cover nuclear, radiological, chemical and biological risks. The German scheme, on the other hand, excludes nuclear risks, while insurers in the United States have the option to exclude coverage for NBCR risks.

1.174           For a detailed description of the operation and ownership structures of foreign terrorism insurance schemes, see Section 5 of the Pottinger Report.

ANNEX A:  POTTINGER REPORT

1.175            The Pottinger Report can be accessed at http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2015/Terrorism%20Insurance%20Act%20Review%202015/Downloads/PDF/Terrorism_Insurance_Act_Review-2015.ash

ANNEX B:  FINITY REPORT

1.176           The Finity Report can be accessed at http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2015/Terrorism%20Insurance%20Act%20Review%202015/Downloads/PDF/Terrorism_Insurance_Act_Review-2015.ash .

Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Amendments to the scope of the Terrorism Insurance Act 2003

1.177           This Schedule is compatible with the human rights and freedoms recognised or declared in the « international » instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

1.178           This Schedule amends the Terrorism Insurance Act 2003 (the Act) to clarify that losses are covered by the scheme if they are attributable to terrorist attacks using chemical or biological means.

Human rights implications

1.179           This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

1.180           This Schedule is compatible with human rights as it does not raise any human rights issues.



Chapter « 2 »          

Improving Employee Share Schemes

Outline of chapter

2.1                   Schedule « 2 » to this « Bill » amends the Corporations Act so that ESS disclosure documents of certain start-up companies lodged with ASIC are not made available on ASIC’s public register.

Context of amendments

2.2                   The Government announced a package of reforms to support national innovation and increase the attractiveness of small businesses and start-ups. As part of these reforms, it aims to make it easier for start-up companies to offer ESS interests.

2.3                   ESSs give employees shares in their employer-company as part of, or as a bonus to, their employment remuneration. In this way, ESSs align the company and employees’ interests, motivate employees and enable employees to share in their employer’s success.

2.4                   ESSs are considered to be an offer of securities or other financial products to investors. Most disclosure documents for offers of securities, including ESS interests, must be lodged with ASIC and made available for public inspection under sections 718 and 1274 of the Corporations Act.

2.5                   The public disclosure of ESS documents may be discouraging start-up companies from offering ESS schemes. This is because public disclosure may allow competitors to access potentially commercially sensitive information at a stage when the start-up company is still establishing market share.

Summary of new law

2.6                   This Schedule amends the Corporations Act so that ESS disclosure documents do not need to be made publicly available if:

•        the offer is of an ESS interest under an ESS;

•        the disclosure document states that ESS interests will be made available only to employees of the company or its subsidiary, and relate only to ordinary shares;

•        none of the equity interests in the issuing company or the companies in its group are listed for quotation  in the official list of an approved stock exchange at the end of the issuing company’s most recent income year (the pre-lodgement year);

•        the issuing company and all companies in its group were incorporated less than 10 years before the end of the

pre-lodgement year; and

•        the issuing company has an aggregated turnover not exceeding $50 million for the pre-lodgement year.

Comparison of key features of new law and current law

New law

Current law

ESS disclosure documents lodged with ASIC are exempt from public inspection if:

•        the offer is of an ESS interest under an ESS;

•        the disclosure document states that the ESS interests will be made available only to employees of the company or its subsidiary, and relate only to ordinary shares;

•        none of the equity interests of the issuing company or the companies in its group are listed for quotation  in the official list of an approved stock exchange at the end of the issuing company’s most recent income year (the pre-lodgement year);

•        the issuing company and all companies in its group were incorporated less than 10 years before the end of the pre-lodgement year; and

•        the issuing company has an aggregated turnover not exceeding $50 million for the pre-lodgement year.

ESS disclosure documents lodged with ASIC must generally be made available for public inspection.

Detailed explanation of new law

2.7                   Most disclosure documents for offers of financial products must be lodged with ASIC and made available for inspection by the public under existing sections 718, 719 and 1274 of the Corporations Act. Existing subsection 1274( « 2 » ) creates an exemption and prohibits the public from inspecting specific types of documents lodged with ASIC, such as liquidators’ and receivers’ reports.

2.8                   The « Bill » amends subsection 1274( « 2 » ) of the Corporations Act to ensure that ESS disclosure documents do not need to be made publicly available if:

•        the offer is of an ESS interest under an ESS;

•        the disclosure document states that ESS interests will be made available only to employees of the company or its subsidiary, and relate only to ordinary shares;

•        none of the equity interests of the company issuing the ESS interests (the issuing company ) or the companies in its group are listed for quotation  in the official list of an approved stock exchange at the end of the issuing company’s most recent income year (the pre-lodgement year );

•        the issuing company and all companies in its group were incorporated less than 10 years before the end of the

pre-lodgement year; and

•        the issuing company has an aggregated turnover not exceeding $50 million for the pre-lodgement year.

  [Schedule « 2 » , items « 2 » and 3, subparagraph 1274( « 2 » )(a)(iva) and subsection 1274(2AA)]

2.9                   These conditions are broadly the same as the conditions for qualifying for the ESS start-up concession in section 83A-33 of the Income « Tax » Assessment Act 1997 (ITAA 1997) which grants a concession from upfront taxation for employees of certain start-up companies. Terms used in the new law are also defined in the same way as in Division 83A of the ITAA 1997 [Schedule « 2 » , items 1 to 3, section 9, subparagraph 1274( « 2 » )(a)(iva) and subsection 1274(2AA)].

2.10               Some changes have been made to the requirements in the ITAA 1997 to ensure that the conditions are based on the characteristics of the company and the ESS interest (rather than the employee) and to remove « tax » integrity rules. The timing rules have also been changed so that they relate to the income year before the documents are lodged with ASIC, rather than the income year before the employee receives their interest as in the ITAA 1997. This change is necessary because ESS disclosure documents are lodged with ASIC (and either released or exempt from disclosure) before the ESS interests are issued to employees.

Condition 1 - Offer is an ESS interest under an ESS

2.11               The exemption from disclosure is not available unless the disclosure document relates to an offer of an ESS interest under an ESS. [Schedule « 2 » , items « 2 » and 3, subparagraph 1274( « 2 » )(a)(iva) and paragraph 1274(2AA)(a)]

2.12               ESS interest and ESS have the same meanings as in section 83A-10 of the ITAA 1997. An ESS interest is a beneficial interest in a share of the company or a right to acquire a beneficial interest in a share of the company [Schedule « 2 » , item 1, section 9] . An ESS is a scheme under which ESS interests in a company are provided to employees or associate of employees of the company or its subsidiaries (including past or prospective employees) and relate to the employee’s employment [Schedule  « 2 » , item 3, paragraph 1274(2AA)(a)] .

2.13               The « Bill » uses different methods for capturing the ITAA 1997 definitions of ESS interest and ESS. The new law applies the ITAA 1997 definition of ESS interest by amending the dictionary section in the Corporations Act so that it defines ESS interest by reference to the definition in the ITAA 1997.

2.14               On the other hand, the « Bill » does not insert a new dictionary definition of ESS but instead applies the ITAA 1997 definition by inserting the words ‘within the meaning of the ITAA 1997’ in new subparagraph 1274( « 2 » )(AA)(a). A different approach is used because there is already a definition of ESS in existing section 9 of the Corporations Act and this definition continues to apply in all sections of the Corporations Act, except section 1274.

2.15               The differences between the definitions of ESS in the ITAA 1997 and section 9 of the Corporations Act are subtle and in many cases, will not have any practical effect. The main differences are summarized in Table 2.1.



 

Table 2.1 : Comparison of the ITAA 1997 and Section 9 Definitions of ESS

ITAA 1997 Definition

(applies to the new law)

Section 9 Definition

(applies to all other sections in the Corporations Act)

Limited to situations where the interests are provided ‘to’ certain persons

Extends to situations where the interests are provided to or ‘for the benefit’ of specified persons

Limited to shares in the company

Extends to shares in the company or its holding company

Limited to employees of the company or its subsidiaries

Extends to employees of a related body corporate

Widely defines employment relationships and includes service contracts with independent contractors

Narrowly defines employment relationship

 

Condition « 2 » - Certain information included in the disclosure document

2.16                Two pieces of information must be included in the disclosure document in order to qualify for the exemption from disclosure.

2.17               First, the disclosure document must state that the ESS interests will only be made available to employees of the company or its subsidiary [Schedule « 2 » , item 3, subparagraph 1274(2AA)(b)(i)] .

2.18               Employees , company and subsidiary have the same definitions as in Division 83A of the ITAA 1997.  [Schedule « 2 » , item 3, subparagraph 1274(2AA)(b)(i)]

•        Employees include employees, directors and independent contractors (section 83A-325 of the ITAA 1997). This is broader than the ordinary English meaning that applies in other sections in the Corporations Act.

•        Company means a body corporate or any other unincorporated association or body of persons (section 995-1 of the ITAA 1997). This is broader than the definition of ‘company’ which generally applies in the Corporations Act as it may include corporations which are not registered.

•        The ITAA 1997 definition of a subsidiary states that it is to be worked out in the same way as in the Corporations Act. It is not possible to simply apply the Corporations Act definition because the ITAA 1997 adopts a broader definition of company.   

2.19               Second, the disclosure document must state that the ESS interests will only relate to ordinary shares. The ESS interest may include rights to or indirect interests in ordinary shares, such as options to purchase ordinary shares. However, it must not include interests relating to non-voting or preference shares. [Schedule « 2 » , item 3, subparagraph 1274(2AA)(b)(ii)]

Condition 3 - Prohibition on listing

2.20               The exemption from disclosure will not apply if an equity interest of the issuing company or one of the companies in its group was listed on an approved stock exchange at the end of the pre-lodgement year. [Schedule25, item 3, paragraph 1274(2AA)(c)]

2.21               Approved stock exchanges include both Australian and foreign stock exchanges. They are listed in Schedule 5 of the Income « Tax » Assessment Regulation 1997 . [Schedule « 2 » , item 1, section 9]

2.22               The pre-lodgement year is the issuing company’s most recent income year before the income year in which the disclosure document was lodged with ASIC [Schedule « 2 » , item 3, paragraph 1274(2AA)(c)] and the income year is the period for which the company works out its taxable income under the ITAA 1997 [Schedule « 2 » , item 1, section 9] . The income year (and hence the pre-lodgement year) are not necessarily the same for all companies in a group. If the companies in a group have different

pre-lodgement years, only the pre-lodgement year of the issuing company is relevant.

Example 2.1 : Definition of pre-lodgement year

Company A has one subsidiary (Company B). Company A’s income year ends on 30 June. Company B’s income year ends on 31 December.

Company A lodges an ESS disclosure document with ASIC on 29 September 2018.

The end of the pre-lodgement year is 30 June 2018.

2.23               The prohibition on listing only needs to be met at the end of the pre-lodgement year. In other words, it does not matter for the purposes of the exemption if one of the companies becomes listed after this point. Similarly, it does not matter if one of the companies in the group is listed on a stock exchange prior to the end of the pre-lodgement year, provided that the company is « no » longer listed at the end of the pre-lodgement year.

2.24               The issuing company’s group includes:

•        the issuing company;

•        a subsidiary of the issuing company;

•        a holding company of the issuing company; and

•        a subsidiary of that holding company.

[Schedule « 2 » , item 3, paragraph 1274(2AA)(c)]

2.25               For the purposes of the new disclosure exemption, only those companies which are subsidiaries, holding companies or subsidiaries of holding companies at the end of the pre-lodgement year are part of the group. For example, if a company had a subsidiary at the beginning of its pre-lodgement year but the subsidiary had been wound-up by the end of the pre-lodgement year, the subsidiary would not be part of the company’s group for the purposes of the new law. [Schedule « 2 » , item 3, paragraph 1274(2AA)(c)]

2.26               The question whether a company is a subsidiary is worked out in the same way as in section 46 of the Corporations Act [Schedule « 2 » , item 3, subparagraph 1274(2AA)(c)(ii)] . A company (Company A) is a subsidiary of the issuing company if the issuing company controls the composition of Company A’s board, controls more than half of the votes at Company A’s general meetings or holds more than half of Company A’s share capital. Company A is also a subsidiary of the issuing company if Company A is a subsidiary of a subsidiary of the issuing company.

2.27               The holding company is a company of which the issuing company is a subsidiary (see section 9 of the Corporations Act). Under subsection 83A-33(7) of the ITAA 1997, investments by venture capital and « tax » exempt entities are ignored when identifying holding companies [Schedule « 2 » , item 3, subsection 1274(2AB)] .

Example 2.2 : Prohibition on listing - company groups

Assume that Tech Wiz Pty Ltd wants to offer ESS interests to its employees.

Tech Wiz Pty Ltd is part of a corporate group. The following diagram shows the structure of the group and the percentages connote the ownership interests. Only one company in the group, Wiz Bang Ltd, is listed.

The prohibition on listing applies to Tech Wiz Pty Ltd, its holding companies, its subsidiaries and the subsidiaries of its holding company.

The subsidiaries of Tech Wiz Pty Ltd are:

•        Jnr Wiz Pty Ltd; and

•        Baby Wiz Pty Ltd.

The holding company of Tech Wiz Pty Ltd is Big Tech Pty Ltd. Big Tech Pty Ltd’s subsidiaries are:

•        Wiz Bang Ltd;

•        Tech Wiz Pty Ltd;

•        Jnr Wiz Pty Ltd; and

•        Baby Wiz Pty Ltd.

All of the companies in the diagram need to meet the third eligibility condition (prohibition on listing) because they are holding companies, or subsidiaries of Tech Wiz Pty Ltd, or subsidiaries of the holding company (Big Tech Pty Ltd). As Wiz Bang Ltd is listed, Tech Wiz Pty Ltd’s ESS disclosure documents are not exempt from disclosure.

Condition 4 - Incorporation for less than 10 years

2.28               The fourth requirement is that all companies in the issuing company’s group must have been incorporated less than 10 years before the end of the pre-lodgement year. The prohibition is on incorporation for 10 years or more under Australian law or foreign law [Schedule « 2 » , item 3, paragraph 1274(2AA)(d)] . Foreign law has the same definition as in the ITAA 1997 and means a law of a country outside Australia and the external territories [Schedule « 2 » , item 1, section 9] .

2.29               The group of companies includes the issuing company, the subsidiary of the issuing company, a holding company of the issuing company, and a subsidiary of that holding company at the end of the prelodgement year (see paragraphs 2.24 to 2.27 above) [Schedule « 2 » , item 3, paragraphs 1274(2AA)(c) and (d))] . Unlike the second condition, investments by venture capital and « tax » exempt entities need to be taken into account when identifying holding companies.

Example 2.3 : Incorporation for less than 10 years

Little Tick Tock Tech lodges an ESS disclosure document with ASIC. Little Tick Toch Tech is part of a group of companies as shown below.

African Charitable Providers was incorporated in South Africa 15 years ago but none of the other companies in the group were incorporated within the last 10 years. Charitable Providers is an Australian deductible gift recipient.

Little Tick Toch Tech’s group of companies includes itself, its subsidiaries, its holding company, and subsidiaries of its holding company.

Little Tick Tock Tech’s holding company is Tick Tock Tech. Tick Toch Tech’s other subsidiaries are Charitable Providers and African Charitable Providers.

Therefore, Little Tick Toch Tech fails the fourth eligibility condition as one of the companies in the group was incorporated more than 10 years ago.

Condition 5- Aggregated turnover not exceeding $50 million 

2.30               The issuing company will not be eligible for the exemption from disclosure if its aggregated turnover is more than $50 million in the income year prior to lodging the disclosure document with ASIC. [Schedule  « 2 » , item 3, paragraph 1274(2AA)(e)] .

2.31               Aggregated turnover has the same meaning as in the ITAA 1997 [Schedule « 2 » , item 1, section 9] . Under section 328-115 of the ITAA 1997, aggregated turnover is the ‘annual turnover’ of:

•        the issuing company;

•        the issuing company’s ‘affiliates’ (that is, any company that would carry out its business by following the wishes of the issuing company); and

•        any entity ‘connected’ to the issuing company (that is, any entity that the issuing company controls or any entity that is controlled by a third company who also controls the issuing company).

2.32               Aggregated turnover does not include amounts from intra-group transactions. The fifth eligibility condition also excludes turnover from venture capital and DGR investors under subsection 83A-33(7) of the ITAA 1997. [Schedule « 2 » , item 3, subsection 1274(2AB)]

Example 2.4 : Aggregated turnover not exceeding $50 million

DEF lodges an ESS disclosure document with ASIC. DEF is part of a group of companies:

The ordinary income of the companies in the group for the pre-lodgement year was as follows:

•        ABC - $10 million

•        DEF - $20 million

•        XYZ - $30 million

ABC and XYZ are connected to DEF. Therefore the aggregated turnover of DEF is $60 million and DEF fails the fifth eligibility condition.

Consequences of failing to meet the conditions at a later point in time

2.33               The conditions only need to be satisfied in, or at the end of, the pre-lodgement year and if the conditions are satisfied, the exemption applies for all time. In other words, if the entity fails to meet one or more of the conditions in a later income year, the ESS disclosure document remains exempt. There would be a significant administrative burden on ASIC if ASIC was required to reconsider whether previously-lodged ESS documents should continue to remain exempt at the end of every income year.

Example 2.5 : Entity fails to satisfy the conditions in later years

Chip Chip Innovation has an income year that ends on 30 June. Chip Chip Innovation lodges as ESS disclosure document with ASIC on 16 August 2020.

Chip Chip Innovation satisfies all of the eligibility conditions for, or at the end of, the pre-lodgement year (the 2019-2020 income year). Accordingly, the disclosure document lodged on 16 August 2020 is exempt from disclosure.

