Compliance: Theory and Practice in the Financial Services Industry

12A. Derivatives

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Outline

   Definitions
   Licensing and Disclosure Requirements
   Confirmations

 


Definitions

CA s764A(1) - Things that are Financial Products
Subject to subdivision D (s765A), the following are financial products for the purposes of Chapter 7: ...
(c)  a derivative.

CA ss765A(1)(n) and (p) exclude from the definition of "financial product" so much of an arrangement as is not a derivative because of s761D(3)(a) and an arrangement that is not a derivative because of s761D(4) (see below).

CA s761D(1) - Definition of Derivative
A derivative is an arrangement under which:
(a)   a party to the arrangement must, or may be required to, provide at some future time consideration of a particular kind or kinds to someone;
(b)   that future time is not less than the number of days, prescribed by regulations made for this purpose, after the day on which the arrangement is entered into; and
(c)   the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, for example, one or more of the following:
  •    an asset;
  •    a rate (including an interest rate or exchange rate);
  •    an index;
  •    a commodity.

Under s761D(2), anything declared by the regulations to be a derivative for the purposes of s761D is a derivative for the purposes of Chapter 7. A thing so declared is a derivative despite anything in ss761D(3) and (4) (see below).

At the time these provisions were enacted, I expressed the view that the definition of "derivative" was likely to be one of the most problematical provisions in the FSR reforms. It is extremely broad and has the potential to capture a range of transactions that would not generally be considered to be derivatives by market participants.

One needs to have regard to the Explanatory Memorandum for the Financial Services Reform Bill to understand what the draftsperson was trying to achieve in using this definition. Para 6.72 of the Explanatory Memorandum for the Financial Services Reform Bill said:

    

"The definition of 'derivative' in proposed section 761D has been formulated to replace the existing definition of 'futures contract' in section 72 of the proposed Corporations Act. As recommended by CASAC in its report entitled 'Regulation of On-exchange and OTC Derivatives Markets' the definition focuses on the functions or commercial nature of derivatives rather than trying to identify each product that will be regarded as a derivative. The definition proposed by CASAC in its report has been used in developing the definition in proposed section 761D."

Para 6.73 of the Explanatory Memorandum for the Financial Services Reform Bill said:

    

"Features of the definition of 'derivative' to note are:

 

•    

under the arrangement a person must or may be required to provide consideration at some future time. This ensures that options that otherwise fall within the definition are captured (proposed paragraph 761D(1)(a));

 

•    

the consideration is of a particular kind or kinds. This would cover those contracts that provide for cash settlement or physical delivery (proposed paragraph 761D(1)(a));

 

•    

contracts, such as spot foreign exchange transactions, which could vary in value as a result of movements in the exchange rate during the settlement period, will be excluded by regulation under proposed paragraph 761D(1)(b);

 

•    

the definition covers all arrangements where the amount of the consideration or the value of the arrangement varies by reference to something else (of any nature whatsoever and whether deliverable or not), including but not limited to a commodity (proposed paragraph 761D(1)(c));

 

•    

it encompasses arrangements under which both the amount of the consideration or the value of the arrangement varies by reference to something else. This ensures that the definition covers deliverable options and futures contacts under which the consideration remains the same but the value of the arrangement varies by reference to something else (proposed paragraph 761D(1)(c));

 

•    

all consideration, including initial or periodic consideration, the amount of which was fixed at the time the arrangement was entered into, is taken into account, ensuring that options under which the obligation to pay the other party a variable amount only arises on the occurrence of a future contingent event [sic are covered];

 

•    

proposed paragraph 761D(3)(a) excludes from the regime a range of transactions involving the future delivery of something, including such things as contracts for the sale of land with a three month settlement period, while bringing within the regime those forward rate agreements that should be regarded as derivatives, because they are being used for hedging or speculative purposes. This is a difficult dividing line to draw as much depends on the intentions of the particular parties concerned. The existing Corporations Law seeks to deal with this issue by the concept of the likelihood of the agreement being settled other than by delivery (see definition of 'eligible commodity agreement' in section 9 of the Corporations Law). However, CASAC explicitly rejected this test on the basis that the 'unlikely' requirement was not clear and some futures contracts such as deliverable share futures may not be likely to be closed out. Proposed section 761D seeks to address this issue by:

 

 

-   

applying the relevant exclusion to tangible property only. It would not therefore apply to a deliverable share or bank bill future, as the underlying property is intangible (proposed subparagraph 761D(3)(a)(i));

 

 

    

rather than focussing on the mandatory delivery aspect, it looks to whether the arrangement can settled by cash or by set-off between the parties. If the arrangement relates to tangible property and can not be cash settled, it will fall outside the definition of derivative (proposed subparagraph 761D(3)(a)(ii));

 

 

-   

contracts which provide for some top-up of cash in the event that tangible property does not meet the standard for delivery would none the less be excluded from the definition as a result of the reference to wholly settled by cash in proposed subparagraph 761D(3)(a)(ii);

 

 

-   

looking to the wider context in which the arrangement is made and recognising that while a contract on its face appears to require delivery of tangible property, market practice or the rules of a market or clearing and settlement facility mean that delivery is not mandatory, but that the contact can be closed out by entering into an offsetting transaction (proposed subparagraph 761D(3)(a)(iii)).

 

•    

The definition covers all options other than:

 

 

-   

options over unissued shares, which fall within the definition of 'security' (proposed paragraph 761D(3)(c));

 

 

-   

options over tangible property which do not allow for cash settlement. Such options would fall within the exclusion in proposed paragraph 761D(3)(a); and

 

 

-   

any other options prescribed by regulations (proposed paragraph 761D(3)(d) allows regulations to exclude things from the definition of 'derivative').

 

 

[Editorial note: this list of exclusions should have included options over unissued interests in managed investment schemes, as these fall within s764A(1)(b)(iii) if the scheme is registered and s764A(1)(ba)(iii) if the scheme is not registered, and therefore cannot be a derivative (s761D(3)(c)). It should also have included options that confer an equitable right or interest in an issued share or debenture (these fall within para (c) of the definition of "security" and therefore within s764A(1)(a)) or an equitable right or interest in an issued interest in a managed investment scheme (these fall within s764A(1)(b)(ii) if the scheme is registered and s764A(1)(ba)(ii) if the scheme is not registered), and so again cannot be a derivative (s761D(3)(c)).]

 

•    

Proposed subsection 761D(4) takes out of the definition of 'derivative' arrangements that only vary by reference to a general inflation index. This is intended to take outside the definition arrangements that would otherwise be derivatives merely because they have an inflation clause in them."

Thus, the words "may be required" in (a) and "ultimately determined" in (c) are intended to pick up options, where the obligation to pay the other party a variable amount only arises on the occurrence of a future contingent event (ie the exercise of the option). The reference in (a) to the consideration being "of a particular kind or kinds" is intended to capture contracts or options that provide for cash settlement or physical delivery of underlying product, rate or index. The reference to the value of the arrangement varying in (c) is said to be intended to capture all deliverable (as distinct from cash settled) options and futures contracts where the consideration payable under the option or futures contract does not change but the inherent value of the arrangement does because of movements in the value of the underlying product, rate or index.

At the time these provisions were enacted, I queried then whether a court would agree with the interpretation that all non-excluded options are caught by the definition of "derivative", having regard to the words "something else" in that definition. If you have a deliverable (rather than a cash settled) option over a thing and the value of that option varies simply because of variations in the value of that thing, can that variation fairly be said to have occurred because of "something else"? The other problem with this interpretation is that, if it is right, then theoretically any agreement to buy or sell property that has a fluctuating market value, that falls outside the exclusion for sales and purchases of tangible property in s763D(3)(a) (see below) and that is not immediately settled, effectively becomes a derivative simply because the value of that agreement will vary, between the time it is made and the time it is settled, by reference to that fluctuating market value.

