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Corporations Law (Securities and Futures) Amendment Bill 1994



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House: Senate

Portfolio: Attorney- General

Commencement: On the day on which the Act receives the Royal Assent.

Purpose

The purpose of the Corporations Law (Securities and Futures) Amendment Bill 1994 ("the Bill") is to provide a more flexible regulatory coverage of new and innovative investment products on Australian securities and futures exchanges. In particular, the Bill will allow prescription by regulation of certain investment agreements so that they may be regulated as if they were "securities" or "futures contracts" under the Corporations Law. At present, certain forms of speculative investments (such as some derivatives) do not satisfy current definitions in the Corporations Law.

Background

[ Special Note: This Bill is, to all intents and purposes, the same in substance as the Corporations Law Amendment Bill 1994 ("First Version") which was introduced on 16 November 1994. This Bill, the Corporations Law (Securities and Futures) Amendment Bill 1994 ("Second Version"), contains what are essentially the same proposed amendments but utilises a different drafting approach. The difference between the two Bills can be summarised as follows:

. the First Version directly amended the existing provisions of section 72 (futures) and section 92 (securities) of the Corporations Law to enable new types of financial products (certain hybrid financial derivatives) to be regulated within the existing sections;

. the Second Version achieves the same objective by leaving the existing sections 72 and 92 of the Corporations Law intact and introduces two new sections, s.72A and s.92A as free- standing sections, to treat the new hybrid derivatives separately but on the same basis as if there were an exchange- traded futures contract or a security.

The Background information contained in the Bills Digest for the First Version is restated as the subject matter of the Bill is the same. It is understood that the First Version of the Bill will remain on the Notice Paper until the Parliament is prorogued. The Bill to be considered will be the Second Version.]

Although the Bill contains only 8 clauses, the subject matter is complex. The main aim of the Bill is to bring within the coverage of the Corporations Law hybrid financial investment products including new forms of financial derivatives. This Bill is only concerned with exchange- traded derivatives. It is important to make the distinction between exchange- traded derivatives and investment in privately negotiated derivatives (which are not regulated).

The national Corporations Law provides separate regulation of futures contracts (Chapter 8) and securities (Chapter 7). The definitions for a "futures contract" and "securities" are found in Chapter 1 of the Corporations Law (at sections 72 and 92, respectively). As a generalisation, futures contracts can only be traded on a futures exchange while securities are traded on the stock exchange. Recent developments in products for financial investment have seen the creation of hybrids which were not contemplated when the Corporations Law was initially framed.

Proposed amendments to the Corporations Law to rectify this anomaly were originally included in the Corporations Legislation Amendment Bill 1994 introduced into the House of Representatives on 24 March 1994. Those proposed amendments were subsequently withdrawn by the Government to allow the proposal to have "further exposure" before entering into law. 1 An exposure draft was subsequently released on 5 September 1994 for public comment by interested parties. This Bill (in the form of the First Version and the Second Version) now "resubmits" the proposed amendments for consideration by the Parliament.

The main impetus for the proposed amendments is the development of a share ratio contract by the Australian Stock Exchange. A share ratio contract allows an investor to trade on the degree to which individual shares move relative to the market. 2 A share ratio contract is a hybrid of both a security and a futures contract. The argument for including a share ratio contract within the definition of a securities is because the contracts require specialised knowledge of individual shares which is usually found associated the stock exchange. Stock brokers, as members of the Australian Stock Exchange (ASX), will be required to comply with the ASX business rules on share ratio contracts, and demonstrate relevant experience and expertise with such investment products.

As well as covering an existing specific product like the share ratio contract, the Bill is intended to allow the futures and securities regimes in the Corporations Law to cover, where necessary, other new and innovative investment products that do not fall clearly within the definitions of "securities" or "futures contracts".

This is particularly relevant to derivatives. Derivatives are financial contracts based on instruments (such as bank bills, bonds, shares) or commodities (such as wheat, oil, currencies). They can take the form of swaps, options, futures and forwards. Elements of these can be combined into more complex instruments, such as swaptions. The share ratio contract is an example of a derivative. 3

One way of classifying derivatives is into futures contracts, options and swaps. For example:

.a "futures contract" is an obligation to buy or sell an asset at a stated price on a specified date in the future;

.an "option" is the right (but not the obligation) to buy or sell an asset at some time in the future; and

.a "swap" is an exchange of income streams but, generally, not principal. 4

Derivatives are generally traded on organised exchanges like the Sydney Futures Exchange ("exchange- traded" derivatives) or through private negotiation ("over- the- counter" derivatives). The over- the- counter markets have developed strongly in recent years and have a large turnover.

Over- the- counter derivatives will not be regulated by this Bill as they are seen as privately negotiated contracts which are tailored to a customer's needs. Most over- the counter derivatives are traded in Australia by the banks and these contracts include interest rate options and currency options. Exchange- traded derivatives use a standard contract specification and are regulated by the Bill.

Derivatives are traded both domestically and internationally. New technology has greatly assisted the packaging and trading of derivatives through international capital markets. Derivatives provide an opportunity to hedge against a multitude of risks involved in trade and investment. A consequence of not having a well designed and flexible regulatory system for derivatives is that derivatives trading activities may move offshore. 5

Many derivatives transactions are, arguably, a gaming or wagering contract. Most gaming and wagering contracts in Australia are null and void. Specific legislation authorises certain types of gaming and wagering contracts on strict conditions. Thus, betting on racehorses (wagering) and in casinos (gaming) are regulated in Australia. It is necessary for the Bill to include a provision to exempt these new forms of financial investment from gaming and wagering laws.