In the 2020-2021 income year, Chip Chip Innovation grows rapidly and its aggregated turnover increases to $65 million.

The ESS disclosure document lodged on 16 August 2020 remains exempt and does not need to be released at the end of the 2020-2021 income year.

Chip Chip Innovations now decides to employ an additional 10 staff. It establishes a new ESS for the 10 additional staff and lodges a new ESS disclosure document with ASIC on 16 September 2021.

The ESS disclosure document lodged on 16 September 2021 is not exempt from disclosure because Chip Chip Innovations did not satisfy the conditions in the 2020-2021 income year.

Example 2.6 : Entity fails to satisfy conditions at the time of lodgement

Milmil Tech has an income year that ends on 30 June. Milmil Tech lodges as ESS disclosure document with ASIC on 1 May 2019.

Milmil Tech satisfies all of the conditions as at 30 June 2018. However, it becomes listed on the ASX on 1 February 2019.

The new law requires the conditions to be satisfied for, or at the end of, the pre-lodgement year. Milmil Tech’s pre-lodgement year is 30 June 2018 and it satisfied all of the conditions at this point in time. Therefore, Milmil Tech’s ESS disclosure documents are exempt from disclosure. It is not relevant that Milmil Tech failed to satisfy one of the conditions in a later income year or at the time of lodgement.

Supplementary and replacement documents

2.34               The exemption also applies to supplementary and replacement documents lodged with ASIC [Schedule « 2 » , item « 2 » , paragraph 1274( « 2 » )(iva)] . Under existing section 719, a supplementary or replacement document must be lodged when the company becomes aware of a misleading statement in, or omission from, the initial disclosure document or a new circumstance arises, and that misleading statement, omission or new circumstance is materially adverse to investors.

2.35               Supplementary documents are taken to be part of the initial disclosure under existing subsection 719(4) and they are not treated as a new disclosure. This means that the disclosures required by the first condition may be contained in either the initial disclosure document (provided these disclosures were not amended by the supplementary document) or the supplementary document. [Schedule « 2 » , item 3, paragraph 1274(2AA)(b)]

2.36               As supplementary documents are part of the initial disclosure, the pre-lodgement year is the income year before the initial disclosure documents was lodged with ASIC. In other words, the second to fifth conditions for qualifying for the exemption only need to be satisfied in, or at the end of, the income year before the initial disclosure document was lodged. The disclosure exemption remains available, even if the company « no » longer satisfies the second to fifth conditions at the time of lodging the supplementary document. [Schedule « 2 » , item 3, paragraph 1274(2AA)(c)]

2.37               Replacement documents are new disclosure documents under the existing law. Accordingly the relevant disclosures required by the first condition must be contained in the replacement document. Similarly, the pre-lodgement year relates to when the replacement document was lodged with ASIC, that is, the second to fifth conditions need to be satisfied in or at the end of the income year before the replacement document was lodged with ASIC. [Schedule « 2 » , item 3, paragraph 1274(2AA)(c)]

Example 2.7 : Supplementary and replacement documents: required disclosures (condition 1)

Kilobyte Company, Megabyte Company and Terabyte Company lodge initial disclosure documents. Each disclosure document states that the ESS interests will be made available only to employees of the issuing company or subsidiary, and relate only to ordinary shares (‘the required disclosures’).

Kilobyte Company and Megabyte Company both lodge supplementary disclosure documents to correct misleading statements. Kilobyte Company’s « amendment » relates to one of the required disclosures and the supplementary document states that ESS interests relate to both ordinary shares and preference shares. Megabyte Company’s « amendment » does not relate to any of the required disclosures.

Terabyte Company lodges a replacement document. The replacement document does not contain the required disclosures.

For Kilobyte Company and Megabyte Company, the disclosure exemption is only available if the required disclosures are contained in the initial disclosure document as supplemented by the supplementary document. Kilobyte Company’s revised disclosure document does not include the required disclosures because they were amended by the supplementary document. Therefore, Kilobyte Company cannot take advantage of the exemption.

Megabyte Company’s supplemented disclosure document contains the required disclosures and its documents will be exempt from disclosure (provided that it also satisfied conditions « 2 » to 5).

Terabyte Company will only be able to rely on the disclosure exemption if the required disclosures are contained in the replacement document. The replacement document does not include the required disclosures and therefore the exemption is not available.

Example 2.8 : Supplementary and replacement documents: pre-lodgement year (conditions « 2 » to 5)

Bit Bit Company and Choff Choff Company both lodge initial disclosure documents with ASIC on « 2 » June 2018. Both companies have income years which end on 30 June.

On 3 September 2018, Bit Bit Company becomes aware of a misleading statement in its initial disclosure document and lodges a supplementary document. The misleading statement does not relate to any of the disclosures required by the first condition.

Choff Choff Company undergoes a major restructure and changes its investment focus. On 3 September 2018, Choff Choff  Company lodges a replacement document with ASIC.

Both Bit Bit Company and Choff Choff Company satisfy all of the conditions in, or at the end of, the 2016-17 income year. However, they both experience significant growth in the 2017-18 income year and do not satisfy the conditions at the end of the 2017-18 income year.

Disclosure documents are exempt from disclosure if the conditions are satisfied in, or at the end of, the relevant pre-lodgement year.

•        For initial disclosure documents, the pre-lodgement year is the income year before the initial disclosure document was lodged with ASIC.

•        For supplementary documents (which are taken to be part of the initial disclosure document), the pre-lodgement year is the income year before the initial disclosure document was lodged with ASIC.

•        For replacement documents (which are new disclosure documents), the pre-lodgement year is the income year before the replacement document was lodged with ASIC.

The pre-lodgement year for both companies’ initial disclosure documents and Bit Bit Company’s supplementary document is the 2016-17 income year. Both companies satisfied the conditions in, or at the end of, the 2016-17 income year. Therefore, both companies’ initial disclosure documents and Bit Bit Company’s supplementary document are exempt from disclosure under section 1274.

With respect to Choff Choff’s replacement document, the pre-lodgement year is the 2017-18 income year. Choff Choff did not satisfy all of the conditions in, or at the end of, the 2017-18 income year and as a result, its replacement document is not exempt from disclosure.

Scope of exemption

2.38               The exemption from disclosure in Schedule 5 is limited to ESS disclosure documents and does not extend to other disclosure documents lodged by start-up companies, such as those relating to the offer of shares to investors outside the company. This is because, when outside investors are involved, public disclosure is key to ensuring that potential investors have access to adequate information to make informed investment decisions.

2.39               Further, the amendments only alter the public’s right to access the documents under section 1274 of the Corporations Act. Information contained in an ESS disclosure document may still be made available under other laws of the Commonwealth, such as freedom of information legislation.

 Consequential amendments

2.40               None

Application and transitional provisions

2.41               The amendments apply to initial ESS disclosure documents and replacement documents lodged with ASIC after the commencement date. The amendments will only apply to supplementary disclosure documents if both the initial disclosure document and the supplementary disclosure document were lodged with ASIC after commencement. [Schedule « 2 » , item 4, section 1637]

Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Improving employee share schemes

2.42               This Schedule is compatible with the human rights and freedoms recognised or declared in the « international » instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

2.43               This Schedule amends the Corporations Act so that employee ESS disclosure documents lodged with ASIC are not made publicly available for certain start-up companies.

Human rights implications

2.44               This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

2.45               This Schedule is compatible with human rights as it does not raise any human rights issues.

 



Chapter 3          

Deductible gift recipients

Outline of chapter

3.1                   Schedule 3 to this « Bill » amends the ITAA 1997 to add six organisations as specifically listed deductible gift recipients (DGR): The Australasian College of Dermatologists, College of Intensive Care Medicine of Australia and New Zealand, The Royal Australian and New Zealand College of Ophthalmologists, Australian Science Innovations Incorporated, The Ethics Centre Incorporated and Cambridge Australia Scholarships Limited.

Context of amendments

3.2                   The income « tax » law allows income « tax » deductions for taxpayers who make gifts of $ « 2 » or more to a DGR. DGRs are entities which fall within one of the general categories set out in Division 30 of the ITAA 1997 or are specifically listed by name in that Division.

3.3                   DGR status helps eligible organisations attract public financial support for their activities.

Summary of new law

3.4                   The amendments add The Australasian College of Dermatologists, College of Intensive Care Medicine of Australia and New Zealand, The Royal Australian and New Zealand College of Ophthalmologists, Australian Science Innovations Incorporated, The Ethics Centre Incorporated and Cambridge Australia Scholarships Limited as DGRs specifically listed by name.

3.5                   This ensures that gifts of $ « 2 » or more to the organisations will be « tax » deductible.

Detailed explanation of new law

The Australasian College of Dermatologists

3.6                   Taxpayers may claim a « tax » deduction for gifts to The Australian College of Dermatologists made for education or research in medical knowledge or science, from the day the « bill » commences. [Schedule 3, item 1, item 1.2.20 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11]

3.7                   The Australasian College of Dermatologists trains and provides continuing professional development to dermatologists and supports scientific research in the field of dermatology. It also educates and advocates to the public, government and other health care professionals about dermatological matters.

College of Intensive Care Medicine of Australia and New Zealand

3.8                   Taxpayers may claim a « tax » deduction for gifts to the College of Intensive Care Medicine of Australia and New Zealand Ltd made for education or research in medical knowledge or science, from the day the « bill » commences. [Schedule 3, item 1, item 1.2.21 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11]

3.9                   The College of Intensive Care Medicine of Australia and New Zealand cultivates and encourages high principles of practice, ethics and professional integrity in relation to intensive care medicine practice, education, assessment, training and research. It has established fellowships and advocates on any issue which affects the ability of College members to meet their responsibilities to patients and to the community.

The Royal Australian and New Zealand College of Ophthalmologists

3.10               Taxpayers may claim a « tax » deduction for gifts to The Royal Australian and New Zealand College of Ophthalmologists made for education or research in medical knowledge or science, from the day the « bill » commences. [Schedule 3, item 1, item 1.2.22 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11]

3.11               The Royal Australian and New Zealand College of Ophthalmologists is responsible for the training and professional development of ophthalmologists in Australia and New Zealand. It leads improvements in eye health care in Australia and New Zealand through continuing professional training, education, research and advocacy. It also promotes and facilitates the improvement of eye health care internationally, particularly in developing countries, and in relation to indigenous populations.

Australian Science Innovations Incorporated

3.12               Taxpayers may claim a « tax » deduction for gifts made to Australian Science Innovations Incorporated from 1 January 2016. [Schedule 3, item « 2 » , item 2.2.44 in the table in subsection 30-25( « 2 » ) of the ITAA 1997]

3.13               Australian Science Innovations Incorporated (ASI) is a

not-for-profit organisation whose mission is to inspire, challenge and raise the aspirations of students in science. ASI organises, fosters and promotes Australian participation in the « International » Biology, Chemistry, Physics and Earth Science Olympiads and related activities, as well as engaging in other activities designed to encourage science excellence in secondary education.

The Ethics Centre Incorporated

3.14               Taxpayers may claim a « tax » deduction for gifts made to The Ethics Centre Incorporated from 24 February 2016. [Schedule 3, item 3, item 3.2.14 in the table in subsection 30-40( « 2 » ) of the ITAA 1997]

3.15               The Ethics Centre Incorporated is an independent not-for-profit organisation that has been working for over 25 years to improve lives and support communities built on strong ethical foundations. Its core objective is to relieve the significant distress faced by those struggling with complex ethical decisions and the personal and community suffering resulting from unethical behaviour.

3.16               It is expected that The Ethics Centre Incorporated will soon become a company limited by guarantee, and so its name will become The Ethics Centre Limited. When this occurs, the name will be updated in the ITAA 1997, and a commencement proclamation will be registered. If the name change does not occur within 12 months, the provisions are repealed. [Schedule 3, items 12 and 13, table item 3.2.14 in the table in subsection

30-40( « 2 » ) of the ITAA1997 and table item 48AAA in the table in section 30-315 of the ITAA 1997; Schedule 3, item 14; Commencement information item « 2 » .]

Cambridge Australia Scholarships Limited

3.17               Taxpayers may claim a « tax » deduction for gifts made to Cambridge Australia Scholarships Limited from 1 July 2016 to 1 July 2021. [Schedule 3, item 4, item 9.2.27 in the table in subsection 30-80( « 2 » ) of the ITAA 1997]

3.18               Cambridge Australia Scholarships Limited is a not-for-profit entity established and located in Australia for the charitable purpose of advancing education by widening access to the University of Cambridge for outstanding Australian students from all backgrounds.

Consequential amendments

3.19               The index is updated for the six organisations gaining DGR specific listing. [Schedule 3, items 5, 6, 7, 8, 9 and 10, section 30-315 of the ITAA 1997; Schedule 3, item 11]

Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Deductible gift recipients

3.20               This Schedule is compatible with the human rights and freedoms recognised or declared in the « international » instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

3.21               Schedule 3 to this « Bill » amends the ITAA 1997 to update the list of specifically listed DGRs to include The Australasian College of Dermatologists, College of Intensive Care Medicine of Australia and New Zealand, The Royal Australian and New Zealand College of Ophthalmologists, Australian Science Innovations Incorporated, The Ethics Centre Incorporated and Cambridge Australia Scholarships Limited.

Human rights implications

3.22               This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

3.23               This Schedule is compatible with human rights as it does not raise any human rights issues.



Outline of chapter

4.1                   Schedule 4 to this « Bill » makes amendments to provide income « tax » relief to New Zealand special category visa (subclass 444) (SCV) holders in Australia who have been impacted by disasters in the 2014-15 year and later years by:

•        amending the Income « Tax » Assessment Act 1936 (ITAA 1936) to provide a « tax » rebate for the ex-gratia Income Support Allowance (ISA), and

•        amending the Income « Tax » Assessment Act 1997 (ITAA 1997) to provide an income « tax » exemption for the ex-gratia Disaster Recovery Payment (DRP).

Context of amendments

4.2                   The Australian Government makes certain payments to eligible Australians to assist when a major disaster happens, and these payments are exempt from income « tax » , or an income « tax » rebate is available.

4.3                   The Government may extend these payments and the equivalent « tax » treatment to New Zealand SCV holders on an ex-gratia basis.

4.4                   The New Zealand SCV is a temporary visa allowing New Zealand citizens to reside, work and study indefinitely in Australia as long as they remain New Zealand citizens. New Zealand citizens arriving in Australia are generally eligible for a New Zealand SCV, subject to meeting other eligibility criteria (such as not constituting a health or behaviour concern). New Zealand SCV holders generally pay Australian « tax » because they are Australian residents for « tax » purposes.



Ex-gratia Income Support Allowance to New Zealand SCV holders

4.5                   The Disaster Recovery Allowance (DRA) is means-tested, short-term income support for eligible Australians who have suffered a loss of income as a result of a major disaster. The DRA is taxable, but recipients may be entitled to the Beneficiary « Tax » Offset.

4.6                    Where the Minister for Justice has made a determination and the DRA has been activated, the Prime Minister may also decide to provide an equivalent ISA to New Zealand SCV holders.

4.7                   To qualify for the ISA, New Zealand SCV holders must meet the same eligibility criteria as Australian citizens applying for the DRA. Under the Programme Guidelines, New Zealand SCV holders must also demonstrate they have participated in the Australian taxation system for at least one year in the past three financial years. Payments of the ex-gratia ISA are made on the same terms as payments of the DRA.

4.8                   The DRA is not exempt income but may be eligible for a « tax » offset under section 160AAA of the ITAA 1936.

Ex-gratia Disaster Recovery Payment to New Zealand SCV holders

4.9                   The Australian Government Disaster Recovery Payment (AGDRP) is a non-means-tested, one-off payment to assist with the short-term recovery needs of eligible Australian adults and children who have been adversely affected by a major disaster. Such payments are exempt from income « tax » .

4.10               Where the AGDRP has been activated, the Prime Minister may also decide to provide an equivalent DRP to New Zealand SCV holders.

4.11               To qualify for the DRP, New Zealand SCV holders must meet the same eligibility criteria as are applied to Australian citizens applying for the AGDRP. Under the Programme Guidelines, New Zealand SCV holders must also demonstrate they have participated in the Australian taxation system for at least one year in the past three financial years. Payments of the DRP are made on the same terms as payments of the AGDRP.

4.12               The ITAA 1997 does not provide an ongoing « tax » exemption for DRP payments. In past financial years, the Australian Government has provided New Zealand SCV holders with a « tax » exemption for the DRP for those years. This gave the payments equivalent « tax » treatment to Australian citizens in receipt of a corresponding AGDRP.

Summary of new law

4.13               This measure amends the ITAA 1936 to provide a « tax » rebate for recipients of the ISA. This measure also amends the ITAA 1997 to provide an income « tax » exemption for the DRP.

4.14               The measure benefits taxpayers as they are now eligible for « tax » relief for the 2014-15 income year and all future years, where the relevant determination is made by the Minister for Justice because a major disaster has occurred.

Comparison of key features of new law and current law

New law

Current law

The ISA is a rebatable benefit for payments made for disasters occurring in the 2014-15 year and future years.   

The ISA is taxable for payments made for disasters occurring in the 2014-15 year and future years.

The DRP is exempt from income « tax » for payments made for disasters occurring in the 2014-15 year and future years.

The « tax » treatment of the DRP is not explicit in the ITAA 1997 for payments made for disasters occurring in the 2014-15 year and future years.

Detailed explanation of new law

Income Support Allowance

4.15               Subsection 160AAA(1) of the ITAA 1936 contains a list of rebatable benefits.

4.16               The ISA payment is included in the list of rebatable benefits for the 2014-15 year and future years. [Schedule 4, items 1 and « 2 » , paragraph 160AAA(1)(ab) and subsection 160AAA( « 2 » ) of the ITAA 1936]

4.17               As a result, New Zealand SCV holders in receipt of an ISA for disasters occurring in the 2014-15 year and future years are entitled to an income « tax » rebate.

