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FMC Bill – Licensing matters

by Stephen on August 12th, 2013



 Amongst the information that can be gleaned from the recent unveiling of a series of Cabinet decisions affecting the implementation of the Financial Markets Conduct Bill (“FMC Bill”) is the likely shape of the licensing regime for a number of financial services.  This includes fund managers, providers of Discretionary Investment Management Services (“DIMS”), independent trustees of restricted schemes, derivatives issuers and licensed intermediaries (such as person-to-person lending services and crowd-funding platforms).


Core eligibility criteria are specified in the FMC Bill itself, with the detail to be specified by regulations.  For licensees generally, regulations will impose additional requirements around the holding of professional indemnity insurance, standard reporting to the FMA, contracting out of basic duties of care and a ‘fit and proper person’ test for key personnel in related companies who provide the licensed service.


 Regulations will also specify:


 ·         the detailed requirements for specific categories of licensees (DIMS, independent trustees of restricted schemes (e.g. workplace savings schemes) and derivatives issuers);


 ·         the obligations of operators of person-to-person lending services; and


 ·         the rules for licensing of crowd-funding services (which will operate as a separate category of ‘prescribed intermediary’ – with a relatively flexible concept of ‘crowd-funding platform’ being introduced, with the FMA having discretion about conditions of licence under this category).


The release of the Cabinet papers also followed a raft of changes to the FMC Bill, a number of which were in the form of a Supplementary Order Paper which also included proposed changes to supporting (or complementary legislation).


The comments which follow discuss the requirements for all licences under the FMC Bill licensing regime and the specific requirements for DIMS and derivatives issuers.


All licences under the FMC Bill

For licensees generally, regulations are to provide:


 ·         Requirements for licensees to hold insurance – to ensure that insurance requirements are tailored to the nature and scale of applicant’s operations and risk exposures, the FMA will have the power to require (professional indemnity) insurance as a licence condition to meet costs and claims that could arise from civil proceedings.  Before doing so, the FMA must be satisfied that it is necessary or desirable having regard to the purposes of the FMC Bill (including the need to minimise unnecessary compliance costs).


·         Standard reporting by licensees to FMA – the FMA has general powers to require licensees to report on matters that are relevant to meeting eligibility criteria for a licence (e.g. reporting of significant events that impact on the licensee’s business).  The FMC Bill also provides a number of reporting obligations for managers and supervisors of managed investment schemes. 


 ·         Event-based reporting– for consistency and transparency, reporting on particular matters to the FMA as a standard condition is also likely (e.g. insolvency of the business or any of its directors or senior managers, appointment of a receiver, liquidator etc., if the business or any of its directors or senior managers is charged with or dishonesty offence, civil / regulatory action against the business or any of its directors or senior managers or any disciplinary action pending or taken, where relevant to the performance of its functions under the licence, changes to directors or senior management, changes to the auditors and major transactions).


 ·         Responsibility for outsourcing – the FMC Bill provides that a manager of a managed investment scheme must monitor and remain liable for any functions that are contracted out.  Similar provisions apply to fund managers and DIMS licensees.  Cabinet Paper 3 states that duties will be implied into the contracts of other retail services to prevent contracting out certain of their duties and will be liable for the performance of outsourced functions (including for any negligence on the part of the outsourcing contractor).


 ·         Fit and proper person requirements – requirements will be imposed for the directors and senior management of the governing bodies of licensees.

DIMS licensees

DIMS manage a person’s investments under an investment authority and range from a personalised service provided as part of financial advice to a wholly class service where investors sign up to a model portfolio of investments.


A DIMS differs from a managed investment scheme, because each investor holds the underlying financial products (rather than having an interest in a scheme) although the economic outcome may the same.  DIMS providers perform a similar role to fund managers, and the FMC Bill imposes similar legal duties on them (e.g. duty to act in the best interests of investors).  They are also (subject to licence conditions) required to have an independent custodian to hold investor assets.


 Additional regulations will cover:


 ·         Conditions on how DIMS licensees can give incidental advice – The Financial Advisers Act will cover advice to retail clients about whether a DIMS is appropriate and the investment options available under the DIMS.  However, once the client has joined the DIMS, the Financial Advisers Act will not apply to advice on matters incidental to the operation of the DIMS (possibly including amendments to investment options or changes to how returns are reinvested). 


 On the question of the coverage of incidental advice for issues such as conflicts of interest, insufficient adviser skills and knowledge, standards of care – some issues are dealt with under the general duties of DIMS licensees under the FMC Bill’s (e.g. acting honestly / complying with a professional standards of care).  Incidental advice will also be an area where the FMA can impose licence conditions


 ·         Terminating DIMS client agreements – DIMS providers will be required to enter into written client agreements with investors (the contents of which will be prescribed).  That prescriptive is to include how custody over assets will be provided and how rights relating to investor’s assets will be exercised.


 Of particular importance is how the client agreement may be terminated, and the consequences for the investor’s assets (i.e. the client owns the assets held by the DIMS and could, absent any contractual restrictions, be free to withdraw them and take control).  However, there are likely to be contractual restrictions and, in addition, there may be circumstances when it is undesirable for investors to take control of assets (e.g. when the assets are wholesale investments for which small holdings are not generally permitted, and which retail investors have difficulty exercising rights or making decisions).