Regulation of these financial products will not remove the element of risk found in any investment but regulation should allow fair and orderly trading. Some overseas markets have seen huge individual losses in derivatives (e.g. Metallgesellschaft AG lost

$US1 billion in 1993 mainly on oil derivatives; Kashima Oil lost $US1.5 billion trading in foreign exchange derivatives and George Soros' hedge funds lost US$600 million in a single day). In the case of Metallgesellschaft AG the situation was controlled through a combination of monitoring by the New York Mercantile Exchange ("Nymex") and internal management by the company. 6

More recently, the financial collapse of Orange County in California (estimated losses of $US2.5 billion) has been described as a "derivatives- triggered bankruptcy crisis". 7 It is reported that local Councils in Australia, as a generalisation, have little of the financial freedom enjoyed by Orange County. The 1989 financial difficulty encountered by a London borough known as the "Hammersmith and Fulham case" (speculative use of interest rate swaps) is also noted. 8

Views are divided on whether there is a need for broad regulation of derivatives. The Sydney Futures Exchange and the Australian Investment Managers' Association have surveyed fund managers and concluded that investment managers are conservative and tended towards the existing highly regulated exchange- traded products. The Sydney Futures Exchange price index contract was the most popular equity derivative. 9

The President of Germany's Bundesbank, Mr Hans Tietmeyer, is on record as stating that he did not think that there is any reason for specific regulation of derivatives, for the time being. 10 A similar view has been expressed by the United States Treasury in evidence to a Congressional Committee considering proposed legislation. 11

As noted above, the Bill is designed to allow greater flexibility for exchange- traded derivatives. The Bill does not regulate over- the- counter ("private") derivatives.

Main Provisions

Clause 4 adds a proposed new section 72A to the Corporations Law to allow agreements such as futures derivatives to be identified in Regulations made under the Corporations Law. The proposed new section 72A covers derivatives which are to be traded on a futures exchange as if they were a conventional futures agreement. The proposed new section also allows the exemption of specified agreements from the operation of the Corporations Law.

Clause 6 adds a proposed new section 92A to the Corporations Law to allow agreements (whether or not they are also futures agreements) to be identified in Regulations made under the Corporations Law and treated as if they were conventional securities. The proposed new section 92A covers agreements which are to be traded on the stock exchange. The proposed new section also allows the exemption of specified agreements from the operation of the Corporations Law.

Clauses 7 and 8 exempt any newly prescribed exchange- traded derivatives from the effects of gaming and wagering laws.

Endnotes

1. Australia, Hansard, House of Representatives, Second Reading Speech by the Hon Mr Michael Lavarch, Attorney- General, 8 June 1994: 1745. See also the Second Reading Speech to the Corporations Law Amendment Bill 1994 in Senate Hansard of 16 November 1994 at p.3154, and the almost identical Second Reading Speech to the Corporations Law (Securities and Futures) Amendment Bill 1994 in Senate Hansard of 5 December 1994 at p.3780.

2. A study of the share ratio contract is provided in ASX Perspective, issued by the Australian Stock Exchange in November 1994. This Quarterly Journal notes at page 9:

The Australian Stock Exchange's ratio contract, the first of its kind in any world securities market, will initially cover eight of Australia's top 20 market capitalised stocks. The initial contracts will cover four resource stocks - BHP, CRA, MIM and Western Mining, along with News Corporations and three banks - ANZ, National Australia and Westpac.

3. Carew, E. How Australia's Derivatives Markets Operate, Australian Financial Markets Association, Sydney, 1993: 4.

4. See Dauggaard, D. and Valentine, T. 'The Reregulation of Banking: Its Implications for the Industry and Derivatives Markets' in Economic Papers, Economic Society of Australia, Volume 13, No. 1, March 1994: 17- 40 at 18.

5. Ryland, M. 'Derivatives Regulation: The International Aspect', Journal of Banking and Finance Law and Practice, Vol 5(3), The Law Book Company, September 1994: 173- 196 at 173.

6. Ibid, at 183.

7. Hay, D. 'Orange County Quake', Australian Financial Review, 16 December 1994.

8. See Hogan, R. 'Orange "won't happen here" ', Australian Financial Review, 13 December 1994.

9. 'Derivatives used "conservatively"', The Canberra Times, 2 December 1994.

10. Bloomberg, 'Controls on derivatives not needed: Bundesbank chief', Australian Financial Review, 3 March, 1994.

11. Bloomberg, 'Derivatives don't need regulation, US Treasury tells Congress, Australian Financial Review, 20 September, 1994. See also Bloomberg 'Derivatives face tough task to banish their bad name', Australian Financial Review, 30 December 1994.

Acknowledgment

The author acknowledges the assistance of Mr Michael Ryland BA (Hons), LLB (NSW) for his perusal and comments on the first draft of the Bills Digest prepared for the First Version of the Bill i.e. Corporations Law Amendment Bill 1994. As noted above, almost all of that Digest has been restated in this Bills Digest. The author takes responsibility for the content of the Bills Digest. Mr Ryland's journal article (cited above) on Derivatives Regulation: The International Aspect is recommended reading and it is listed on the Parliamentary ISR database (MICAH reference 02- 9394).

B. Bailey (06 2772434)

Bills Digest Service

Parliamentary Research Service 13 January 1995

This Digest does not have any legal status. Other sources should be consulted to determine whether the Bill has been enacted and, if so, whether the subsequent Act reflects further amendments.

Commonwealth of Australia 1995.

Except to the extent of the uses permitted under the Copyright Act 1968, no part of this publication may be reproduced or transmitted in any form or by any means, including information storage and retrieval systems, without the prior written consent of the Parliamentary Library, other than by Members of the Australian Parliament in the course of their official duties.

Published by the Department of the Parliamentary Library, 1995.