4.18               The Minister for Justice must have made the relevant determination under section 36A of the Social Security Act 1991 (that the event is a ‘Part 2.23B major disaster’). [Schedule 4, item « 2 » ,  paragraph 160AAA ( « 2 » )(b) of the ITAA 1936]

4.19               This « amendment » ensures that New Zealand SCV holders in receipt of the ISA are eligible for the « tax » treatment equivalent to Australian citizens receiving the DRA.

Disaster Recovery Payment

4.20               The table in section 51-30 of the ITAA 1997 lists welfare payments which are exempt from income « tax » , as well as any special conditions.

4.21               A new item is inserted into the table, making the DRP to New Zealand SCV holders exempt from income « tax » for disasters occurring during the 2014-15 year or later years. [Schedule 4, item 5, item 5.2 in the table in section 51-30 of the ITAA 1997]

4.22               The exemption is subject to a special condition that a determination has been made under section 1061L of the Social Security Act 1991 (as to what constitutes being ‘adversely affected’). [Schedule 4, item 5, item 5.2 in the table in section 51-30 of the ITAA 1997]

4.23               This « amendment » ensures that New Zealand SCV holders in receipt of the DRP are eligible for the « tax » treatment equivalent to Australian citizens receiving the AGDRP.

4.24               This « amendment » does not change the eligibility criteria or terms of the DRP, which are equivalent to the AGDRP.

Consequential amendments

4.25               The index for exempt payments is updated to include ex-gratia disaster recovery payments to special category visa (subclass 444) holders. [Schedule 4, item 3, section 11-15 of the ITAA 1997]

4.26               The list of « tax » offsets is updated to include ex-gratia income support allowance payments to special category visa (subclass 444) holders. [Schedule 4, item 4, section 13-1 of the ITAA 1997]

Application and transitional provisions

4.27               These amendments apply to ex-gratia payments for eligible disasters occurring during the 2014-15 year and later years.

4.28               These amendments apply retrospectively to payments of ex-gratia DRP and ISA and are beneficial to affected taxpayers.

Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

« Tax » exemption or rebate for ex-gratia disaster-related payments to New Zealand SCV holders

4.29               This « Bill » is compatible with the human rights and freedoms recognised or declared in the « international » instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

4.30               This « Bill » provides an income « tax » exemption for New Zealand SCV holders in receipt of the DRP, and provides a « tax » rebate for New Zealand SCV holders in receipt of the ISA, following major disasters in the 2014-15 financial year and later years.

Human rights implications

4.31               This « Bill » does not engage any of the applicable rights or freedoms.  

Conclusion

4.32               This « Bill » is compatible with human rights as it does not raise any human rights issues.



Chapter 5          

Derivative money of retail clients

Outline of chapter

5.1                   Schedule 5 to this « Bill » amends the Corporations Act to provide greater protection for retail client money and property held by financial services licensees in relation to over-the-counter derivative products. These amendments align the Australian client money regime with community expectations regarding the level of protection that should be afforded to retail consumers of complex financial products and services.

5.2                   All legislative references in this Chapter are to the Corporations Act, unless otherwise stated.

Context of amendments

5.3                   The Corporations Act limits how financial services licensees may use money or property they receive from clients (or on the client’s behalf) in connection with a financial service provided to the client, or a financial product held by the client. The objective of these limitations is to ensure that money and property relating to the provision of a financial service or product that is received by a licensee from, or on behalf of a client, is handled appropriately by the licensee.

5.4                   In particular, the Corporations Act and the Corporations Regulations 2001 (Corporations Regulations) specify designated accounts into which client money can be deposited, how money can be invested and the circumstances under which the licensee may withdraw client money from designated accounts. Section 981H provides that client money is held on trust by the licensee for the benefit of the client.

5.5                   The rules make specific and significant exceptions to these protections for dealing in derivatives. A derivative is a financial product with value derived from the change in value of an underlying asset or market factor.

5.6                   Client money or property related to a derivative or to a dealing in a derivative may be used for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee (including dealings on behalf of people other than the client).

5.7                   Once money has been withdrawn from client accounts for any of the above reasons, it ceases to be protected by the statutory trust and may expose clients to higher levels of counterparty risk. That is, there is a higher risk that clients may not be able to recover their money if there is a deficit in the client money account and the licensee becomes insolvent or is otherwise unable to pay the deficiency.

5.8                   Counterparty risk is mitigated for exchange-traded derivatives by the rules of exchanges and clearinghouses which impose stringent capital, reporting and reconciliation requirements in relation to client money. However, licensees are not bound by these rules when dealing with over-the-counter derivatives.

5.9                   An over-the-counter derivative is a derivative that is bilaterally negotiated between retail investors and licensed providers.

5.10               The existing client money regime does not differentiate between wholesale and retail clients, or whether derivatives are traded on an exchange or over-the-counter. This is because the use of derivatives has developed beyond what was contemplated when the existing regime came into effect. For example, at that time, it was uncommon for retail clients to deal in over-the-counter derivatives. This is « no » longer the case.

5.11               Wholesale clients typically have considerable experience dealing in derivatives and the capacity to assess risks associated with the use of their money.

5.12               However, retail clients may not understand or appreciate the risks associated with their client money being used to meet certain obligations of the licensee. Thorough assessment and evaluation of counterparty risk in derivatives markets is complex, and cannot be reasonably expected of retail clients.

5.13               This Schedule makes legislative amendments to strengthen the protection for retail clients dealing in over-the-counter derivatives. It also allows ASIC to make client money reporting rules to assist it in effectively monitoring the use of client money and identifying where client money has been used for a non-permitted purpose by a financial services licensee.

5.14               The Government is also developing related amendments to the Corporations Regulations to address integrity concerns with the ability of licensees to withdraw money related to derivatives or a dealing in derivatives from client accounts in accordance with the written directions of the client, or to pay the licensee money to which it is entitled. This will prevent licensees using their client « agreements » to avoid the effect of the amendments made by this Schedule.

Summary of new law

5.15               This Schedule provides that financial services licensees may only use retail client money or property related to a derivative to meet an obligation where:

•        the entry into of the derivative is cleared through:

-                a licensed clearing and settlement facility; or

-                a clearing and settlement facility, the operator of which is authorised to operate the facility in a foreign country in which the operator’s principal place of business is located, and that meets any requirements specified in regulations; and

•        the licensee incurred the obligation, in connection with the derivative, under the operating rules of the clearing and settlement facility.

5.16               This Schedule also allows ASIC to make rules in relation to the reporting and reconciliation of derivative retail client money by financial services licensees.

5.17               Contravention of the client money reporting rules may give rise to a civil penalty. Regulations may provide for alternatives to civil proceedings.

Comparison of key features of new law and current law

New law

Current law

Client money or property held in connection with a product or financial service or that is, or relates to, a dealing in a derivative may be used to meet certain obligations incurred by the licensee if:

•        the entry into of the derivative is cleared through:

-       a licensed clearing and settlement facility; or

-       a clearing and settlement facility, the operator of which is authorised to operate the facility in a foreign country in which the operator’s principal place of business is located, and that meets any requirements specified in regulations; and

•        the licensee incurred the obligation, in connection with the derivative, under the operating rules of the facility.

Client money or property held in connection with a product or financial service that is, or relates to, a dealing in a derivative may be used for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee (including dealings on behalf of people other than the client).

ASIC may, by legislative instrument, make rules (the client money reporting rules) for purposes relating to derivative retail client money. These rules may impose:

•        requirements to report information;

•        reconciliation requirements; and

•        requirements incidental or related to either of the above.

Financial services licensees must comply with these rules.

ASIC does not have the power to make or enforce reporting and reconciliation requirements in relation to derivative retail client money unless the derivative is traded on a licensed financial market.

The client money reporting rules may include penalties not exceeding $1 million for breaches of the reporting rules.

Regulations may provide alternatives to civil proceedings.

« No » equivalent.

Detailed explanation of new law

Limiting the circumstances in which licensees may use client money or property

5.18               The Corporations Act contains specific rules for client money and property held by financial services licensees that is related to a derivative or a dealing in a derivative. In particular, financial services licensees may use client money and property for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee (including dealings on behalf of people other than the client).

5.19               This may expose clients to significant counterparty risk, particularly in relation to over-the-counter derivatives that are not cleared through a clearing and settlement facility. Retail clients are not generally in a position to adequately assess and evaluate these risks.

5.20               This Schedule addresses this situation by amending the Corporations Act to provide that financial services licensees may only use retail client money or property related to a derivative to meet an obligation where:

•        the entry into of the derivative was or will be cleared through an authorised clearing and settlement facility; and

•        the licensee incurred the obligation, in connection with the derivative, under the operating rules of the facility.

[Schedule 5, items « 2 » to 4, subsections 981D( « 2 » ) and 984B(3) and section 981D].

5.21               A facility will be an ‘authorised clearing and settlement facility’ if it is:

•        a licensed CS facility (defined in section 761A to mean a clearing and settlement facility the operation of which is authorised by an Australian CS facility licence); or

•        a clearing and settlement facility that satisfies the following requirements:

-       the operator of the facility is authorised to operate the facility in the foreign country in which the operator’s principal place of business is located; and

-       any requirements specified in the regulations for this purpose.

[Schedule 5, item 1, section 761A (definition of ‘authorised clearing and settlement facility’)]

5.22               Preventing derivative retail client money from being used to meet the licensees’ obligations except in the circumstances specified provides retail clients with a level of consumer protection that is appropriate to their expected level of experience and capacity to adequately assess and evaluate the risk associated with dealing in derivatives.

5.23               The amendments in this Schedule prescribe that only derivative retail client money related to a derivative cleared through an

Australian-licensed clearing and settlement facility, or through a clearing and settlement facility, the operator of which is authorised to operate the facility in a foreign country in which the operator’s principal place of business is located, may be used to meet an obligation incurred under the operating rules of a clearing and settlement facility.

5.24               Derivatives traded on an exchange will be cleared through a clearing and settlement facility, while over-the-counter derivatives commonly transacted by retail clients are generally not cleared. The restrictions imposed on the use of derivative retail client money and property do not apply to derivatives cleared through a clearing and settlement facility, in recognition that such derivatives are subject to stringent capital, reporting and reconciliation requirements imposed by the relevant clearing house in relation to client money and property. These requirements provide an appropriate level of protection for derivative retail client money and property that are traded through an exchange.

5.25               Additional requirements may be specified in regulations in relation to foreign clearing and settlement facilities to which this rule will apply, principally to address integrity concerns. For example, regulations may be made to ensure that licensees will not be able to use derivative retail client money to meet obligations incurred under the operating rules of foreign clearing and settlement facilities that do not provide adequate protection for that money.

5.26               The current law will continue to operate in respect of client money and property held by financial services licensees on behalf of wholesale clients. This is consistent with financial services regulation more broadly: wholesale clients are generally not given the same level of regulatory protection as they are better able to adequately assess and evaluate the relevant risks.

Derivative retail client money and property

5.27               Derivative retail client money is defined as money paid to a financial services licensee by or on behalf of a client in connection with:

•        a financial service that:

-       has been, will or may be provided to the client; and

-       is or relates to a dealing in a derivative; or

•        a financial product that is a derivative; and

the financial service or product would be provided to the client as a retail client if the service or product were provided to the client when the money was paid. [Schedule 5, item 1, section 761A (definition of ‘derivative retail client money’)]

5.28               An equivalent definition of derivative retail client property has also been created. [Schedule 5, item 1, section 761A (definition of ‘derivative retail client property’)]

5.29               For the purposes of the definitions of ‘derivative retail client money’ and ‘derivative retail client property’, ‘retail client’ includes clients who are sophisticated retail investors as set out in section 761GA. This ensures that the sophisticated investor carve-out contained in section 761GA cannot be exploited to circumvent the amendments in this Schedule. While sophisticated investors are generally high net worth individuals, like other retail clients, they may not always have the requisite knowledge of complex financial services such as derivatives to evaluate the risks associated with how licensees use derivative client money .   [Schedule 5, item 1, section 761A (subparagraph (b)(ii) of the definitions of ‘derivative retail client money’ and ‘derivative retail client property’)]

Client money reporting rules

5.30               To ensure ASIC can effectively monitor and enforce the limitations on the use of derivative retail client money, ASIC may make rules (the client money reporting rules ) dealing with prescribed matters for purposes relating to derivative retail client money. Imposing new reporting and reconciliation requirements on financial services licensees in relation to derivative retail client money will assist ASIC to identify where client money has been used for a non-permitted purpose and will enhance ASIC's surveillance of the sector. Retail investors may benefit from greater transparency in relation to client money accounts through a reduction in the risk of client losses through fraud, and the duration and extent of that fraud. Enhanced monitoring of client money accounts should also benefit licensees by reducing the risk of fraud, error and other operational breaches. [Schedule 5, item 14, subsection 981J(1)]

5.31               The client money reporting rules will focus on reporting and reconciliation requirements for client monies, and do not cover client property. Client property in this context can include a range of property such as securities held by licensees or other parties on behalf of clients, which are held and transferred in a fundamentally different way to money in client trust accounts. The risks arising in respect of client property are also likely to be different. For these reasons reporting and reconciliation requirements are considered appropriate to apply to client monies and not to client property.

5.32               It is appropriate for the detail of the client money reporting requirements to be determined by ASIC in client money reporting rules, given the complexity involved in prescribing specific reporting requirements and the need to ensure the rules keep pace with market developments. Developing and maintaining an appropriate regulatory framework for derivative client money requires close continuous monitoring of derivative markets and the ability to update the reporting requirements at short notice, which ASIC is best positioned to undertake.

5.33               The client money reporting rules form a suite with certain other rules ASIC can make under the Corporations Act . Each of these rules have similar objectives in allowing ASIC to prescribe, in detail, matters conducive to the appropriate regulation and supervision of financial markets, particularly derivatives markets.

5.34               The main rules in this regard are the market integrity rules, for which provision is made in section 798G, and the derivative transaction rules, which ASIC can make under section 901A. Given that the market integrity rules, derivative transaction rules and the client money reporting rules cover the same broad area of activity, and collectively contribute to the same overall outcome of well-regulated and supervised financial and derivatives markets, the client money reporting rules have been aligned with the other two sets of rules to the greatest extent possible.

5.35               The client money reporting rules may impose:

•        requirements to report information;

•        reconciliation requirements; and

•        requirements that are incidental or related to the above requirements.

[Schedule 5, item 14, subsection 981K(1)]

5.36               A non-exhaustive list of matters incidental or related to requirements to report accounting information and reconciliation requirements are also prescribed. The client money reporting rules are generally expected to be centred on the licensee, the management of their client money trust accounts, and any possible breaches of the client money requirements by the licensee through the reporting of accounting and financial information showing the flows of funds in and out of their client money trust accounts. The rules would not ordinarily require licensees to report personal information about their clients. [Schedule 5, item 14, subsection 981K( « 2 » )]

5.37                The Privacy Act 1988 (Privacy Act) is the primary vehicle for ensuring the protection of personal information at the Commonwealth level. The Privacy Act imposes certain obligations on ASIC regarding the collection of personal information that would inform the scope of the client money reporting rules. Consistent with Commonwealth Government policy, ASIC is also required to comply with the guidance and requirements of the Office of the Australian Information Commissioner (OAIC) in dealing with personal information that ASIC collects. The OAIC expects to be consulted on any agency proposals involving the handling of personal information that might have a significant impact on the privacy of individuals, including any personal information included in client money reporting rules. To comply with these expectations, ASIC would be expected to consult the OAIC on any proposed client money reporting rules that may involve the handling of personal information or have a significant impact on the privacy of individuals.

5.38               Regulations may limit the requirements ASIC may impose on financial services licensees by providing that the client money reporting rules:

•        cannot impose requirements (or certain kinds of requirements) in relation to certain classes of persons or money; or

•        can only impose requirements (or certain kinds of requirements) in relation to certain classes of persons or money in certain circumstances.

[Schedule 5, item 14, subsection 981J( « 2 » )]

5.39               This allows the scope of the client money reporting rules to be restricted in the future if necessary, to tailor the scope of the reporting power so it is fit for purpose and does not impose undue regulatory burdens. For example, regulations may specify a threshold of activity that must be met before financial services licensees are subject to certain kinds of requirements. Alternatively, regulations may provide that certain transactions cannot be made subject to requirements in the client money reporting rules. It is important to note that other secrecy provisions would prevail over the regulations, except in relation to disclosures made by licensees to ASIC for the purposes of Subdivision AA in Division « 2 » of Part 7.8 of the Corporations Act.

5.40               The definition of ‘client money reporting rules’ is inserted into the list of definitions for Chapter 7 of the Corporations Act. [Schedule 5, item 6, section 761A (definition of ‘client money reporting rules’)]

5.41               The rules constitute a disallowable legislative instrument for the purposes of the Legislation Act 2003 .

Consultation on draft rules

5.42               ASIC must consult the public on a proposed client money reporting rule before it is made. This ensures that stakeholders have the opportunity to review and comment on draft rules before they are made. [Schedule 5, item 14, subsection 981L(1)]

5.43               The ways in which ASIC may comply with this requirement are not limited. However, to provide certainty, the Schedule provides that ASIC is taken to comply with the obligation if ASIC makes the proposed rule, or a description of the content of the proposed rule available on ASIC’s website, and invites the public to comment on the proposed rule. [Schedule 5, item 14, subsection 981L( « 2 » )]

5.44               A failure to comply with this consultation requirement does not invalidate a client money reporting rule. [Schedule 5, item 14, subsection 981L(3)]

5.45               As explained above, ASIC would be expected to consult the OAIC where proposed client money reporting rules potentially involve the handling of personal information that could impact on the privacy of individuals.

