Margin and securities lending
Are current obligations imposed on brokers sufficient to reduce the risk of investor loss?
Past lessons, effectiveness to date and where to from here
Current legislative obligations and ASIC requirements regarding margin and security lending are moving in the right direction, but the risk of loss from internal fraud still remains high, according to Deloitte Forensic Principal, Forde Nicolaides.
What is needed is independent expertise at a granular level to look at, for example, unusual trading in securities or irregular transactions against client accounts and other red flags that usually exist before a collapse. This might be a function of better compliance checks, internal/external audit procedures and periodic reviews by external experts.
If you have concern about a possible incident of fraud, please contact the Financial Planners Association Whistleblowers hot line, or if you have specific questions about the appropriate checks for fraud within your organisation, please feel free to contact Forde on +61 (03) 9671 7679.
Deloitte Forensic’s credentials
Deloitte has one of the leading forensic practices in Australia which includes a multi-disciplinary team of specialists who provide in-depth forensic services to Australian and overseas based financial institutions. Our team comprises staff with former regulatory experience with Australia’s banking, corporate, insurance and superannuation regulators and also ex law enforcement staff that specialised in corporate fraud and corruption investigations. The Deloitte Forensic team has considerable familiarity and experience with financial services investigations having assisted the receivers and managers of Opes Prime Stockbroking Pty Limited in 2008 and 2009 with their investigations into the groups collapse.
1. The Corporations Legislation Amendment (Financial Modernisation) Act
The recent passage of the Corporations Legislation Amendment (Financial Modernisation) Act in late 2009 provides for the regulation of margin lending facilities. Amongst other things, the Act requires:
- issuers and advisers of margin lending facilities to be licensed by ASIC under an AFSL;
- advisers to only provide advice that is appropriate to the client's individual circumstances;
- margin lenders to meet new responsible lending requirements;
- consumers to have access to external dispute resolution services; and
- clarity around responsibility for notifying clients in the case of a margin call.
The new conduct and disclosure requirements will take effect from 1 January 2011 and ASIC opened applications for a Australian Financial Services licences (AFSL), on 1 February 2010.
However, the underlying issues and causes of collapses such as Opes Prime require more than financial adviser training/ new licensing and better disclosure in a PDS issued to investors.
Whilst these regulations will improve the landscape to reduce investor risk, the complexity of margin lending products requires a deeper look at the causes of such collapses and then identifying faster ways to prevent misconduct.
Most financial services firms are already appropriately licensed and their advisers trained in the products they sell such that regulations now making this compulsory for industry participants will not necessarily mean the risk of investor loss is reduced. A financial services firm can have well trained advisers and have all its proper licensing requirements in place but then so did a number of the collapsed entities over the last two to three years.
2. Collapses – common pitfalls provide lessons from the past
A number of the financial institution collapses in 2008 – 2009 exhibit common characteristics, some of which may act as “red flags” for those seeking to avoid the same mistakes:
- Non-compliance with customer identification and acceptance procedures at the time of opening an account
- Significant related party transactions
- Lack of objective procedures to undertake financial assessment of customers at the time of increasing the account limit
- Lack of transparency in the customer ownership structure and trading authorities
- Unclear ownership of collateral and/or underlying securities
- Lack of understanding of financial services contracts and product disclosure statements
- Non-reconciliation of trade books at the close of each business day
- Flawed mark-to-market process
- Slack guidelines and/or manipulation on determination of LVRs
- Assignment of high LVRs (loan to value ratios) to relatively non-liquid and low volume stocks
- Lack of controls over the margin call processes and recovering loans in default
- Preferential treatment to certain customers by providing higher LVRs, allowing non-payment or delayed payment of margin calls, allowing off-record transactions
- Covering margin calls with unsupported collateral
- Non-disclosure of substantial holdings
- Inadequate reporting structure due to lack of legal disclosure requirements
3. Is current regulation sufficient to minimise the risk of investor loss
As a result of the Corporations Legislation Amendment (Financial Services Modernisation) Act 2009, a margin lending facility will now be regulated as a financial product under Chapter 7 of the Corporations Act 2001. The new Act applies from 1 January 2010.
The regulations include the requirement to issue a Product Disclosure Statement and that financial advisers offering margin lending products will be subject to responsible lending requirements including sufficient training and knowledge about the products being offered to investors. ”Much of this already occurs in practice within the financial services industry and even occurred amongst the financial services entities that collapsed in 2008. Accordingly the risk of investor loss from internal fraud (for example) cannot be mitigated by knowledge and training of the margin lending product alone.
“Due to the distinctive nature of margin lending loans, the volatility of the market and the subjectivity or greater potential manipulation associated with determining the loan value, the new legislation and regulatory guides issued by ASIC do not fully address the critical risks associated with these loans including financial crime and may not provide appropriate protection to parties to these loans.