Take the example of an agreement to buy shares on the ASX, which settles on a T+2 basis. Over those 2 days, the value of that agreement will vary with movements in the market value of the shares in question. On the view of the definition of "derivative" expressed in the Explanatory Memorandum for the Financial Services Reform Bill, that agreement to buy shares would be a derivative. [Some may argue that an agreement to purchase shares on a stock market gives the purchaser an equitable interest in the shares purchased and therefore the agreement falls within paragraph (c) of the definition of "security" in s761A and is therefore a "security" in its own right. Accordingly, it will not be a derivative because of the operation of s761(3)(c) (see below). However, the better view is that an agreement to buy shares on a stock market does not give the buyer an equitable interest in any underlying shares because of the way in which the clearing and settlement process works.]

Consider also a standard equipment lease financing. Typically the customer/lessee will be obliged to pay a residual that will vary by reference to the value the financier/lessor obtains by selling the equipment on the termination of the lease. Potentially this arrangement falls within the definition of "derivative" – it is an arrangement under which a person (the lessee) may be obliged to make a payment in the future that is ultimately determined or varies by reference to the value of an asset (the equipment). Note that this is not a bi-partite arrangement for sale of the equipment between the lessor and the lessee (if it was, it would convert the lease into a hire purchase contract) and therefore it cannot fall within the exclusion for sales and purchases of tangible equipment in s761D(3)(a). Nor is it covered by the incidental product exclusion in s763E – if something is a derivative, it is caught by s764A and therefore specifically excluded from the operation of s763E. Hopefully, if this issue were ever to come before a court, the court would look to totality of arrangement and find it was not a derivative but just part of a credit facility.

The Federal Court picked up my point above about the meaning of "something else" in Keynes v Rural Directions Pty Ltd (No 2) [2009] FCA 567, holding that forward contracts for supply of grain were not "derivatives" for the purposes of the Corporations Act because they did not satisfy the requirements of s761D(3)(c). The court said:

    

"The consideration under the forward contracts is fixed and the plaintiffs do not rely on that part of the definition which refers to the amount of the consideration. They submit that under the forward contracts the value of the arrangement … varies by reference to the market price of wheat or barley from time to time. By way of example, they submit that if the price of wheat or barley rise, and a buyer enters into a contract to sell the same quantity at the then market price, the "value of the arrangement" from the buyer's point of view will increase by the increase in market price.

    

The plaintiffs also call in aid s 761B which provides as follows:

     "If:
     (a)   an arrangement, when considered by itself, does not constitute a derivative, or some other kind of financial product; and
     (b)   that arrangement, and one or more other arrangements, if they had instead been a single arrangement, would have constituted a derivative or other financial product; and
     (c)   it is reasonable to assume that the parties to the arrangements regard them as constituting a single scheme;
    

the arrangements are, for the purposes of this Part, to be treated as if they together constituted a single arrangement."

    

I do not think s 761B assists the plaintiffs. Taking the example given by the plaintiffs, I do not think another contract, say a contract by the buyer to sell the wheat or barley he has contracted to purchase, can be at one and the same time part of the arrangement for the purposes of determining the value of the arrangement and be the something else within s 761D(1)(c).

    

On the face of it, the words the value of the arrangement are very broad, and, if the plaintiffs' submissions are correct, many transactions would be derivatives, even though they would not be considered to be derivatives as a matter of ordinary language. Almost all forward contracts for goods which are readily obtainable in the market would be caught. Under the regulations, the prescribed period in the case of contracts, other than foreign exchange contracts, is one business day (reg 7.1.04(1) and see also reg 7.1.04(2)). I acknowledge the fact that there are the exceptions in s 761D(3) but even so, one is cautious of an interpretation of subs (1) which would catch an ordinary transaction like the sale and purchase of a motor vehicle with payment of the purchase price today and delivery in one week's time. It seems to me that the answer lies in the meaning of the "something else" referred to in the paragraph. It includes an asset, a rate (including an interest rate or exchange rate), an index or a commodity and things of any nature whatsoever and whether or not deliverable. In my opinion, although the precise boundaries of the definition may be difficult to identify, the matters the plaintiffs relied on, that is, the fact that there is a market for goods and that a party to the arrangement may enter into a transaction, is [sic not] "something else" for the purposes of paragraph (c).