Compliance with the client money reporting rules

5.46               ASIC has a range of options to enforce compliance with the client money reporting rules, including:

•        bringing civil proceedings for contravention of the client money reporting rules;

•        entering into an alternative to civil proceedings with the relevant person or persons; or

•        applying to the court for one or more orders.

5.47               A person aggrieved by an alleged contravention of the client money reporting rules may also apply to the court for one or more orders.

5.48               Detailed information on these options is set out below.

Civil penalties and alternatives to civil proceedings

5.49               Financial services licensees must comply with the client money reporting rules. Those who do not comply with the rules may be liable to a civil penalty. [Schedule 5, items 14 and 21, subsection 981M(1) and table item 31A in the table in subsection 1317E(1)]

5.50               The client money reporting rules may include a penalty amount for a rule, not exceeding $1 million [Schedule 5, item 14, subsection 981K(3)] . This is equivalent to the maximum penalty under the market integrity rules, which contain corresponding reporting and reconciliation requirements made in connection with dealings in exchange-traded derivatives. Equivalence with the maximum penalty under the market integrity rules is consistent with the principle that penalties should be consistent for offences of a similar kind or level of seriousness.

5.51               A maximum penalty of $1 million reflects that misuse of retail client money is a serious matter that can result in significant monetary losses for affected retail investors and undermine confidence in Australian financial markets.

5.52               Safekeeping of client monies is a critical factor in preserving investor confidence in financial and derivatives markets, and it is important that penalties for breaches of the law in this area (including the reporting rules) are sufficiently severe to have a genuine deterrent effect. In addition, the amount of client money that is entrusted to licensees may be very large. For example, the collapse of the broker MF Global resulted in around $320 million of client monies being placed at risk in Australia alone. As the cost to the individual investors and wider confidence in the financial system from a breach of the client money rules is potentially very significant, the proposed penalty amount is considered appropriate for ensuring a commensurate deterrent effect.

5.53               Regulations may provide for a person who is alleged to have not complied with the client money reporting rules to do one or more of the following as an alternative to civil proceedings:

•        pay a penalty to the Commonwealth (not exceeding three-fifths of the maximum penalty amount set out in the client money rules for the rule);

•        undertake or institute remedial measures (including education programs);

•        accept sanctions other than the payment of a penalty to the Commonwealth;

•        enter into a legally enforceable undertaking (including an undertaking to take specified action within a specified period; an undertaking to refrain from taking specific action; and an undertaking to pay a specified amount within a specified period to the Commonwealth or to some other specified person).  

[Schedule 5, item 14, section 981N]

5.54               A similar provision for alternatives to civil proceedings is provided for in the market integrity and the derivative transaction rules. It is important that ASIC has a wide range of options at its disposal for enforcing all of these rules. This Schedule allows the regulations to prescribe ways for ASIC to deal with breaches of the client money reporting rules expeditiously by providing for a person to make a payment and/or accept an alternative action, such as to institute remedial measures or enter into an enforceable undertaking in place of civil proceedings.  If a person decides to enter into an alternative to civil proceedings the monetary amount payable cannot exceed three-fifths of the maximum amount that a court could require payment of in civil proceedings.

Court orders

5.55               The Court may make such order or orders as it thinks fit if, on the application of a person aggrieved by an alleged contravention by another person of the client money reporting rules, it appears to the Court that:

•        the other person did contravene the client money reporting rules; and

•        the applicant is aggrieved by the contravention.

[Schedule 5, item 16, paragraph 1101B(1)(d)]

5.56               Examples of orders the Court may make on contravention of the client money reporting rules include, but are not limited to:

•        an order giving directions about complying with a provision of the client money reporting rules [Schedule 5, item 17, paragraph 1101B(4)(b)] ;

•        an order requiring a person to disclose to the public or to a specified person specified information that the person possesses or to which they have access [Schedule 5, item 18, subparagraph 1101B(4)(c)(i)] ;

•        an order requiring a person to publish advertisements at their expense [Schedule 5, item 18, subparagraph 1101B(4)(d)(i)] .

5.57               The Court may also, or alternatively, make orders to disclose information or publish advertisements under the general powers of courts in the Corporations Act. [Schedule 5, item 27, section 1324B]

5.58               Where a person has suffered, or is likely to suffer, loss or damage as a result of a contravention of the client money reporting rules, the Court may make such orders as it thinks appropriate. These orders may be against a person or the persons who contravened the rules, or who were involved in the contravention. This may occur in a proceeding, on application by the aggrieved person or persons, or on application by ASIC with prior written agreement from the aggrieved. [Schedule 5, item 28, subsections 1325(1), ( « 2 » ) and (3)]

Orders relating to civil penalties

5.59               Subsection 981M(1), which requires compliance with the client money reporting rules, is listed as a ‘civil penalty provision’. This means that contraventions of the client money reporting rules are subject to the civil penalties regime in Part 9.4B. [Schedule 5, item 21, table item 31A in the table in subsection 1317E(1)]

5.60               The Court may order a person to pay the Commonwealth a pecuniary penalty if a declaration of contravention of the client money reporting rules by the person has been made by a Court. The maximum amount that the court may order the person to pay for contravening a client money reporting rule is the penalty amount set out in the client money reporting rules for the rule. [Schedule 5, items 22 to 24, subsection 1317G(1C) (heading), paragraph 1317G(1C)(b) and subsection 1317G(1D)]

5.61               The Court may order a person who has contravened the client money reporting rules to compensate another person (including a corporation), or a registered scheme, for damage suffered by the person or scheme that resulted from the contravention. [Schedule 5, items 25 and 26, section 1317HB (heading) and paragraph 1317HB(1)(a)]

5.62               Subsection 981M(1) has not been made a ‘financial services penalty provision’. This ensures consistency with the market integrity rules in relation to the making of pecuniary penalty orders and compensation orders. [Schedule 5, item 20, paragraph (b) of the definition of ‘financial services civil penalty provision’ in section 1317DA]

Protection from liability - giving information to ASIC

5.63               Persons who give information to ASIC regarding the client money reporting rules have limited protection from liability in two circumstances:

•        where financial services licensees give information to ASIC under a requirement of the client money reporting rules; and

•        where a person gives information to ASIC in relation to a contravention or a suspected contravention of the client money reporting rules.

Protection from liability for information given under the client money reporting rules

5.64               A financial services licensee (including persons acting on its behalf, such as its officers, employees or contractors) that provides information to ASIC as required by the client money reporting rules is protected from any liability arising from this conduct. Providing this immunity is important for ensuring that licensees are not penalised for complying with the client money reporting rules. [Schedule 5, item 14, section 981P]

Qualified privilege for information given in relation to a contravention or a suspected contravention of the client money reporting rules

5.65               A person has qualified privilege in respect of the giving of any information to ASIC in relation to a contravention or a suspected contravention of the client money reporting rules. Qualified privilege is provided in situations where the public interest requires communication without the potential liability for defamation. In this case, providing qualified privilege for persons giving information to ASIC relating to a contravention or a suspected contravention of the client money reporting rules will improve ASIC’s ability to monitor and enforce compliance with the rules. [Schedule 5, item 15, paragraph 1100A(1)(b)]

5.66               ‘Qualified privilege’ is defined in section 89 of the Corporations Act. Under section 89, a person who has qualified privilege in respect of any act, matter or thing has:

•        qualified privilege in proceedings for defamation; or

•        is not, in the absence of malice on the person’s part, liable to action for defamation at the suit of a person;

as the case requires, in respect of that act, matter or thing.

Hierarchy of rules

5.67               Prioritisation rules have been included to provide clarity in the event of inconsistency between the client money reporting rules and other rules that may impose requirements relating to derivatives. The client money reporting rules are incorporated into the established hierarchy of rules in the Corporations Act.

5.68               Each of the market integrity rules (made under section 798G), the derivative transaction rules (made under section 901A) and the derivative trade repository rules (made under section 903A) prevail over the client money reporting rules to the extent of any inconsistency. [Schedule 5, items 8 and 10 to 14, note 3 of subsection 793B( « 2 » ), note « 2 » of subsection 822B( « 2 » ), note 3 of subsection 901E( « 2 » ); note 6 of section 903D, and subsection 981M( « 2 » )]

5.69               However, the client money reporting rules prevail to the extent of any inconsistency with the operating rules of a licensed market or of a licensed CS facility. [Schedule 5, items 7 and 9, paragraphs 793B( « 2 » )(d) and 822B( « 2 » )(c)]

Appeal to the Administrative Appeals Tribunal

5.70               Appeals may not be made to the Administrative Appeals Tribunal (AAT) for a review of:

•        a decision by ASIC to make client money reporting rules;

•        a decision by ASIC to do or not do anything under regulations made to set out alternatives to civil proceedings for contraventions of the client money reporting rules.

5.71               It is appropriate that a decision to make client money reporting rules is not subject to review by the AAT, as the decision excluded is more akin to a policy and rule-making decision. The making of legislative instruments is a decision of a legislative character, and should not be subject to review by the AAT. The rules are also disallowable by the Australian Parliament.

5.72               The second type of excluded decision relates to a decision by ASIC to propose or agree to an alternative to a civil penalty proceeding. Such a decision is preliminary in nature and does not in itself have a conclusive effect on the person alleged to have committed a contravention. The person remains free to reject the proposed alternative (if any) and deal with the matter in civil proceedings before a court. In addition to being preliminary, these decisions have a law enforcement nature. They are based on a judgment by ASIC regarding the most appropriate enforcement approach in response to an alleged breach of the law. Making such decisions subject to AAT review could jeopardise the effective investigation of alleged breaches and the subsequent enforcement of the law.   [Schedule 5, item 19, paragraphs 1317C(gdd) and (gde)]

Application provisions

5.73               The amendments made by this Schedule that limit the uses to which licensees may put derivative retail client money and derivative retail client property apply to a use of money or property on or after the day after the end of the period of 12 months beginning on the day this « Bill » receives the Royal Assent, whether the money was paid or the property was given to the licensee before, on or after that commencement. [Schedule 5, item 5, section 1636A]

5.74               All other amendments apply from commencement (12 months after Royal Assent).

Regulation impact statement

Executive Summary

What is client money?

5.75               Client money is money paid to an Australian financial services licensee (AFSL) by or on behalf of a client in connection with:

•        a financial service that has been, or may be provided; or

•        a financial product held by the client;

but not as payment for that service or product. [18] It remains the client’s own money, although it is held by their AFSL. For example, client money may be paid to meet opening and margining requirements for a trading account. [19]

5.76               The Government is concerned about the use of a particular type of client money: that which is associated with dealings in over-the-counter (OTC) derivatives (referred to in this document as ‘derivative client money’).

5.77               OTC derivatives are contracts between two parties which derive their value from shifts in the value of an object in the underlying market (such as assets, indexes or interest rates). They are privately negotiated without going through an exchange or other intermediary.

What is the problem the Government is trying to solve?

5.78               The Government wants to change the way client money in relation to derivatives is regulated in Australia because the regime « no » longer meets the needs of financial services consumers.

5.79               The current regulatory framework does not adequately protect retail clients, as it exposes their OTC derivative client money to risks of which they are likely unaware.

5.80               While most client money in Australia is to be held in trust for the client, [20] AFSLs can use derivative client money in a broad range of ways - for their own and other clients’ purposes. It is commonly used to hedge the risks that a broker takes when it issues OTC derivatives to its clients, and can be lost or delayed in the event that an AFSL becomes insolvent.

5.81               Consequently there is a risk that clients may not receive all of their client money back if there is a deficit in the client money account and the AFSL holder becomes insolvent.

Why is Government action needed?

5.82               Investor confidence depends on robust and responsive regulation of the financial system. Inappropriate risk must be dealt with swiftly and poor design remedied.

5.83               The ASIC as the financial services regulator is unequivocal about the need for reform.

5.84               While many AFSLs have taken it upon themselves to protect retail derivative client money as standard practice, this is not universal and will not become so without regulatory change. Without such reform, retail clients will continue to suffer unnecessary (and often unexpected) losses in the event that their AFSL becomes insolvent.

What policy options are the Government considering?

5.85               To better protect retail clients, the Government has considered prohibiting AFSL use of derivative client money; continuing to allow AFSLs to use derivative client money to hedge, provided there are safeguards in place; and maintaining the status quo.

What is the likely net benefit of each option?

5.86               Prohibiting AFSLs’ use of retail OTC derivative client money may affect the viability of some AFSLs, particularly those that are thinly resourced (above the regulatory minimum). However, client money will be much safer - and investor confidence in the industry is likely to increase. On balance, the Government believes this option has the highest net benefit.

5.87               Hedging with safeguards should not have a significant impact on AFSLs, would improve AFSL resilience and limit the ways in which client money can be used.

5.88               Maintaining the status quo would not have much impact on AFSLs in the short term (although inadequate regulation may affect its reputation in the longer term), and consumer protection would continue to be inadequate.

Who will the Government consult, and how will it consult them?

5.89               The Government has consulted extensively on its reform package. In late 2015 and early 2016, the Government sought public comment on a policy paper, draft legislation and regulation. Since then, officials have met with a broad range of stakeholders - including AFSLs, regulators and other experts - to explore and test the case for change.

What is the best option from those considered?

5.90               The Government proposes to amend several aspects of the Corporations Act and Corporations Regulations to create a more tailored and contemporary client money regime that prohibits AFSL use of retail OTC derivative client money for their own and other clients’ purposes.

5.91               This final assessment - second pass Regulatory Impacts Statement (RIS) considers public feedback, evaluates alternative paths for reform, and explains why the Government remains confident that its proposed approach (with minor refinements) is the most appropriate solution.

How will the Government implement and evaluate its chosen option?

5.92               The final chapter recommends a careful approach to implementation. The Government will seek ASIC’s assistance in monitoring the impacts of reform, and advice on mitigation as needed. The Government has also included a one year transition period to allow industry to adjust.

Glossary

Term

Definition

Australian Financial Services Licensee (AFSL)

A business licensed by ASIC to provide financial services.

BCBS-IOSCO framework for non-centrally cleared derivatives

The Basel Committee on Banking Supervision and « International » Organisation of Securities Commissions’ Margin Requirements for Non-centrally Cleared Derivatives (the BCBS-IOSCO framework) is designed to reduce the potential for contagion from the default of a market participant by ensuring that OTC derivatives exposures have enough collateral. In addition, by bringing bilateral risk management practices more into line with those used in central clearing, the framework should improve transparency and risk comparisons, and promote central clearing for derivatives that meet the preconditions for safe and reliable clearing .

Broker

A party that arranges transactions between a buyers and sellers (typically on commission basis).

Client money

In broad terms, client money is money paid to a financial services provider in connection with a financial service or financial product, but not as remuneration to acquire that service or product. 

With specific regard to OTC derivatives, client money is commonly money deposited with issuers (by investors) to meet the requirements associated with trading in these products, such as margining.

Collateral

Collateral is a borrower's security against a repayment obligation, such as a loan (or open OTC derivative position). Collateral serves as protection for the lender (or issuer) against the borrower's or investor’s default (failure to meet their repayment obligation).

Contract-for-difference (CFD)

A common retail OTC derivative whose value is based on the difference between the current value of an asset (such as a share) and its value at the time the CFD is closed out.

Counterparty

Counterparties are parties that face each other during a transaction. 

Counterparty credit risk

Counterparty credit risk is the risk one party to a contract faces that another party to that contract will not meet their contractual obligations.

Derivative

A financial product whose value is based on (derived from) the change in value of an underlying asset, index or other object. See s761D of the Corporations Act.

Exchange

A licenced financial market accessible to retail consumers where financial products are bought and sold. For example, the Australian Securities Exchange (ASX).

Futures

A (standardised) exchanged-traded contract between two parties to buy or sell a specified asset at a specific point in the future for a price agreed now.

Hedge

An investment position intended to offset the potential losses (or gains) associated with another investment.

Issuer

An issuer is an AFSL that issues retail OTC derivatives to investors.

Margin forex

A common retail OTC derivative the value of which is based on the changes in exchange rates between the opening and the closing of the contract.

Margining

Margining is the process of exchanging collateral to protect against counterparty credit risk in financial contracts and is a key component of risk reduction strategies. It is intended to reduce the kind of contagion and spill-over effects experienced in the GFC, by ensuring that collateral is available to offset losses caused by the default of a derivative counterparty. The collateral exchanged can be by way of direct transfer of, or granting security over, certain assets.

Options

A derivative that represents a contract sold by one party (option writer) to another party (option holder). Options can be exchange-traded or OTC.

Prime broker

An investment bank that offers hedging services to issuers. The use of a prime broker enables issuers to hedge their investor OTC derivatives position with a counter party (typically on a net basis).

Product Disclosure Statement

A document (prepared by the issuer) that must be provided to the investor (by the issuer) and sets out the essential features of the financial product (in this case, the OTC derivative).

Retail client

A retail client is a person as identified in section 761G of the Corporations Act. Generally speaking, retail clients are individuals or small businesses.

Retail over-the-counter (OTC) derivative

Retail OTC derivatives are a flexible derivative that is bilaterally negotiated between a retail investor and an issuer, such as a CFD. 

Sophisticated investor

A sophisticated investor is an investor as defined in section 708(8) of the Corporations Act. An AFSL is exempt from providing disclosure documents to an investor classified as a sophisticated investor.

Wholesale client

A financial product or service is provided to a person as a retail client unless subsections 761G(5), 761G(6), 761G(6A) or 761G(7), or s761GA, provides otherwise. A financial product or service is provided to, or acquired by, a person as a wholesale client if it is not provided to, or acquired by, the person as a retail client.