Following the collapse of Opes Prime and other financial services entities in 2008, the investors to margin lending products essentially become ‘unsecured creditors’ ranking much lower in any potential dividend should assets become available to an external administrator. This was disputed by the Opes investors and was eventually settled.
The complexity of these corporate collapses should not be under estimated: ultimately there are often few significant unencumbered assets available and inevitably claims arise.
Other than Opes Prime, other examples of disasters originating from the lack of specific regulation in this area include Tricom, Storm Financial, Chartwell Enterprises, Prime Broker Securities /Chiamera Capital and Lift Capital. The collapse of these entities has prompted the government to consider reform in 2009 and implement specific laws and regulatory guidance covering complex financial products.
Some of the measures the government has taken to minimise the risk of losses caused by the absence of specific regulations are:
- In March 2008 ASIC issued statements in relation to securities lending and short selling. The statements included disclosure requirements in relation to substantial holdings and settlement risk issues in relation to securities lending.
- It was also declared that an act of providing misleading information to the market to impact price and/or volume of securities will be considered a criminal offence and will attract fine and/or imprisonment.
- In March 2008, ASX entailed that the brokers collect information about ‘naked’ and ‘covered’ short sells and provide this information to ASX. A constraint of minimum 20% margin over the short position was also made mandatory.
- In June 2008, the government issued a green paper on ‘Financial Services and Credit Reform’ seeking feedback on possible reforms to various areas of the financial services sector. A complete chapter of the green paper was dedicated to Margin Loans.
- On 25 June 2009, the government issued Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009. Proposed schedule 1 splits all margin lending facilities into two categories; - standard margin lending facilities and non-standard margin lending facilities. The schedule defines when a facility would be classified under each of these categories and sets out requirements applicable to respective categories. The schedule also requires a lender to undertake an assessment of the borrowers before providing or increasing limits of any facility. Requirements have also been proposed on the lenders in relation to notice of margin calls to the clients.
- Subsequent to the issue of Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009, Corporations Amendment Regulations 2009 and an explanatory statement were issued. The regulations were aimed to give effect to the matters dealt with in the Modernisation Bill on the national regulation of margin loans.
- In July 2009 the government issued two consultation papers on margin lending, setting out the requirements which will be imposed on the holders of financial services licences including strict compliance procedures in respect of margin calls. A minimum training requirement has also been proposed for all financial advisors.
- The function of supervision and surveillance of financial markets and market participants is currently undertaken by ASX. An announcement was made in August 2009 that the function will be handed over to ASIC effective the third quarter of 2010.
- In November 2009, the Corporations Legislation Amendment (Financial Services Modernisation) Bill 2009 received Royal Assent and is effective from 1 January 2010 with some transitional rules.
- On 21 December 2009, ASIC issued a consulation paper on ‘Non-standard margin lending facilities – improving disclosure for retail clients (CP 129)’ which sets out the key features and risks which ASIC proposes should be disclosed in a Product Disclosure Statement for such facilities. Importantly, the draft proposals include a requirement that the following disclosures be made in a PDS:
- an explanation of who owns the investment, covering the transfer of securities from the client to the provider and the client’s right to repurchase equivalent marketable securities
- an explanation of what the provider will or may do with the transferred securities, including any arrangements that could increase or decrease the risk to the client that the provider will be unable to fulfil a request for repurchase of the transferred securities and whether or not they are held on trust
- an explicit statement of the possible circumstances in which the provider might not fulfil a request to return equivalent securities, such as:
- the provider on-lending the securities and thus being unable to satisfy a repurchase request;
- the provider giving a charge over the securities to a third party;
the provider becoming insolvent;
- the provider exercising their discretion under the arrangement to elect not to return the securities or equivalent securities; or
- if the market for securities is or becomes illiquid and there are no equivalent securities available
This disclosure will help to reduce the risk of internal fraud where financial institutions include, as part of their compliance controls, procedures to ensure that a clients securities are dealt with in accordance with the PDS.
4. Where to from here?
Retail investors sometimes fail to understand the risks of margin lending products or the ‘fine print’ that may be contained in detailed PDS or lending agreements they receive. Further, they may not review the performance of the financial institution they are dealing with or any ‘red flags’ that may arise concerning their account where investigation is needed (for example where irregular entries appear against their loan facility statements, even favourable entries).
Even where investors do understand the risks and know the financial product well, their exposure to loss from internal fraud and weak broker controls is something they cannot readily weigh in to their investment decision.
Financial crime and misconduct in at least some of the collapses appear to have occurred systematically and need to be identified early, to prevent or minimise significant investor losses.
The ability to investigate a financial services institution at a granular level not only requires a deep understanding of the industry, the products offered and the usual forms of financial crime but importantly an ability to quickly obtain and examine vast amounts of electronic data including client accounts, loan statements, securities listings, details of any trades and of course emails.
In many corporate collapses, the smoking gun is often found amongst email communications between the failed entity’s management. Investment companies that have the right data analytics systems in place will be in a better position to be able to reassure already nervous investors.