The Financial Markets Conduct Act 2013 will introduce a new licensing regime for the provision of discretionary investment management services (DIMS).
When the relevant parts of the FMC Act come into effect, authorised financial advisers (AFAs) will lose the ability to provide any form of class DIMS—these will become the exclusive domain of providers with an entity-level DIMS licence under the FMC Act. AFAs will still be able to offer personalised DIMS, although financial advisers who are not AFAs will lose the ability to provide any form of DIMS.
The FMC Act will also amend the Financial Advisers Act 2008 to allow regulations to prescribe specific requirements for AFAs that provide DIMS, and for custodians and other brokers.
The Ministry of Business, Innovation, and Employment sought feedback on proposed regulations in July 2013 through a discussion document. The discussion document canvassed proposed obligations of both DIMS providers and custodians.
As the provisions of the FMC Act relevant to DIMS providers are not expected to come into force until 1 December 2014, the Minister has separated the regulation of custodians from that of DIMS providers. Policy decisions relating to DIMS providers are expected to be made in the first quarter of 2014.
Custodians are regarded as brokers in terms of the FAA, and the FMC Act will amend the FAA to make that position clearer.
At present, brokers are subject to relatively limited regulatory requirements—the key requirements being to comply with a minimum standard of care and to hold retail client funds in trust. Once the relevant parts of the FMC Act become law, DIMS providers (including AFAs) will need to have an independent custodian by default. They will also need to believe, on reasonable grounds, that the custodian is appropriate.
The FMC Act will amend the FAA to allow further requirements for custodians (and other brokers) to be imposed by regulation. These obligations will come into force with the first phase of the FMC Act on 1 April 2014, subject to transitional provisions.
Although the content of the Cabinet paper reflects the proposals contained in MBIE’s discussion document, one notable aspect is express acknowledgement that one driver of the changes is the Ross Asset Management collapse, and the contribution to that collapse made by the lack of robust systems and processes on the part of the custodian purported to hold Ross Asset Management clients’ assets.
Custodians will need to report to clients at least every six months on money and property held, and transactions carried out, on their behalf.
Clients can agree to opt out of written reports only if they have continuous electronic access to that information.
Notable by its absence is a requirement to provide information on asset values and any changes in those values. This reflects the driver of these changes being appropriate oversight and regulation of custodians, rather than provision of performance-based information to clients.
Annual audit and assurance review
Custodians will need to have a representative sample of client trust accounts audited annually, and have an annual assurance engagement review undertaken of the custodian’s processes, procedures, and controls.
The assurance review will involve an assessment of whether the custodian’s processes, procedures, and controls enable it to meet prescribed control objectives, and whether they have operated effectively during the past year.
The Cabinet paper acknowledges that this requirement will impose additional costs on custodians not already carrying out these reviews of $30,000–$60,000 annually, but does not propose any alternatives for those custodians. It appears that the policy decision has been made that these are minimum standards that all custodians will need to comply with.
The control objectives that custodians will be assessed against will be relatively high level, and will generally set out the outcomes that the custodian’s systems and procedures should be achieving. One example given is that transactions are properly authorised and processed in a complete, accurate, and timely manner.
Each control objective will be principles-based, and custodians and auditors will retain flexibility about how these objectives are met. Proposed objectives will be included in the draft regulations yet to be released.
We agree with principles-based benchmarks being provided to custodians to give certainty over the purpose of the assurance reviews. Applying those benchmarks consistently across the industry will be critical if that certainty is to be achieved.
Reconciliation of assets
Custodians will need to have adequate procedures for regular reconciliation of client assets, including the escalation and resolution of variances.
These are to be compared against internal and external records on an appropriately frequent basis, taking into consideration the type of assets held.
It is envisioned that cash would be reconciled daily, with others undertaken at different frequencies depending on the product type and frequency of trading. It is intended that FMA guidance, auditors, and industry practice set the procedural requirements for undertaking these reconciliations, rather than prescribing these through regulation.
All of the above obligations, as well as the existing obligations for brokers under the FAA, will be extended to custodians who hold assets on behalf of wholesale clients.
Exceptions will only be allowed for clients considered to be ‘truly wholesale’ institutional investors (such as investment businesses and government agencies).
Although it may in fact be operationally easier for custodians to hold assets for wholesale clients on the same basis as for retail clients, rather than differentiate between the two, we question the imposition of an absolute rule against wholesale investors being able to opt out of these obligations, and the creation of a sub-category of ‘truly’ wholesale investors.
Historically, under both securities law and the FAA, investors classified as ‘wholesale’ have been permitted to opt out of certain protections intended for retail investors, on the basis of their greater investment knowledge and expertise and access to advice. We would have expected any policy decision that fetters the freedom of wholesale investors to be made through legislation, rather than regulations. This decision is best viewed as just one of the number of regulatory responses to the Ross Asset Management collapse, and an example of the flexibility inherent in the new framework for regulating financial market conduct.
The rejection of proposals to provide relief for custodial arrangements operating under the NZX Participant Rules has been carried through from the discussion document. Whilst those Rules do not have universal application, they are broadly similar to what has been proposed. Rather than recognise the robustness of the NZX Participant Rules, the effect of the Cabinet decisions is that those Rules will need to be amended to align with the proposed regulations.
Overall, the proposed requirements are largely sensible, although we have reservations about the merits of overlaying a new set of requirements on top of those already in place for NZX participants, as well as concerns over the addition of a further layer of complexity by creating a sub-class of wholesale investors with compulsory retail investor protections.
In practice, we expect that most custodians will recognise the inevitability of what has been proposed, and will be well positioned to accommodate any new requirements that are not already being observed.
Now that the policy decisions have been made, consultation draft regulations are expected to be released in late November 2013, with the regulations coming into force (subject to any transitional provisions) on 1 April 2014.
Consultation as to the appropriate transitional period for each requirement is on-going, with an indicative timeframe of six months to a year for most.
Given that conduct obligations will extend to custodians holding assets for a range of financial service providers in the future, it is important that providers engage as soon as possible once the draft regulations are released. A key question to ask is whether the new regulations are consistent with the legislative purpose of avoiding unnecessary compliance costs.
If you would like to discuss the proposals, or would like our assistance with a submission once draft regulations are released, please contact David Ireland on +64 4 498 0840, Catriona Grover on +64 4 498 0816, or Nick Summerfield on +64 4 498 0876, or email the team at email@example.com.