Introduction

5.93               Client money is money paid to an AFSL by or on behalf of a client in connection with a financial service that has been, or may be provided; or a financial product held by the client - but not as payment for that service or product. [21] It remains the client’s own money, although it is held by their AFSL.

5.94               The Government is concerned about the use of a particular type of client money: that which is associated with dealings in OTC derivatives (referred to in this document as ‘derivative client money’).

5.95               OTC derivatives are contracts between two parties which derive their value from shifts in the value of objects in the underlying market (such as assets, indexes or interest rates). They are privately negotiated without going through an exchange or other intermediary.

5.96               This RIS explores the case for change in respect of the regulation of derivative client money. It has been refined at each stage of the policy process, to inform key decisions.

5.97               This version follows considerable consultation on draft legislation and regulation to give effect to the Government’s client money reforms.

What is the problem the Government is trying to solve?

Key issues with the client money regime

5.98               The Corporations Act establishes a regulatory framework governing how AFSLs must deal with client money. [22] These requirements are set out in Divisions « 2 » and 3 of Part 7.8 of the Corporations Act and Regulations 7.8.01 to 7.8.07 of the Corporations Regulations.

5.99               The use of derivatives has developed beyond what was contemplated when the existing regime came into effect in 2001.

5.100           The Government wants to resolve the following issues with the regulatory framework.

5.101           The current framework provides inconsistent and inadequate protection of retail clients’ client money. OTC derivative client money in particular can be exposed to more risk than clients appreciate.

5.102           While the client money regime did not cause any of the recent AFSL collapses in Australia (for example,  MF Global Australia or BBY Ltd), the regime did not stem the loss of, or promote the swift return of, client money.

5.103           According to ASIC, where an AFSL that has used client monies collapses retail clients often report that they did not realise their client money was at risk in the first place.

5.104           The Government also sees a need to improve AFSL reconciliation and reporting on retail client money to promote effective oversight and the faster return of client money in the event that an AFSL becomes insolvent.

5.105           The Government therefore proposes to empower ASIC to make rules for AFSLs in respect of reconciliation of, and reporting on, retail OTC derivative client money.

5.106           However, this part of the reform is not dealt with in this RIS as ASIC will be legally required to consult on any rules it wishes to make - and will be in a better position to assess impacts at that time.

5.107           ASIC in particular is concerned that the current regime does not adequately protect the interests of retail clients and that AFSLs should only be able to use client money for the purposes stipulated by the client - namely to support investments made on behalf of the client .This chapter sets out the context for the remaining issue, and explains why it is significant.

5.108           When the Corporations Act and Corporations Regulations were drafted in 2001, they were intended to facilitate exchange-traded futures. They did not foresee the market in OTC derivatives. [23]

5.109           As client money of retail clients is now exposed to more risk than was anticipated, the existing provisions « no » longer serve retail investors.

5.110           Moreover, there is a G-20 reform agenda underway to better regulate the provision of OTC derivatives. Australia has taken steps to implement these reforms, including the Financial System Legislation « Amendment » (Resilience and Collateral Protection) Act 2016 . The client money reforms proposed in this RIS ensure that the standard of client protection in Australia keeps pace with other advanced economies.

Context: Australian OTC derivatives trade

Retail trade          

5.111           AFSLs with permission to issue retail OTC derivatives provide a range of financial services, including contracts-for-difference (CFDs), binary options and margin foreign exchange (margin FX or forex).

5.112           CFDs are a way of betting on the change in value of a share, foreign exchange rate or a market index. CFDs often use borrowed money, which can magnify gains or losses.

5.113           Binary options are a type of option where the investor tries to predict the short-term movements of a share price, currency, index or commodity. Unlike other options the holder does not have the right to buy or sell the underlying asset. They are relatively new in Australia.

5.114           Forex trading is when an investor attempts to generate a profit by speculating on the value of one currency compared to another. Foreign currencies can be traded because the value of a currency will fluctuate, or its exchange rate value will change, when compared to other currencies. Forex trading is normally conducted through 'margin trading', in which a small collateral deposit - (worth a percentage of a total trade's value) is required to trade.

5.115           ASIC warns that all three products (and OTC derivatives in general) are speculative, complex and high-risk. They are highly leveraged, their value can change quickly, and the markets they speculate on are hard to predict and monitor (markets are open 24 hours a day, seven days a week). Moreover, risk management systems such as

stop-loss orders will only give investors limited protection by capping their losses, and may cost a premium to guarantee operation.

5.116           OTC derivatives are not like investing in shares - investors buy from, and sell to, the issuer of the OTC derivative. In trading with these firms, investors bet that their provider (the issuer) is in a sound financial position and will be able to meet their obligations to the investor (the client). The chance that the provider may not be able to fulfil their obligations to the investor is known as ‘counterparty risk’.

5.117           The 2016 Investment Trends Report estimates that there are 37,000 [24] active retail OTC derivatives investors in Australia. The median size of retail notional positions is $7,200 which is relatively small and suggests these investors are not limited to those with a sophisticated understanding of the risks that may be associated with financial investments and with trading in OTC derivative contracts.

5.118           There are about 65 AFSLs that actively issue retail OTC derivatives, including about seven that are prudentially regulated. The total revenue base of these licensees is $700 million. They serve clients in Australia and overseas.

5.119           Based on recent ASIC surveillance, it seems that the market is highly concentrated: five of the 58 AFSLs that are not

prudentially-regulated (or markets or clearing participants), account for about 79 per cent of market share based on revenue and about 93 per cent based on net profit.

5.120           ASIC’s 2012 Review of client money handling practices in the retail OTC derivatives sector found that most CFD issuers have very low market share, and some are part of « international » groups. Issuers with larger market share include domestic and offshore firms. CFDs are the most common OTC derivative products issued in the Australian OTC retail derivatives market.

5.121           The remaining AFSLs either offer OTC derivatives as part of a broader suite of products (that is, not core business), or are primarily small to medium-sized enterprises.

Box 1 - Business models for CFD issuers

5.122           In Australia, there are two types of business models for CFDs: ‘market maker ’and ‘direct market access’. Market maker and direct market access models are both provided over-the-counter and are the most commonly available CFDs in Australia and overseas. Several CFD providers offer both market maker and direct market access CFDs.

5.123           In both cases, the CFD provider determines the underlying assets on which CFDs may be traded. They also define the terms and conditions of the client agreement, including the margin requirements for client accounts.

Market maker model (OTC)

In a market maker business model, the CFD provider comes up with their own price for the underlying asset on which the CFDs are traded. The firm determines the amount of principal risk it can hold, and hedges the remainder (sometimes referred to as a B-Book or C-Book strategy).

Direct market access model (OTC)

In a direct market access model, the CFD provider places the investors’ order into the market for the underlying asset. The price the investor pays will be determined by the underlying market. Firms that use this model typically hedge all trades with their clients, to protect themselves from losses (sometimes referred to as an A-Book strategy).

Issue: « no » regulatory distinction between retail and wholesale clients

5.124           The Corporations Act defines retail clients and wholesale clients differently. [25] It recognises that, in general, clients in different categories will need different levels of protection and assistance to invest confidently.

5.125           However, the client money regime within the Corporations Act does not differentiate between types of client. Consequently, the regulation provides:

•        inconsistent, and in some instances inadequate, protection of retail and sophisticated investors’ client money; and

•        insufficient flexibility for wholesale clients (for example,  so that they can use their client money to comply with OTC derivative margining requirements).

5.126           For more information about the distinction between retail and wholesale clients, see Appendix A .

Issue: inconsistent and inadequate protection of client money of retail clients

Existing regime

5.127           In Australia, AFSLs must hold client money in trust - with a couple of significant exceptions.

Diagram 5.1 : Broad protections afforded to client money [26]

5.128           AFSLs must keep client money in designated ‘client money accounts’, which are generally operated as a statutory trust. This means, subject to some exceptions explained below, that funds deposited on behalf of a client in a client money account are held for the benefit of that client and cannot be used to meet the obligations of another client or be used by the AFSL. This is to protect client money in the event that the AFSL defaults.

5.129           However, there are broad exceptions to these protections. Section 981D of the Corporations Act and paragraphs 7.8.02(1)(a) and (c) of the Corporations Regulations limit the protections otherwise provided to client monies.

5.130           Section 981D permits money deposited by one client to be used (and withdrawn from the client account) in connection with dealings in derivatives. This is not limited to dealings ‘on behalf of’ a particular client, or to margins required by, for example, clearing and settlement facility operators (as distinct from counterparties to OTC derivative trades with the licensee).

5.131           Paragraphs 7.8.02(1)(a) and (c) of the Regulations also permit money to be withdrawn from client accounts for transactions where authorised by general written directions or for which the AFSL is entitled.

5.132           It is understood that some AFSLs obtain broad authorisations in their client « agreements » and product disclosure statements to make withdrawals from client money accounts for any purpose, including as working capital and for proprietary trading. This permission is often sought as part of the sign-on process for retail clients and requires the client to sign a standard form agreement between the retail client and AFS licensee which may be more than 30 pages. Retail clients do not usually seek or obtain independent legal advice before signing such client « agreements » .

5.133           Once money has been withdrawn from client accounts (under the broad permitted use set out in s 981D of the Corporations Act or paragraphs 7.8.02(1)(a) or (c) of the Regulations), it ceases to have the protections afforded to it by the statutory trust and may be exposed to higher levels of counterparty credit risk, for which clients are not compensated.

AFSLs that use client money

5.134           There is « no » reliable data about the total number of AFSLs that use OTC derivative client money, or the amount they use. Nor is the total amount of derivative client money held by AFSLs known (the last reliable estimate is from a 2012 ASIC report, which says that the quantum of all client money held by CFD issuers was in the order of $511 million. [27]

5.135           A proximate measure of those AFSLs that use derivative client money: of the top five AFSLs by market share that issue retail OTC derivatives, only one uses client money other than in relation to the exposure of the individual client.

5.136           Of those that do use derivative client money, one common use is to hedge the risk the AFSL takes when it enters a derivative contract with a client.

5.137           The group of AFSLs that use retail client money (and to some extent, their clients), are the populations most likely to be affected by the proposed reforms.

5.138           Feedback from industry stakeholders indicates that direct market access firms are more likely to rely on the use of derivative client money than those that operate a market maker model, although this distinction is not absolute.

5.139           Under the current client money regime, retail client money is put at risk each time there is a failure of a retail OTC derivative issuer. In two high profile examples from recent years, MF Global Australia's proceedings affected about 11,000 active client accounts across all business lines, and each client account may represent one or more clients; BBY Limited's ongoing proceedings have identified potential claims from close to 4,000 clients in its OTC businesses alone. ASIC has identified other instances where retail client money was put at risk or retail clients have suffered losses.

Diagram 5.2 : AFSLs that use retail OTC derivative client money

The difference between OTC and exchange-listed derivatives from a regulatory standpoint

5.140           It is important to differentiate between the risks associated with exchange-traded and non-centrally cleared derivatives (that is, OTC derivatives). Exchange-traded derivatives include derivatives over a wide range of underlying contracts such as government bonds, bank bills, stock indices and individual listed equity stock. The former is significantly safer than the latter, because:

•        they are traded through brokers authorised by a licensed exchange to deal in these products;

•        they are regulated by the exchange’s operating rules and ASIC market integrity rules;

•        the exchange and the relevant clearing house are responsible for registering, clearing and processing all trades;

•        the terms and conditions are standardised; and

•        as the exchange or a central clearinghouse acts as the counterparty to every transaction, the counterparty credit risk is far less than if derivatives are not centrally cleared.

Risks of not keeping client money in trust

5.141           There have been a series of AFSL insolvencies in which client money has been lost, or could easily have been lost, at significant cost to clients, some of whom were not aware that their money was at risk. In these instances, AFSLs had been using their clients’ derivative client money as permitted by law (for the most part).

5.142           Not holding client money in trust poses the following financial risks.

•        Exposure to counterparty credit risk - the AFSL’s hedge counterparty could become insolvent, and unable to repay the client money (this risk may be pronounced with counterparties that are offshore, related, not prudentially regulated, or otherwise unreliable).

•        Use of client money to hedge other clients’ positions facilitates cross-subsidisation across client cohort, and exposes individual clients to more risk than they necessarily sign up for with the AFSL.

•        It generally takes longer to determine entitlement, retrieve and return client money in the event of insolvency. This is because:

-       counterparties may dispute the funds provided by or on behalf of a client as client money, and may be reluctant or unable to return it;

-       there is potential for inadequate reconciliation or confusion about entitlement, especially given the range of ways it can be used and co-mingling of client and AFSL funds; and/or

-       an external administrator may treat client money outside trust accounts as an asset of the AFSL holder, and include those monies in funds for distribution to creditors instead (or ahead of clients).

Why is Government action needed?

5.143           The problems caused by the current client money provisions for retail derivatives are the result of regulation that « no » longer meets the needs of those it regulates, and in fact stands to produce some unintended and perverse consequences. As such, Government regulatory action is required to remedy the problem.

5.144           In October 2015, the Government, as part of a wider response to its root-and-branch examination of Australia’s financial system (the Murray Financial System Inquiry), announced that it would ‘develop legislation to facilitate participation of Australian entities in « international » derivative markets and better protect client monies’ by end-2015. [28] The Government also noted that improvements were needed to ensure that investors’ money is adequately protected when held by intermediaries. This announcement also brought Australia into line with « international » developments.

5.145           Currently, in the event of a licensee's insolvency, the extent of any shortfall in a client’s money is ultimately dependent on the successful recovery of client funds. Consequently the regime inadequately protects retail clients’ money as clients are also unlikely to understand the risks associated with how their money might be used.

What is a ‘retail client’?

5.146           Retail investors, or clients, of retail OTC derivatives comprise a range of different type of investors, including a large proportion of 'ordinary', inexperienced ‘mum and dad’ investors.

5.147           ASIC research showed that there was low utilisation of professional financial advice by retail clients before investing in these products.

5.148           ASIC research further showed that many retail investors do not have a clear grasp of how retail OTC derivatives work before they begin to trade. ASIC Report 205 [29] (which focused on CFDs) states that the lack of understanding about key concepts and key aspects of how CFDs work means many retail investors "do not clearly understand the key risks and benefits of CFDs, and so may not be making good decisions about whether or not to trade them".

Retail clients should only bear risks they can understand and evaluate

5.149           When retail investors engage in an OTC derivative transaction there is generally an understanding the investor could potentially make losses as a result of adverse market movements. However, what is less well understood is the potential to make a loss as a result of the way a client’s money has been handled by the AFSL holder when the holder as OTC derivative issuer or holder’s broker defaults. [30]

5.150           ASIC advises that retail clients are not necessarily sophisticated enough to fully understand or effectively evaluate the risks that their client money is exposed to when it is not held in trust by the AFSL holder. As most client money for other types of financial products, such as securities, is held in trust, retail clients also often assume that their OTC derivative client money is dealt with in the same way as it is held for other types of financial products.

5.151           Government action should address the treatment of OTC derivative client money, while continuing to allow retail clients to make gains and losses as a result of market movements on those financial products.

5.152           Self-regulatory solutions are unlikely to be successful on their own as:

5.153           The current market structure and regulatory regime incentivises continued use of client money by some operators.

•        Using client money for hedging and daily operating costs provides operators with a ‘free-kick’, as it reduces their capital costs.

•        Regulatory arbitrage is occurring as some operators enter the Australian market to take advantage of the current provisions.

5.154           Results from a 2012 ASIC survey [31] suggest that marketing products based on a client money use point-of-difference would be ineffective due to information asymmetries. 

•        Retail investors may not understand the risks their client monies are exposed to, and hence the benefits of using an OTC derivatives issuer that does not make use of client money.

•        Thorough disclosure standards are already outlined in ASIC’s Regulatory Guide 227 Over-the-counter contracts for differences: Improving disclosure for retail investors but appear to have reached the limit of their effectiveness due to the complex nature of the products and lack of understanding of clients about the arrangements for holding client money, particularly retail clients.

5.155           Government action is also required as the Australian regulatory regime for OTC derivatives is currently less stringent, in a number of critical areas, compared to many other jurisdictions. For example:

•        the UK Financial Conduct Authority prohibits the use of client money by firms;

•        the US Commodity Futures Trading Commission imposes very high capital requirements on issuers (starting from a minimum of $20 million) and requires retail derivatives to be traded on a licensed exchange (which means clients are protected by the rules of the exchange); and

•        the Monetary Authority of Singapore and the Securities and Futures Commission of Hong Kong impose restrictions on a firm's use of leverage (that is, how much exposure a firm can take on).

What policy options is the Government considering?

5.156           Diagram 5.3 gives an overview of the options the Government considered for retail client money provisions.

Diagram 5.3 : Policy options

Title: Relates to OTC derivative client money

 

Option 1: Full protection (as per draft legislation)

5.157           The Government has consulted extensively on this option, including on draft legislation and regulation that would give it effect.

5.158           Option 1 would essentially discontinue AFSL use of retail OTC derivative client money for their own (or other clients’) purposes . Client money of retail clients would not be able to be used by the AFSL as working capital, or in connection with proprietary trading, hedging, or to meet the obligations in relation to any person other than the client.

5.159           Specifically, the draft legislation and regulation propose to:

5.160           Limit the exception provided by section 981D of the Corporations Act for retail clients, [32] so that AFSLs cannot use the OTC derivative client money other than for the client who provided the particular money to the licensee.

5.161           Tighten the existing permitted uses of derivative client money, such as the ability to rely on general directions or an AFS licensee’s entitlement to client money, in the context of retail clients to support this change.

Option « 2 » : Hedging with safeguards

5.162           Several submissions from interested parties suggested alternatives to the proposed reform in respect of retail client protections (Option 1).