 As a result, the prescriptions will include that investors have a right to terminate DIMS client agreements without penalty, and take control of assets within a reasonable period to allow for transfer or liquidation of their portfolio.  And the client agreement and DIMS licensee will need to deal appropriately with any wholesale assets held for the client.


 ·         DIMS record keeping – adequate record keeping is important for ongoing monitoring and enforcement of DIMS licensees’ compliance obligations.  Regulations will provide that records be kept for a minimum of 7 years, including records of all acquisitions and disposals of financial products relating to the service and all documents required to be produced by the licensee under the FMC Bill and regulations.


 ·         Exempt services – regulations may exempt from the licensing requirement for DIMS.  The Financial Advisers Act sets out a number of exemptions (largely focussed on the giving of financial advice and included to allow persons or professions to continue to act in the ordinary course of their business).  There are some exemptions that need to be applied to DIMS under the FMC Bill, including in the case of exemptions for not-for-profits that provide low-level management of clients’ funds in basic deposit products on a cost-recovery basis, statutory activities of Crown organisations (other than Public Trust), and traditional trustee company activities that involve discretionary investment management services.  This is to be carried over as a standard condition of licence for DIMS.


 ·         Wholesale DIMS – DIMS providers can offer both retail services and wholesale services.  Wholesale services are those offered only to wholesale investors and are not subject to many of the obligations that apply to retail services.  An area of potential ambiguity and risk for investors is around whether they are part of the retail service offered by the DIMS, and receive the associated regulatory protections, or are being treated as part of the wholesale service and expected to negotiate these matters themselves.  A condition of holding a DIMS licence will be an obligation to inform investors under a wholesale service that they are being treated as wholesale (and not are not subject to the same protections as the retail clients).


 DIMS licence – scope for regulatory arbitrage?


 The have been some boundary questions affecting who can provide DIMS – and the application of the FMC Bill and the Financial Advisers Act.  These issues appear to have been addressed by a process of alignment – particularly by the SOP referred to above.  This includes making it clear that a provider of class DIMS to retail clients must be licensed under the FMC Bill and that DIMS licensees will be acting as ‘brokers’ if they receive investor money.


It seems likely that further boundary issues will be identified through the regulation-making process, reducing the scope for regulatory arbitrage by tailoring a service offering to fit what is perceived to be the lower level of regulation.


Derivatives issuers


Derivatives issuers are the only category of licensees with a roughly equivalent existing licensing regime under the Securities Markets Act.  Cabinet Paper 3 makes it clear that a number of the discretions provided to the FMA under the Securities Markets Act are to be continued under the new regime in terms of the broad terms and conditions on which a licence is licence is granted.  power, which they use to impose conditions on which the licence is granted, including:


 ·         Capital adequacy – the FMA will have a discretion, on a case by case basis, to impose capital adequacy and liquidity requirements on derivative issuers (but these requirements will not apply to entities which are already subject to prudential regulation by the Reserve Bank, such as banks).


 ·         Handling of client funds – the basic approach to the handling of client funds in the Futures Industry (Client Funds) Regulations 1990 will be continued (including keeping client money separate from the issuer’s own funds).


 The current regime was designed for exchange-traded derivatives contracts.  Particular issues arise in respect of retail over-the-counter (“OTC”) contracts which have developed significantly over the past 20 years and were not envisaged by the current regulations.  For exchange-traded derivatives, margins received from customers are on-paid to the exchange’s clearing participants and clearing houses, which are regulated by the exchange.  However, OTC contracts solely involve the derivatives issuer and the customer.  The derivatives issuer has a choice about whether and how to hedge its exposure to the derivatives contract with the customer.  The current regulations are unclear about how it can use client money in these hedging activities.  Cabinet Paper 3 proposes that derivatives issuers have obligations to provide adequate protection to client money when hedging.  This might include, only placing client money with creditworthy and properly regulated counterparties, or with counterparties who agree to abide by the same treatment of client money as the derivatives issuer itself.


 ·         Ongoing reporting and record keeping – standard licence conditions will specify ongoing client reporting by derivatives issuers to clients along with reasonably commonplace record keeping/retention obligations.


 ·         Client suitability requirements – Cabinet Paper 3 includes a recommendation that the FMA continue to have discretion over the inclusion of product appropriateness requirements as a condition of licences.  The rationale for these requirements is that for more complex products, disclosure alone may not result in informed decisions.  Such requirements give product providers some degree of responsibility for ensuring that investors know the risks of what they are acquiring, or have received advice.


 While considering the appropriateness of derivatives products for a client would appear prudent, as a business practice, it is argued that enabling the FMA to impose specific conditions is a method of providing the flexibility required to respond to specific activities or practices of concern, in a fast-changing environment.  However, the acid test will be whether this is coupled with adequate industry and public guidance.


 ·         Leverage limits – such limits apply to derivatives contracts that involve a small up-front margin payment being used to support a much larger exposure to an underlying asset or variable.  The FMA does not currently impose leverage limits, although it could under the existing law.  Cabinet paper 3 proposes a continuation of the existing policy that the FMA have discretion to impose such limits – such as by specifying these as a licence condition.




The new regime under the FMC Bill regime is earmarked as coming into force in April 2014 – but will be subject to a transition period of 2 years.  An exposure draft of the regulations is likely to be distribution for comment in October – and whilst there has been one round of consultation on the shape of the regulations – this is still quite a tight timetable for such a large body of new regulations. 


 Further information


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


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