FMA designates investment company shares now regulated as managed investment products

Introduction

Yesterday, the FMA used one of the new tools in its regulatory toolkit to designate newly-issued shares in investment companies as managed investment products. With effect from 19 May 2017, shares will fall within the designation if:

• they are issued by an investment company; and
• there are reduced powers for shareholders and/or entrenched key service provider arrangements.

The effect of this use of the FMA’s designation power under the Financial Markets Act 2013 is that the investment company issuing those shares will be regulated as managed investment schemes (“MIS”). As a result, it will also need to:

• obtain a license from the FMA to act as an MIS manager;
• appoint a licensed supervisor; and
• comply with additional governance and (assuming that a PDS is required for the offer) disclosure obligations.

A three-step test

The designation applies where a three-step test is met:

• The shares are issued by an investment company; and
• There are reduced powers of shareholders and/or “unreasonably” entrenched key service provider arrangements; and
• The shares are not quoted on the NZX main board.

What is an investment company?

An investment company is a company:

• whose principal business consists of investing in investment property; and/or
• that holds itself out as being a company whose principal business consists of investing in investment property.

Investment property is broadly defined and covers a range of asset usually held by MISs, including financial products, commodities, foreign currencies and real estate. It may be a single asset or a portfolio of assets. There is no distinction between active and passive investment strategies or direct investment and indirect investment strategies – for example, holding the assets through an SPV (although the FMA notes that in some cases, such a SPV may be treated as an investment company in its own right). The FMA also notes that companies whose principal business is not investment will not be caught – and gives the example of a farm operation that owns land for the purpose of farming.

Reduced powers of shareholders

The designation specifies three bright line tests for when there will be reduced powers of shareholders:

• the shares do not confer on the holder all of the rights set out in section 36(1)(a) of the Companies Act 1993;
• a director of the investment company can be appointed / removed other than by a resolution of shareholders; and
• the shareholder’s rights to vote on the appointment / removal of directors are disproportionate to the amount to be paid for the shares.

And then the FMA adds that, even where none of the bright-line tests are triggered, it may consider individually designating shares as MIPs when:

• An investor’s ability to exercise the rights and powers attached to their shares is restricted (as compared to sections 104-109 of the Companies Act), making it more difficult for them to vote on the appointment / removal of a director.
• An issuer structures the terms of its share offer in a manner which avoids the shares being classed as disproportionate immediately after the issue of those shares, but raises concerns that investor voting rights will be disproportionate when a vote on director appointments / removals is held.

Entrenched key service provider arrangements

A number of bright line tests are also used to determine whether there are “unreasonably” entrenched key service provider arrangements. A key service provider is an asset manager, investment manager, or investment adviser. The tests focus on the terms in which key service provider arrangements are entered into- and include:

• the key service provider owns or controls assets material to the operation of the investment company’s business, the benefit of which the company could not reasonably obtain for materially similar cost on arm’s-length terms if the services agreement is terminated;
• the services agreement is on more favourable terms to the key service provider than arm’s-length terms;
• the services agreement is, or will be for a term longer than 3 years, and cannot be terminated by the investment company without cause under the terms of the agreement; and
• the services agreement requires the investment company (or associated person such as a subsidiary) to pay a termination fee (i.e. a break fee) for terminating the services agreement which is more than the lesser of:
o 30% of the payments for the entire term of the agreement; and
o 50% of the payments for the remaining term of the agreement.

Exclusion for NZX main board shares

This exclusion applies because the voting, quorum and other governance requirements that apply to NZX main board listed companies mean that these shares should retain equity-like characteristics (and not in economic substance be MIPs).

Designation to prevent use of crowd funding exclusion

The FMA notes that shares designated as MIPs should not be offered through an equity crowd funding platform.

The other exclusions in Schedule 1 of the FMC Act remain available, if they apply.

The mischief the FMA is trying to prevent

The MIS regime imposes a higher regulatory burden than that for offers of equity securities.

As a result, the FMA is responding to concerns from the managed funds industry about investment companies they believe are operating like MISs (and issuing MIP-like shares), but avoiding the MIS compliance burden. This is being done by offering shares, using a company structure (that are no different in substance to an MIS) as a loophole without having to be licensed or comply with MIS regime requirements.

Also, during its PDS review process, the FMA has seen examples of share offers with terms that make the economic substance of the shares offered less like equity securities and more like MIPs. And whilst the FMA thinks an investment company can be used as a legitimate alternative collective investment structure to a MIS – in some cases the proposed terms did not confer shareholder rights (such as equity voting rights). In other cases, founding shareholders have entrenched themselves as key service providers to such a degree that it is impossible or impractical remove them.

Companies inadvertently caught

The FMA suggests that anyone who believe their shares will be inadvertently caught by the designation to approach them – (e.g. those who believe they are an ‘ordinary’ company but are caught by the definition of ‘investment company’ or the offer terms, company constitution or services agreement technically triggers one of the bright-line tests, but they don’t think the offer breaches the key principles underlying those tests).

Further information

If you would like more information about any of the matters discussed in this note, please contact me.