5.163           While almost all stakeholders agreed that retail clients deserve to be better protected, there was some disagreement about what constitutes the right kind of protection; and appropriate trade-offs in terms of impact on individual financial services, the direct market access business model (which tends to be more reliant on the use of client money), and the OTC derivatives sector as a whole.

5.164           Option « 2 » represents a compromise: allow AFSLs to keep using derivative client money to hedge their own or other clients’ business risk, provided there are a suite of specific safeguards in place to increase the resilience of the AFSLs, the quality of their counterparties, and the potential uses of client monies.

5.165           Option « 2 » draws on public feedback and suggestions, and considerable advice from ASIC on the viability and effectiveness of this approach.

5.166           Specifically, it would:

5.167           Only permit AFSLs to hedge with authorised deposit-taking institutions (Australian-based banks, referred to as ADIs - Authorised Deposit-taking Institutions), and require that they do so directly.

•        Restricting the hedging transaction to Australian banks and foreign subsidiary banks (and excluding foreign branches) would assist recovering such money from those institutions, as the client money may be expected to remain in the jurisdiction. The AFSL would need to deal directly with the ADI when hedging, rather than intermediaries.

•        Such ADIs are subject to Australian Prudential Regulation Authority (APRA) prudential supervision, including risk management and capital requirements.

5.168           Ensure that client money retains its character as “client money”.

•        Client money should be traceable by the retail client when it is passed to the ADI as a hedge counterparty. This is intended to address concern that the client money used for hedging purposes may not be able to be located or recovered after it has been transferred to the hedging counterparty.

•        Ideally, any client money that is passed on to an ADI as a hedge counterparty should continue to be identified as client money and be protected in accordance with Part 7.8 Division « 2 » of the Corporations Act. The current regime means that in many cases the client money loses its character as trust money being held on behalf of the retail client.

•        Note that ASIC has strong reservations about whether this safeguard could be implemented (see Part 5 below).

5.169           Impose additional capital requirements for those AFSLs that use client money.

•        Introducing new regulations that would enable ASIC to impose risk-based capital requirements to mitigate the additional risks created by the use of derivative retail client money as it would provide additional capital to be used in the event of the insolvency of the AFSL holder and so ideally minimise the potential for retail client loss.

5.170           As per Option 1: limit other uses of client money.

•        This option only seeks to facilitate AFSL use of client money to hedge their risk of default. Like Option 1, it seeks to restrict the use of client money for an AFSL’s proprietary trading.

Option 3: Maintain the status quo

5.171           This option involves « no » change to the existing client money regulatory regime in the Corporations Act. It would allow the continued use of OTC derivative retail client money by AFSLs for a range of purposes.

What is the likely net benefit of each option?

Summary of costs and benefits: retail client protections

Table 5.1 : An outline and initial evaluation of regulatory options

 

1. Full protection

« 2 » . Hedging with safeguards

3. Status quo

+

Derivative client money would be as protected as other client money, and in a manner expected by many retail clients.

Retail clients would not be required to evaluate complex risks to their client money.

In the event of AFSL insolvency, clients would be more likely to get their money back quickly and in full.

It would probably reduce the capacity of relatively thinly resourced firms to enter and operate in the Australian market.

It represents a compromise.

Some AFSLs will become more resilient, reducing their risk of default.

Some restrictions would be in place on the use of retail client monies.

Hedge counterparties will be of a higher quality, potentially increasing recoveries in the event of insolvency.

It would cost AFSLs somewhat more (in terms of regulatory compliance) than Option 1 (full protection), but AFSLs could still utilise retail client money to hedge.

There have not been any recent examples where the client money regime has actually caused AFSL failure.

This option would not affect the viability of any AFSLs or their business models.

-

This option may make some AFSLs less viable. Stakeholder feedback suggests that the impact may be felt most by AFSLs which use a direct market access model, as they tend to use client money to hedge their trades. It may reduce competition for a sector of the market, although this is not certain.

It has the potential to increase risk-taking by some AFSLs. That is, some AFSLs may choose to hedge less; and/or to promote products that are cheaper to hedge, but riskier for investors to hold.

While AFSLs will be more resilient and the use of client money curtailed, client money used for hedging would continue to be exposed to more risk than other retail client money.

The compromise would still create material costs for AFSLs, particularly if the additional capital requirements were robust.

Robust capital requirements can be complex for a regulator to implement, monitor and update. ASIC may require additional resources to enforce this element.

Client money is not money paid to an issuer to acquire a specific service or product, and therefore should be treated as the client's money.

It is not clear that clients (especially retail clients) are fully aware of, or can effectively evaluate the current risks to their client money.

Maintaining the status quo would mean derivative client money continues to be treated differently to other client money - and the Government may be asked to account for this discrepancy in the event that an AFSL fails, and results in a loss of client money.

It may also mean that relatively thinly resourced firms are encouraged to enter and remain in the market.

Option 1: Full protection

5.172           The following sets out the benefits and costs of implementing Option 1.

Derivative client money would be as protected as other client money, and in a manner expected by many retail clients.

5.173           Most client money (as defined by section 981A of the Corporations Act), aside from that which is associated with dealings in derivatives, is to be held in trust. It is not money paid for a specific service or product, and is the money in which the client has a beneficial interest.

5.174           ASIC reports that insolvencies of licensed OTC derivative issuers (such as that of BBY Ltd [33] ) often result in complaints from retail clients to the financial regulator; they often stand to lose money, and claim they did not realise that their client money was at risk in the first place.

Retail clients would not be required to evaluate complex risks to their client money.

5.175           The current regime assumes that retail clients can fully understand and evaluate the risks to which their derivative client money is exposed, particularly counterparty credit risk. That is, the chance that their AFSL becomes insolvent and unable to repay their client money.

5.176           To evaluate this risk, clients would need to consider a range of issues (and continue to do so over time) including that:

•        their AFSL may hedge with a related counterparty, the default of which may impact on the viability of their AFSL;

•        their AFSL may hedge with unreliable or unregulated counterparties, some of whom may be offshore;

•        their client money may pass through multiple counterparties and may not be able to be traced;

•        their client money may not be treated as such by the AFSL’s hedge counterparty, which may claim entitlement to the money in the event that the AFSL defaults and financial transactions are closed out;

•        if returned by the hedge counterparty to the AFSL, the money may cease to be held on trust. The liquidator may treat the money as part of the general pool of assets of the AFSL to be distributed by liquidators, rather than subject to special protection.

5.177           ASIC, along with several of the larger AFSL providers in this sector and the Australian Securities Exchange (ASX), are clear that retail clients are not generally able to effectively evaluate all the issues outlined above to come to an informed assessment of the risk associated with the use of the derivative client money, and should not be expected to conduct such an evaluation.

5.178           The existing provisions that allow AFSLs to use derivative client money were carried forward from previous regulations which were directed at exchange traded derivatives, and the policy rationale is less applicable to OTC retail derivatives.

In the event of AFSL insolvency, clients would be more likely to get their money back quickly and in full.

5.179           At present, if an AFSL becomes insolvent, it can take months or years to return derivative client money if it has been deployed outside a trust account (as defined by section 981B of the Corporations Act).

5.180           If Option 1 is implemented (and the AFSL were legally compliant) derivative client money should be administratively and legally much easier to locate and return.

This option would probably reduce the capacity of new relatively thinly resourced firms to enter and operate in the Australian OTC derivatives market.

5.181           AFSLs need to meet minimum capital requirements in order to obtain an operating licence from ASIC. However, it is highly desirable for OTC derivatives issuers to hold capital above and beyond this amount to mitigate the risk of counterparty default and/or to cover the AFSL’s own losses (where their dealings are not fully hedged).

5.182           Because the current regime effectively means that retail clients are providing funding or capital to AFSLs that choose to use derivative client money, it is possible that some of these firms may not be able to continue to operate if this option is pursued.

5.183           This could affect either domestic or foreign firms.

5.184           While some businesses may become less viable, or lose interest in operating in the Australian market, the Government does not consider this to be a bad outcome - if it is because they are unable to meet the costs of doing business and it enhances the protection of derivative client money for retail investors.

This option may make some AFSLs less viable, but should not affect the viability of the direct market access model.

5.185           Through the public consultation process, the Government heard from several AFSLs concerned about the ongoing viability of their business, should this option be implemented. Several individual traders that invest with these AFSLs made similar submissions.

5.186           They suggested that the impact will be felt most by AFSLs that use a direct market access model, as they tend to use client money to wholly hedge with other parties the derivatives trades they enter into with retail clients.

5.187           They also suggested that the direct market access model would not itself survive because it depends on the capacity to use client money to make that model viable.

5.188           The relative impact is not likely to be large, as:

5.189           The regulated population is small relative to all AFSLs; AFSLs that deal in retail OTC derivatives and use derivative client money is smaller still; and of these, it would likely only be a subset that could not continue.

5.190           Moreover, there are entities in Australia that already operate a fully hedged trading strategy, without using client money.

5.191           However, as discussed earlier in this document, it is not possible to determine how much client money is actively deployed by AFSLs for their own purposes. Nor is it possible to definitively say how many AFSLs use retail client money to deal in derivatives; or what funding they might be able to call on in the event that they could not continue to use their clients’ client money.

5.192           This lack of information is part of the problem the Government is seeking to address in pursuing this reform (see the description of the ASIC reporting and reconciliation power earlier).

5.193           While some AFSLs may become less viable, the Government does not believe that the direct market access model itself will become defunct. The United Kingdom introduced comparable client money regulation for CFD issuers in 2014, and the Financial Conduct Authority recently advised Treasury that the direct market access model [34] is still in common use.

This option has the potential to increase risk-taking by some AFSLs.

5.194           A small number of the AFSLs that raised concerns during public consultation also warned that - in the event that client money is « no » longer available for hedging, rather than stop operating, AFSLs may:

•        choose to hedge less of their exposure to trades with clients, and therefore hold more principal risk that they will default on their contracts; and/or

•        promote products that are cheaper for the AFSL to hedge, but riskier for investors to hold.

5.195           These would be poor and unintended consequences if they transpired. In addition to the impact on individual investors, it could increase risk in the sector resulting from AFSL default, which could have flow on consequences for their clients.

5.196           It is not certain that AFSLs would respond in this way, but

risk-taking behaviour is certainly a matter to monitor if and when such an option is implemented.

5.197           However, ASIC notes that robust risk management arrangements, including hedging where appropriate, is an expectation of all AFSLs.

5.198           Given that AFSLs need to maintain appropriate risk management strategies, the inability to use client money to hedge (and thereby requiring additional funding to maintain hedging practices) is more likely to impact upon AFSL profitability rather than the use of hedges to mitigate risk.

5.199           Irrespective of how client money is protected, AFSLs will still be required to act in the best interests of clients, avoid conflicts of interest, and have adequate risk management arrangements in accordance with general law and conditions of their licence.

Impacts by stakeholder group

Table 5.2 : Impacts of Option 1 on key stakeholder groups

Retail clients

AFSLs

Government/regulator

It would significantly increase the level of protection afforded to client money by reducing the counterparty credit risks to which investors are exposed.

Retail clients ought to be better situated, as opportunities for regulatory arbitrage will be removed and less scrupulous operators will be less likely to enter the Australian market.

However it may impose the following costs on investors:

•        investors would « no » longer be able to choose to use an issuer that makes use of client money; and

•        investors may face increased costs as a result of increased issuer compliance and operating costs.

These effects are likely to be limited, as competition based on lower standards of investor protection is of more potential harm than good, the market appears relatively competitive and entry costs are low.

Under this option, there would be a level playing field in the industry in relation to the treatment of client money, as AFSLs would be required to treat their client money in the same way as other AFSLs in the financial sector.

The reputation of the retail OTC derivatives industry may improve too, as retail clients will be less likely to lose their client money in circumstances in which they assumed that it would be protected; and only AFSLs that are adequately funded will be able to operate in the Australian market.

However, Option 1 would increase capital costs of issuers that use client money (predominantly those that use a direct market access issuing model), which may be passed onto investors. Depending on the extent of these capital costs, direct market access operators who had been receiving a ‘free kick’ from the existing provisions may « no » longer be viable.

In addition, AFSLs would likely face increased compliance-related operating costs—including staff training, and the costs associated with one-off changes to disclosure documentation and IT systems.

More broadly, AFSLs would need to analyse the effect of the prohibition of the use of client money on their business practices.

Under this option there may be reduced compliance/monitoring burdens on ASIC as the regulatory framework relating to the use of client money would be simpler and compliance easier to monitor.

Removing regulatory inconsistency with other jurisdictions would also eliminate the occurrence of regulatory arbitrage and its associated risks and regulatory burdens.

However, ASIC would need to review and update its regulatory guidance on client money to reflect revised legislation (potentially at the same time as any rulemaking).

 

The regulatory burden estimate is $516,572 [35]     

5.200           The costs identified here relate specifically to the compliance costs to businesses and individuals in order to comply with or understand the changes to the arrangements. The costs do not reflect the cost to businesses for any loss of revenue due to changes in the law. Certain stakeholders have advised that these reforms will adversely affect their business model, as additional capital will be required to maintain their current hedging practices. 

5.201           Under Option 1, there will be some initial costs to:

•        update IT systems (at an annualised cost of $68,723 for all firms, for an average of two weeks’ work for two IT staff);

•        understand the changes to the legislation as well as monitor compliance with the changed legislation, and for businesses to update their documentation, policies and procedures, and develop and implement training (at an annualised cost of $173,880 for all firms, for an average of five weeks’ work for two compliance staff); and

•        review business processes as a result of the ban on the use of client money (at an annualised cost of $44,178 for all firms, for an average of two weeks’ work for two business operations staff).

5.202           Notably, the cost of securing additional funding to replace any reliance on client monies for working capital is not included in these quantitative costs as it is a second-round impact of Option 1.

5.203           Under Option 1, there will also be some additional ongoing monitoring and review work (at an annual cost of $257,709 for all firms, for an average of two weeks’ work for three compliance staff over the period of a year), but many of these costs will be business as usual.

5.204           For individuals affected by the changes, as a client, there will be a one off cost of $3,987.50 in order to understand the changes, particularly how they affect their financial advice.

5.205           The total annualised regulatory impact on business is $516,572, as displayed in Table 5.3.

5.206           Details on the assumptions used to generate the cost benefit analysis are provided at Appendix E .

Table 5.3 : Regulatory burden estimates of Option 1 - full protection

Option 1

Average annual regulatory costs (from business as usual)

Change in costs ($ million)

Business

Community organisations

Individuals

Total change in costs

Total, by sector

$ 512,585

$0

$3,988

$ 516,572

 

Option « 2 » : Hedging with safeguards

5.207           The following sets out the benefits and costs of implementing Option « 2 » .

This option represents a compromise

5.208           This option does not address the fundamental vulnerability currently faced by retail client money; but would potentially improve the resilience of certain AFSLs and limit the ways in which client money may be used.

Retail clients may be more protected than they are now

5.209           AFSLs would be more limited in the way in which they can use retail derivative client money. Use as working capital, for example, would be prohibited. Client money could only be used to hedge the AFSL’s positions provided there are additional requirements for the licensees to identify client money, there are limits on the identity of the hedge counterparties, and additional capital requirements apply.

5.210           The safeguards, as set out in chapter 4, should make default of the AFSL’s hedge counterparty less likely. It would also limit the purposes for which licensees can use client money.

5.211           At present, none of the identified safeguards are required and are not uniformly used in the sector.

5.212           However, these proposed alternative reforms still leave client money exposed to substantially the same risks as under the status quo.

5.213           While these proposed alternative reforms go some way to addressing adjacent risks (such as the resilience of the AFSLs), they do not address the core risk that that client money may not be returned to retail clients in the event of an AFSL failure.

Derivative client money would still be exposed to more risk than other retail client money

5.214           As client money may be taken out of the client money trust account, there will be significantly less certainty that the tracing requirements will be effective in safeguarding client money. This is the key risk with these proposals, which could undermine the policy objective of the Government's client money reforms.

5.215           This view is strongly supported by ASIC. ASIC does not see any considerable benefit in enhancing the quality of the hedge counterparty. Whilst quality hedge counterparties may increase overall recoveries in the event of insolvency, it does not overcome the fundamental problem of the client money being removed from the protection of a trust account.

5.216           The risk of client money losing its protections is not mitigated by the identity of the hedge counterparty, or whether the hedge counterparty is subject to client money rules. The hedge counterparty would not recognise the client as its 'client', as such, the money would still cease to be identified as money belonging to the client.

5.217           There are significant legal risks for the hedging with safeguards approach. ASIC also advises that seeking to ensure client money continues to be identified as money belonging to the client, after it has been paid out of the client money trust account, is unlikely to be effective under Australian law.

5.218           Imposing additional capital requirements could help to reduce the likelihood of failure, depending on the circumstances of each AFSL. However this still does not address the core problem that client money may not be returned to retail clients in the event of an AFSL failure.

This option would cost AFSLs somewhat more than Option 1 (full protection), and compromise would still have material regulatory and commercial costs for AFSLs

5.219           AFSLs would still have access to retail client money to fund their hedging activities, so would not need to use their own capital, though the cost of compliance would increase.

5.220           However, AFSLs and their ADI hedge counterparties would still incur additional costs because they would need to:

•        prepare the legal documentation (which could be in the form of a separate derivative trading master agreement, to ensure there are « no » set-off rights between the issuer's house trades and client trades);

•        make the operational arrangements (including segregated accounts at the ADI for holding client money); and

•        potentially comply with higher capital requirements.

5.221           Hedging may also become more expensive under this Option because there would be more limits on hedging relationships.

5.222           It is estimated that the difference between Option 1 and Option « 2 » in terms of regulatory costs is sizeable/in the order of magnitude of just under $200,000.

Impacts by stakeholder group

Table 5.4 : Impacts of Option « 2 » on key stakeholder group

Retail clients

AFSLs

Government/regulator

Retail clients would be better protected than they are now, albeit not as well as they would be under Option 1.

Investors may face slightly higher costs due to increased costs for AFSLs to operationalise the change in regulation.

It should not trigger a step-change in AFSL business operations.

AFSLs would still be able to use client money to hedge their trades, although their hedge counterparties would be more limited.

This option would likely increase the cost of hedging due to the more limited set of potential counterparties, and would involve material regulatory costs.

It may be operationally difficult to determine when an AFSL is hedging, as opposed to simply undertaking speculative trade.

It may increase ASIC’s supervisory responsibilities, as this solution is not as straightforward as Option 1. 

 

The regulatory burden estimate is $715,337 [36]    

5.223           The costs identified here relate specifically to the compliance costs to businesses and individuals in order to comply with or understand the changes to the arrangements. The costs do not reflect the cost to businesses for any loss of revenue due to changes in the law.

5.224           Under Option « 2 » , there will be initial costs to:

•        update IT systems in order to be able to effectively track, monitor and audit how they are using client monies is anticipated to be a one off cost of $44,178 for all firms;

•        understand the changes to the legislation as well as monitor compliance with the changed legislation, and for businesses to update their documentation, policies and procedures, and develop and implement training at an estimated cost of $188,567;

•        legal costs to understand changes to the regime;

•        change any commercial arrangements firms may have with banks; and

•        review business processes as a result of increased limits on use of client money.

5.225           Under Option « 2 » , there will also be some additional ongoing monitoring and review work (at an annual cost of $257,709 for all firms, for an average of one weeks’ work for three compliance staff over the period of a year), but many of these costs will be business as usual.

5.226           This option, unlike Option 1, will also have a regulatory cost for ADIs with which an affected AFSL holder has a contractual relationship. The ADI would need to adjust its invest in understanding the changes to legislation, establishing documentation, policies and procedures, set up operational arrangements, and develop and implement training. The estimated compliance cost of this for all ADIs is $117,810.

5.227           For individuals there is expected to be a small one off cost to understand the changes, estimated at $3,987.50

5.228           The total annualised regulatory impact on business is $711,350, as displayed in Table 5.5 below.

5.229           Details on the assumptions used to generate the cost benefit analysis are provided at Appendix E.

Table 5.5 : Regulatory burden estimates of Option « 2 » - hedging with safeguards

Option « 2 »

Average annual regulatory costs (from business as usual)

Change in costs ($ million)

Business

Community organisations

Individuals

Total change in costs

Total, by sector

$ 711,350

$0

$3,988

$ 715,337

Option 3: Maintain the status quo

5.230           The following sets out the benefits and costs of implementing Option 3.

This option would not have any impact on AFSLs or their business models.

5.231           AFSLs would be able to continue to operate as usual.

There have not been any recent examples where the client money regime has actually caused AFSL failure.

5.232           The client money regime does not appear to have caused, or contributed to, any recent AFSL insolvencies.

5.233           While the BBY Ltd (BBY) collapse is not attributed to the misuse of client money, retail clients would probably have recovered all their OTC derivative client money back, had the proposed regulatory regime (full protection - Option 1) been in place and complied with.

5.234           BBY used client money to hedge its own market risk. Saxo Capital Markets Pty Ltd (Saxo), a BBY hedge counterparty, did not recognise the money as ‘client money’ and, as such, BBY lost around $2.5 million in client money upon default. Saxo was assigned legal title to the funds and the retail investors lost their money. BBY could have sent any proportion of the client money pool to Saxo.

5.235           This outcome compares poorly with the outcome for BBY’s ASX funds, which were fully recovered because ASX monitors compliance with its operating rules which reinforce the Corporations Act client money provisions.

It is not clear that clients (especially retail clients) are aware of, or can effectively evaluate the current risks to their client money.

5.236           GTL Tradeup Pty Ltd was another retail OTC derivatives provider with about 1500 clients (half of whom were Australian) that went into liquidation in 2013. It was unable to recover over $1 million of client money used to hedge its own market risk as the money was lost by its Dubai hedging broker. One of GTL’s Australian clients, who can « no » longer access his funds, started a blog online following the firm’s collapse. Writing under the name Maurice Conchis, he said "there would appear to be a common misapprehension that client funds provided to a margin operator like GTL Tradeup is somehow quarantined in a trust. Indeed, I assumed this to be the case. However, it seems that is not the case at all.”

Client money is not money given for a service or product, and should be treated as such. Maintaining the status quo would mean derivative client money continues to be treated differently to other client money.

5.237           Maintaining the status quo does not specifically address any of the existing concerns regarding the protection of client money.

5.238           The Government may be asked to compensate retail clients for any deficiency of money for retail clients in the event that an AFSL fails, and results in a loss of client money.

This option may also mean that relatively thinly resourced firms are encouraged to enter and remain in the market.

5.239           While the Australian financial system is generally very well regulated and has a reputation for being so, in respect of retail OTC derivatives it imposes fewer restrictions than some of its key « international » counterparts, such as Japan and the UK (for example,  it does not set caps on leverage).  

5.240           The ongoing availability of derivative client money - effectively an interest-free loan - and the existing regulatory settings would probably continue to attract new operators to the Australian market.

Impacts by stakeholder group

Table 5.6 : Impacts of Option 3 on key stakeholder groups

Retail clients

AFSLs

Government/regulator

Retail clients’ client money would continue to be exposed to risks that they are not equipped to effectively evaluate.

Retail clients may stand to lose their client money upon AFSL insolvency.

Clients would not be subject to any increase in costs that may result from changes to the regulatory framework.

Clients may benefit from issuers’ efforts to differentiate their business practices, including around the use of client monies.  

Investors would continue to be able to choose between different issuers and may benefit from the more cost-competitive services offered by issuers that use client money to fund hedging transactions.

« No » immediate impact. This Option would allow AFSLs to continue business as usual.

Issuers may face reputational damage (and loss in business) if a future collapse of an issuer further highlights the risks around the currently permitted use of client monies.

As the opportunities for regulatory arbitrage are unaltered under Option 3, ASIC may face increased compliance/monitoring burdens in respect of « international » issuers seeking to enter the Australian market to take advantage of Australia’s permissive regime.

The occurrence of regulatory arbitrage heightens the supervisory burden for ASIC, due to the risks associated with overseas operators providing financial services to Australian clients: when client monies have been moved offshore, ASIC faces jurisdictional difficulties pursuing cases to recover them.

« No » specific benefits for the government have been identified under this option.

 

The regulatory burden estimate is $0

5.241           Option 3 provides a business-as-usual base case for illustrating and comparing the costs and benefits of the other options and, as such, does not impose any additional regulatory burden.

Table 5.7 : Regulatory burden estimates of Option 3 - maintain the status quo

Option 3

Average annual regulatory costs (from business as usual)

Change in costs ($ million)

Business

Community organisations

Individuals

Total change in costs

Total, by sector

$0

$0

$0

$0

Who will the Government consult, and how will it consult with them?

There have been a number of rounds of consultation on changes to the client money regime.

5.242           In November 2011, the then Gillard Government released a discussion paper to seek stakeholder views on issues relating to the use of client money and to review whether the client money provisions of the Corporations Act provide sufficient protection for investors.

5.243           A large number of submissions—greater than 100—were received to the Discussion Paper and the claimed effects of any regulatory change were varied. Several large OTC derivative providers supported the proposal to prohibit the use of client monies by AFS licensees for their own purposes, recognising the importance of aligning Australia’s regulatory framework with overseas developments. However, some CFD providers did not support the proposed changes.

5.244           More recently, the Government released a policy paper, draft legislation and regulation which proposed a suite of specific changes to the client money regime. The policy paper was issued on 22 December 2015, and the draft legislation and regulation followed on 29 February 2016. Interested parties were invited to comment by 25 March 2016.

Consultation is now complete.

5.245           The Government received forty-nine submissions on its proposed reform. Of these, thirty-one did not support the reform, seventeen were supportive, and one was neutral.

5.246           Treasury officials also held discussions with a range of stakeholders to explore key issues raised in submissions and test potential refinements.

Stakeholders agree that client money should be better protected, but diverge strongly on how this is to be achieved.

5.247           There is almost uniform recognition of the need to ensure the law adequately reflects the needs of retail clients and to prohibit the use of retail client money as working capital.

5.248           Stakeholders expressed strong support for the proposal to give ASIC power to make client money reconciliation and reporting rules to enhance transparency and accountability.

5.249           However, there were clear disagreements about the level of protection that retail clients require and the right trade-off between consumer protection and industry competition.

5.250           The reform as a whole has some significant and unwavering supporters, including ASIC, the ASX and issuers who do not currently use client money to hedge derivative positions. These issuers are large market maker firms that collectively have the majority of the CFD market share. These parties believe that retail client money should be wholly protected, and that this outweighs any concerns about business impacts.

5.251           However, the Government also received a relatively large number of submissions from small and medium-sized firms who hedge with client money and individual retail traders, who agree that retail client money should not be used as working capital - but argue for its continued use by issuers for hedging.

Those that want to continue to use client money to hedge fear that prohibiting such practice may have inadvertent consequences.

5.252           Issuers that use client money to hedge are concerned that banning hedging with retail client money will threaten the viability of their business model and unfairly benefit market makers, leading to less competition.

5.253           They, and a small collection of other stakeholders, suggest that the reform could result in more risk-taking by firms that can « no » longer afford to completely hedge their exposures.

5.254           Issuers that use client money argue that they should be permitted to continue to use it to hedge their exposures and have suggested a range of possible safeguards to reinforce client protection.

5.255           Individual retail traders that made submissions strongly favoured the continued use of their client money for hedging. They all trade with issuers that operate direct market access models (that is, the firm fully hedges the positions it takes with clients in the underlying market) as they believe that these firms have more transparent prices and better investment outcomes.

5.256           Both these groups argue that the proposed reforms will lead to less competition and consumer choice. They believe this will leave retail clients further exposed to market maker firms whose interests, they argue, do not necessarily align with their clients’ interests - as to the extent that they do not hedge their trades, they stand to benefit from client loss.

5.257           The Government also heard from a small collection of stakeholders who are concerned that prohibiting use of client money to hedge may prompt some issuers to take more risks (that is, hedge less), due to the increased cost of capital.

5.258           Some smaller issuers also raised concern that differentiating between wholesale and retail investors will pose an additional administrative burden that will unduly impact smaller businesses, and that the inclusion of sophisticated investors in the definition of retail clients will further complicate administration.

Some stakeholders also feel that the scope of reform should be broader.

5.259           Several interested parties felt that the reform did not address other, more significant issues associated with client money such as fraud, inadequate capital requirements and gaps in the insolvency regime. They suggested that, without additional safeguards, retail clients’ overall protection may not significantly improve.

There is broad agreement that the Government should allow AFSLs adequate time to transition.

5.260           Stakeholders generally agreed that the implementation of the reform should allow industry reasonable time to transition.

What is the best option from those considered?

5.261           The Government remains confident that it’s proposed reform of full protection (Option 1), with minor refinements (such as a transition period for changes to retail client provisions), is the best option.

5.262           This view is on the basis that the existing regime « no » longer meets the needs of the consumers of financial services.

5.263           While maintaining the status quo would not have much impact on AFSLs in the short term (although inadequate regulation may affect the sector’s reputation and consumer confidence in the longer term), consumer protection would continue to be inadequate.

5.264           Moreover, the alternative option considered, Option « 2 » , does not materially enhance the protection available to retail client money. Whilst some of the safeguards proposed in Option « 2 » are likely of benefit to the industry, those benefits (such as enhancing the resilience of AFSLs) are in related but ultimately adjacent areas. The core problem of protection of retail client money in the event of insolvency of an AFSL would remain unaddressed.

5.265           Consequently, the potential positive impact that would come from the full protection of retail client money held by AFSLs outweighs the cost that will be incurred by the industry.

5.266           It will also see Australia implement reforms about the management of client monies in line with other jurisdictions, enhancing Australia’s reputation for providing appropriate protection of retail clients.

5.267           The cost to industry has also been considered and weighed against the potential for increased investor confidence in the sector as this is a key reason for the Government’s commitment to these reforms.

5.268           The Government intends to finalise draft legislation and regulation that amend the Corporations Act and Regulations to create a more tailored and contemporary client money regime that prohibits AFSL use of retail derivative client money for their own and other clients’ purposes.

How will the Government implement and evaluate its chosen option?

5.269           The Government will seek to amend the Corporations Act, and make necessary changes to the subordinate legislative instruments.

5.270           A few minor changes will be made to the draft « Bill » and Regulations, including delayed commencement of the retail component of the reform to allow AFSLs time to transition to the new arrangements.

5.271           As part of the ongoing assessment of the Corporations Act and associated regulations, Treasury and ASIC will monitor the effect of any legislative changes to the treatment of client money to ensure they are achieving their intended purpose.

5.272           Consistent with current practice, it is anticipated that ASIC will have a significant role in the enforcement and monitoring of client money handling practices as part of its administration of the Corporations Act.

5.273           In the event that it becomes apparent that any reforms are not having their intended effect, appropriate action will be taken at that time.

Conclusion

5.274           This RIS outlines two policy options that would increase the protection of client money. 

5.275           The available options have been considered according to their respective qualitative and quantitative costs and benefits. This has been balanced against the identified problems that exist with the current framework - in that the current arrangements provide inadequate consumer protection.

5.276           On the information currently available, Option 1 is still the only option that addresses the core problem. It also has the smallest compliance cost impact on businesses and individuals.

5.277           As set out in Part 5, Option 1 clearly addresses the core problem identified. Option « 2 » leaves the core problem unaddressed, and would leave client money exposed to substantially the same risks as under the status quo.

5.278           At best, Option « 2 » could help to reduce the probability of default of the AFSL, and could help to ensure the AFSLs trade with more robust hedge counterparties.

5.279           The key risk if the regime is not updated is that the next time a collapse similar to BBY occurs, clients may not receive all of their client money back if there is a deficit in the client money account and the licensee becomes insolvent or is otherwise unable to pay the deficiency.

5.280           By prohibiting the use of retail OTC derivative client money by AFSLs for their own or other clients’ purposes, the money will be much safer - and investor confidence in the industry is likely to increase.

5.281           Appropriate regulation of these important products will also support the Australian Government’s objective of Australia being a regional financial centre.

Appendix A - What does a retail client look like?

•        Retail investors do not have the same level of knowledge and understanding as other financial market participants, such as banks and brokers. Retail investors are therefore provided with protections under the Corporations Act to ensure they are treated fairly and equitably and promote participation in financial markets.

•        A distinction between retail and wholesale clients was inserted into the Corporations Act by the Financial Services Reform Act 2001 (FSR Act). This was the main piece of legislation in the sixth stage of the Corporate Law Economic Reform Program developed in response to the recommendations of the Financial System Inquiry (Wallis Inquiry) released in 1997. [37]

•        The Wallis Inquiry set out a framework for the regulation of the financial system. The main motivation for drawing the distinction between retail and wholesale clients was to identify those considered in need of regulatory protection, as well as the desire to allow certain clients to participate in wholesale markets, which tend to trade more complex products.

•        The Wallis Inquiry Report suggested that clear definitions of retail clients entitled to disclosure and other consumer protection should be established.

•        The definition of a retail client in section 761G of the Corporations Act relates in different ways to different products. For example, individuals purchasing insurance or superannuation or retirement savings are treated as retail clients if they are purchasing specific products such as motor vehicle insurance or personal or domestic property insurance. All other financial products are subject to four tests: product value, individual wealth, professional investors and small businesses:

-       if an investor is investing in a product with a value greater than $500,000 they are not considered a retail client;

-       if an investor has individual wealth greater than $2.5 million in net assets they are « no » considered a retail clients;

-       small businesses are considered to be retail clients, while other businesses are not; and

-       professional investors [38] are not considered retail clients.

•        While many retail investors are unaware of the risks they bear in relation to client money, this is not true for sophisticated wholesale clients. The intention of the wholesale/retail distinction in the Corporations Act is to ensure that well informed financial institutions do not use their greater understanding of financial products to take advantage of less informed retail clients.

Appendix B - « International » comparisons

•        The existing Australian regulatory regime relating to the use of client money by issuers is an anomaly amongst global practice.

United Kingdom

•        The Financial Conduct Authority (FCA) has amended their Client Assets Sourcebook (CASS) to prevent firms from using title transfer collateral arrangements with retail clients. [39] ASIC has indicated that these amendments were made as the FCA found that the use of title transfer collateral arrangements were not always appropriate for retail clients and generally were not in clients’ best interests.

•        The rules state that where a client transfers full ownership of money to a firm for the purpose of securing or otherwise covering present or future, actual or contingent or prospective obligations, such money should « no » longer be regarded as client money (CASS rule 7.2.3(1)).

•        However, the rules also state that, where a firm makes arrangements for the purpose of securing or otherwise covering present or future, actual, contingent or prospective obligations of a retail client, those arrangements must not provide for the taking of a transfer of full ownership of any of that client's money where the transfer of full ownership is for securing or covering a retail client's obligations under a CFD or a rolling spot forex contract that is a future, and in either case where that contract is entered into with a firm acting as market maker (CASS rule 7.2.3A).

Hong Kong

•        The Securities and Futures (Client Money) Rules states that a licensed corporation or an associated entity of a licensed corporation that receives or holds client money of the licensed corporation must establish and maintain in Hong Kong one or more segregated accounts for client money each of which shall be designated as a trust account or client account (subsection 4(1)).

•        The money in these accounts can be used when it is to be paid to a client, paid in accordance with a written direction, paid in accordance with a standing authority, where required in order to meet the client's obligations to meet settlement or margin requirements or where required to pay money that the client of the licensed corporation owes (subsection 5(1)).

•        However, firms cannot use client money if it would be unconscionable or where it is used for related party transactions or to pay officers or employees (subsections 5( « 2 » ) to 5(3)).

Singapore

•        The Securities and Futures Act (Licensing and Conduct of Business) Regulations state that customer money must be dealt with as belonging to that customer, shall be deposited in a trust account and will not be commingled with other funds or used as margin, guarantee, secure the transaction of or extend the credit of any person other than the customer (subsection 16(1)).

•        Further, the Securities and Futures Act states that firms cannot use customer money for payment of the firm's debts or court orders (section 104A).

Appendix C - Origins of the current regulatory framework

•        The uses of client money in relation to derivatives permitted under the current regime are an unintended consequence of the historical origins of the regime. The basis of the permission for licensees to use client money for margining purposes was to facilitate clearing and settlement arrangements for exchange traded derivatives.

•        Section 981D of the Corporations Act provides that if client money is paid for a financial product that is a derivative, the money may also be used for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee, including dealings on behalf of people other than the client. This allows licensees to withdraw money from a client money account to meet costs associated with hedging their exposure to the initial contract.

•        Paragraphs 7.8.02(1)(a) and (c) of the Corporations Regulations 2001 permit money to be withdrawn from client accounts for transactions where authorised by general written directions or for which the licensee is entitled. These paragraphs have been interpreted broadly by the industry. Some issuers obtain broad authorisations in their client « agreements » to make withdrawals from client money for any purpose, including as working capital. [40]

•        Section 981D has its origins in investor trading in

exchange-traded futures through futures brokers - a trading arrangement under which counterparty credit risk is significantly mitigated through the use of a centralised counterparty. However, as the drafting of the provision refers to 'derivatives', it is broader in application than its original context.

•        The explanatory memorandum to the Financial Services Reform « Bill » 2001 discusses the definition of derivative that was put into the Corporations Act and states:

-                the definition of ‘derivative’ in proposed section 761D has been formulated to replace the existing definition of ‘futures contract’ in section 72 of the proposed Corporations Act. The definition focuses on the functions or commercial nature of derivatives rather than trying to identify each product that will be regarded as a derivative.

•        Notably, when section 981D was added to the Corporations Act as part of the Financial Services Reform Act 2001 , it was uncommon for clients to trade in OTC derivatives, so the definition of derivatives that was inserted to replace the definition of futures contract did not contemplate widespread use of client money arising from the trading in OTC derivatives by clients.

•        In the case of retail OTC derivatives, investors deposit client monies with issuers in order to meet margining requirements imposed in their OTC derivatives contract by the issuer. Client monies therefore serve to act like collateral, reducing the risk to which issuers are exposed. In the event an investor defaults, issuers may access client monies to defray possible losses.

Appendix D - Counterparty credit risk

•        In 2011, ASIC released Regulatory Guide 227: Over-the-counter contracts for difference: Improving disclosure for retail investors , which developed seven disclosure benchmarks for OTC CFD issuers to help retail investors understand risks and assess whether investing in OTC derivatives is suitable for them.

•        Benchmark five relates to client monies and states that the Product Disclosure Statement should clearly:

-                describe the issuer’s client money policy, including how the issuer deals with client money and when, and on what basis, it makes withdrawals from client money; and

-                explain the counterparty credit risk associated with the use of client money for derivatives.

•        If the issuer does not have a client money policy in place, or one that does not incorporate all of the elements described above, it should disclose this in the Product Disclosure Statement.

•        The ASIC regulatory guide states that an issuer’s client money policy should be explained in the Product Disclosure Statement in a way that allows potential investors to properly evaluate and quantify the nature of the risk, if any, to client money.

•        While thorough product disclosure standards are in place, they appear to have reached the limit of their effectiveness due to the complex nature of the products traded and the inability of retail clients to understand the information that is being disclosed.

•        Retail clients tend not to seek personal financial advice before investing in OTC derivatives and they rely disproportionately on advertising and disclosure material provided by issuers.

•        ASIC has commissioned studies of contracts-for-difference investors that have shown that many retail investors do not understand how contracts-for-difference work or the significant risks involved in trading them. This is partly due to the complexity of the products traded. Further, they found that disclosure documents are often difficult to understand and do not highlight key information.

Box « 2 » : GTL and BBY case studies

GTL case study

5.282           GTL Tradeup Pty Ltd (GTL) was issued an AFSL in January 2011 to carry on financial services business in products including derivatives and foreign exchange (FX) contracts. The main liquidity provider of GTL was Dubai-based GTL Trading DMCC (DMCC).

5.283           GTL transferred funds out of its client money account to its parent and was unable to meet client demands for the return of their money.

5.284           When liquidators were appointed to GTL on 26 September 2013, GTL was owed about $4.35m by its parent, and owed about $4.4m to its clients. In this case, the client money regime may have facilitated GTL taking client money out of the segregated client money trust account for a range of purposes.

BBY case study

5.285           The following table sets out the potential distribution to clients in the BBY Ltd (BBY) case. It highlights the potentially different outcomes for clients, when BBY was a market participant and client money was held at an exchange, compared to client money for retail OTC derivatives including client money paid to hedge counterparties.

BBY - estimated surplus/shortfall calculation as at 29 April 2016

Product line

Equities

ETO

Overseas Futures

FX

Saxo

Carbon

IB

Other

Cents in the dollar before costs

1.00

1.00

0.35

0.51

0.36

0.00

0.70

1.00

Note

BBY was a market participant

BBY was not a market participant

Other

Note - Surplus/(shortfall) calculations are before costs of the proceedings, realisation, adjudication and distribution

Source: KPMG BBY Liquidators Annual Report 9 September 2016 https://home.kpmg.com/content/dam/kpmg/au/pdf/bby/bby-liquidators-annual-report-9-september-2016.pdf

5.286           Client monies relating to BBY's equities and exchange traded option (ETO) businesses may be repaid at up to 100 cents in the dollar. 

5.287           For business lines involving OTC products, client money is unlikely to be repaid at 100 cents in the dollar.  This includes client money paid to third parties including hedge counterparties.

Appendix E - Compliance cost assumptions

•        The costings assume an average labour cost of $65.45 per hour, based on default labour costs from the Office of Best Practice Regulation.

•        The costings assume « no » material economies of scale between different size firms within the sector (that is, « no » need to disaggregate calculations on the basis of small/medium/large firm sizes).

•        This is primarily due to the sector being heavily orientated towards online/electronic client contact. Hence any changes would therefore be expected to relate to updating operating systems.

•        It is assumed that all related businesses (only those with AFSLs), whether they currently make use of client money or not, will have to make changes to their business, compliance practices, operating systems and disclosure documents as a result of the changes proposed in Options 1 and « 2 » .

•        The assumed inputs (that is, hours and staff numbers for the required tasks) are based on costings for similar tasks in other regulation impact statements which have been tested through consultation with stakeholders.

Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Client Money

5.288           This Schedule is compatible with the human rights and freedoms recognised or declared in the « international » instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

5.289           The Schedule amends the existing client money regime in the Corporations Act to enhance the protection provided to retail clients of financial services providers.

Human rights implications

5.290           This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

5.291           This Schedule is compatible with human rights as it does not raise any human rights issues.



Schedule 1: « Amendment » to the Terrorism Insurance Act 2003

« Bill » reference

Paragraph number

Item 1, subsection 8( « 2 » )

1.10

Item « 2 »

1.14

Schedule « 2 » : Improving employee share schemes

« Bill » reference

Paragraph number

Items 1 to 3, section 9, subparagraph 1274( « 2 » )(a)(iva) and subsection 1274(2AA)

2.9

Item 1, section 9

2.12, 2.21, 2.22, 2.28, 2.31

Items « 2 » and 3, subparagraph 1274( « 2 » )(a)(iva) and paragraph 1274(2AA)(a)

2.11

Items « 2 » and 3, subparagraph 1274( « 2 » )(a)(iva) and subsection 1274(2AA)

2.8

Item « 2 » , paragraph 1274( « 2 » )(iva)

2.34

Item 3, subparagraph 1274(2AA)(b)(i)

2.17

Item 3, subparagraph 1274(2AA)(b)(i)

2.18

Item 3, subparagraph 1274(2AA)(b)(ii)

2.19

Item 3, paragraph 1274(2AA)(c)

2.22, 2.24, 2.36, 2.37

Item 3, paragraph 1274(2AA)(c)

2.25

Item 3, subparagraph 1274(2AA)(c)(ii)

2.26

Item 3, subsection 1274(2AB)

2.27, 2.32

Item 3, paragraph 1274(2AA)(d)

2.28

Item 3, paragraphs 1274(2AA)(c) and (d))

2.29

Item 3, paragraph 1274(2AA)(e)

2.30

Item 3, paragraph 1274(2AA)(a)

2.12

Item 3, paragraph 1274(2AA)(b)

2.35

Item 4, section 1637

2.41

Schedule 3: DGR specific listings

« Bill » reference

Paragraph number

Item 1, item 1.2.20 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11

3.6

Item 1, item 1.2.21 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11

3.8

Item 1, item 1.2.22 in the table in subsection 30-20( « 2 » ) of the ITAA 1997; Schedule 3, item 11

3.10

Item « 2 » , item 2.2.44 in the table in subsection 30-25( « 2 » ) of the ITAA 1997

3.12

Item 3, item 3.2.14 in the table in subsection 30-40( « 2 » ) of the ITAA 1997

3.14

Item 4, item 9.2.27 in the table in subsection 30-80( « 2 » ) of the ITAA 1997

3.17

Items 5, 6, 7, 8, 9 and 10, section 30-315 of the ITAA 1997; Schedule 3, item 11

3.19

Items 12 and 13, table item 3.2.14 in the table in subsection 30-40( « 2 » ) of the ITAA1997 and table item 48AAA in the table in section 30-315 of the ITAA 1997; Schedule 3, item 14; Commencement information item « 2 » .

3.16

Schedule 4: Ex-gratia disaster recovery payments to special category visa (subclass 444) holders

« Bill » reference

Paragraph number

Items 1 and « 2 » , paragraph 160AAA(1)(ab) and subsection 160AAA( « 2 » ) of the ITAA 1936

4.16

Item « 2 » ,  paragraph 160AAA ( « 2 » )(b) of the ITAA 1936

4.18

Item 3, section 11-15 of the ITAA 1997

4.25

Item 4, section 13-1 of the ITAA 1997

4.26

Item 5, item 5.2 in the table in section 51-30 of the ITAA 1997

4.21, 4.22

Schedule 5: Client money

« Bill » reference

Paragraph number

Item 1, section 761A (definition of ‘authorised clearing and settlement facility’)

5.21

Item 1, section 761A (definition of ‘derivative retail client money’)

5.27

Item 1, section 761A (definition of ‘derivative retail client property’)

5.28

Item 1, section 761A (subparagraph (b)(ii) of the definitions of ‘derivative retail client money’ and ‘derivative retail client property’)

5.29

Items « 2 » to 4, subsections 981D( « 2 » ) and 984B(3) and section 981D

5.20

Item 5, section 1636A

5.73

Item 6, section 761A (definition of ‘client money reporting rules’)

5.40

Items 7 and 9, paragraphs 793B( « 2 » )(d) and 822B( « 2 » )(c)

5.69

Items 8 and 10 to 14, note 3 of subsection 793B( « 2 » ), note « 2 » of subsection 822B( « 2 » ), note 3 of subsection 901E( « 2 » ); note 6 of section 903D, and subsection 981M( « 2 » )

5.68

Item 14, subsection 981J(1)

5.30

Item 14, subsection 981L(1)

5.42

Item 14, subsection 981L( « 2 » )

5.43

Item 14, subsection 981L(3)

5.44

Items 14 and 21, subsection 981M(1) and table item 31A in the table in subsection 1317E(1)

5.49

Item 14, subsection 981K(3)

5.50

Item 14, section 981N

5.53

Item 14, section 981P

5.64

Item 14, subsection 981K(1)

5.35

Item 14, subsection 981K( « 2 » )

5.36

Item 14, subsection 981J( « 2 » )

5.38

Item 15, paragraph 1100A(1)(b)

5.65

Item 16, paragraph 1101B(1)(d)

5.55

Item 17, paragraph 1101B(4)(b)

5.56

Item 18, subparagraph 1101B(4)(d)(i)

5.56

Item 18, subparagraph 1101B(4)(c)(i)

5.56

Item 19, paragraphs 1317C(gdd) and (gde)

5.72

Item 20, paragraph (b) of the definition of ‘financial services civil penalty provision’ in section 1317DA

5.62

Item 21, table item 31A in the table in subsection 1317E(1)

5.59

Items 22 to 24, subsection 1317G(1C) (heading), paragraph 1317G(1C)(b) and subsection 1317G(1D)

5.60

Items 25 and 26, section 1317HB (heading) and paragraph 1317HB(1)(a)

5.61

Item 27, section 1324B

5.57

Item 28, subsections 1325(1), ( « 2 » ) and (3)

5.58

 




[1]     Terrorism Insurance Act 2003 , section 41.

[ « 2 » ]     Towards Responsible Government, The Report of the National Commission of Audit, Phase One, p.205.

[3]     Terrorism Insurance Act 2003 , sections 6-8.

[4]     Terrorism Insurance Act 2003 , subsection 7(1).

[5]     Terrorism Insurance Act 2003 , section 3.

[6]     Australian Reinsurance Pool Corporation, Annual Report 2013-2014 , page 32.

[7]     Towards Responsible Government, The Report of the National Commission of Audit, Phase One, p. 205.

[8]     ARPC Autumn 2013 ‘ Under the Cover’ .

[9]     The Pottinger report examines alternative options which do not involve pooling in Section 6.7 of their report.

[10]   Tier A is CBDs of cities with populations over 1 million. Tier B is urban areas of all State capitals plus cities with populations over 100,000 for example, Newcastle, Geelong, Wollongong. Tier C is all other areas of Australia

[11]   Terrorism Insurance Regulations 2003 , « No » . 162, Explanatory Statement.

[12]   Terrorism Insurance Regulations 2003 , regulation 7 and Schedule 1, paragraph « 2 » (d).

[13]   Pottinger Report, page 76.

[14]   Op cit, page 82.

[15]   Guy Carpenter, ‘ A Comparison of the Federal Terrorism Insurance Backstop Legislation ’, 8 January 2015.

[16]   Sturdevant, Matthew 31 December 2014, Hartford Courant, www.courant.com/business/connecticut insurance/hc terrorism insurance act expires

        20141231 story.html, viewed 29 January 2015.

[17]   Lehrer, Eli, 23 December 2014, The Weekly Standard, www.weeklystandard.com/blogs/market fine after congress fails reauthorize fed backed terrorism risk insurance_822353.html, viewed 29 January 2015.

[18]   It is money paid by the client; or by a person acting on behalf of the client; or to the licensee in the licensee's capacity as a person acting on behalf of the client. See s981A of the Corporations Act for the full definition.

[19]   AFSLs may also hold property on their clients’ behalf. Aside from being a different type of asset, client property has the same characteristics as client money for the purposes of regulation. See s984 of the Corporations Act for the full definition. References to client money in this document should be taken to include client property unless it is explicitly excluded.

[20]   But for a specific set of instances in which it may be withdrawn (see s981A of the Corporations Act and 7.8.02 of the Corporations Regulations).

[21]   It is also money paid by the client; or by a person acting on behalf of the client; or to the licensee in the licensee's capacity as a person acting on behalf of the client. See s 981A of the Corporations Act for the full definition.

[22]   AFSLs may also hold property on their clients’ behalf. Aside from being a different type of asset, client property has the same characteristics as client money for the purposes of regulation. See s 984 of the Corporations Act for the full definition. References to client money in this document should be taken to include client property unless it is explicitly excluded.

[23]   See the Appendix C for further information.

[24]   The data included active investors from « 2010 » -2016.

[25]   See glossary for respective definitions.

[26]   Note that Diagram 5.1 provides a broad, high-level description of the treatment of client money.

[28]   See p 26, ‘Government response to the Financial System Inquiry’, www.treasury.gov.au/fsi

[30]   In addition, there are a number of important issues that an investor must understand when undertaking a financial transaction, such as how the product they are investing in works. Extending the logic that the issues that are important to the financial transaction, such as client money protections, should be disclosed and explicitly agreed to by the investor could result in the investor agreeing to a large volume of material, at which point the requirement would likely lose its impact.

[32]   For the purposes of this proposed reform, the expression ‘retail clients’ also includes clients which would otherwise be retail clients but for satisfying the definition of a ‘sophisticated investor’ for the purposes of section 761GA of the Act.

[33]   BBY Ltd was an Australian stock broking, corporate advisory and asset management firm. Prior to its voluntary administration on 18 May 2015, it claimed to be the largest independent stockbroker in Australian and New Zealand by market share.

[34]   Referred to in the UK as the ‘matched principal’ model.

[35]   Annualised.

[36]   Annualised.

[37]   See Treasury options paper, ‘Wholesale and Retail Clients Future of Financial Advice’, January 2011.

[38]   Professional investors include financial services licensees, bodies regulated by APRA other than superannuation trustees acting for a trust holding less than $10 million in net assets, persons controlling $10 million or a body corporate or unincorporated body that carries on a business of investment in financial products, interests in land or other investments following an offer or invitation to the public.

[39]   Title transfer collateral arrangements in the UK allow firms to treat margin as their own working capital (rather than as client money).

[40]   ASIC Regulatory Guide 212, Client Money Relating to Dealing with OTC Derivatives , July  « 2010 » , p. 7