    

In my opinion, the forward contracts do not fall within s 761D(1) because the condition in para (c) is not satisfied.

    

I turn now to consider whether the forward contracts fall within s 763A and s 763C.

    

The plaintiffs submit that in entering into the forward contracts they were managing a financial risk within s 763A(1) and s 763C. Other than pleading the two sections, they have not pleaded facts in support of their contention, nor is there any evidence in support of it. The plaintiffs submit that a person in their position is likely to enter into a contract when the price was high to avoid the risk of price variations and a production failure. It seems to me that it is possible that a forward contract would be entered into at a particular time in order to manage a risk which has financial consequences; the difficulty in this case is that there is nothing in the [pleadings] to indicate that this was done in the case of the forward contracts. Had the case turned on this point, it would have been necessary to hear from the parties as to whether the plaintiffs should be given the opportunity, assuming they could do so, to provide proper pleadings or particulars of their case under s 763A and s 763C."

An appeal against this decision was rejected by the Full Federal Court in Keynes v Rural Directions Pty Ltd [2010] FCAFC 100.

A similar issue came before the NSW Supreme Court when a party to a litigation funding deed sought to avoid the deed on the basis that it amounted to the provision of a financial service by the litigation funder who did not have the requisite licence to provide such a service. Amongst other things, the plaintiff sought to argue that the deed was a derivative because it provided for a return that was ultimately determined by reference to either the proceeds of the litigation or the legal costs incurred in the litigation. The deed provided for its immediate cancellation if there was a change of control of the plaintiff and for the payment of an early termination fee in those circumstances. The court at first instance (Chameleon Mining NL v International Litigation Partners Pte Ltd [2010] NSWSC 972) held that the litigation funding deed was not derivative, saying:

    

"Section 761D(1)(c) requires the amount of the consideration or the value of the arrangement ultimately to be determined, derived from or vary by reference to (wholly or in part) the value of something else. The word "ultimately" in the subsection plainly qualifies the words "determined, derived from or varies by reference to" (there being no comma before the words which follow the words in parentheses).

    

This is no doubt because it is in the nature of a derivative that the value of the arrangement will (as the word "ultimately" connotes) in every case be affected by (and hence derived from) the value of something else. The Deed does not have this invariable operation, as the facts in the present case demonstrate. The amount of the Early Termination Fee on the particular Change in Control here is not determined or derived from, nor does it vary by reference to the value of, something else."

On appeal (International Litigation Partners Pte Ltd v Chameleon Mining NL [2011] NSWCA 50), three remarkably different findings were reached by the Court of Appeal on this point. Young JA held that the litigation funding deed was not a derivative as it related to and created an interest in the relevant legal proceedings rather than being dependent on "something else". He also held that it was not a contract for the future provision of services nor a credit facility (it was simply an agreement to pay costs but included no loan or advance of money). Giles JA considered that the funding agreement was a derivative because the value of the arrangement was affected by something else, that is, the legal costs or the outcome of the litigation. He also held that it was not a contract for the future provision of services but rather a contract for the provision of money and agreed with Young JA that it was not a credit facility. Hodgson JA, on the other hand, found that some aspects of the litigation funding deed were potentially a derivative but that the arrangement was excluded from being a derivative because it was a contract for future provision of services. He also considered that it amounted to a credit facility and was therefore excluded from being a financial product under s765A(1)(h). On further appeal to the High Court (International Litigation Partners Pte Ltd v Chameleon Mining NL [2012] HCA 45, the High Court unanimously held that the litigation funding facility was a credit facility and therefore excluded from being a financial product under s765A(1)(h). The High Court did not express any view on whether or not the funding agreement was a derivative under s761D.

For a discussion of some of the issues raised by this case, see '3. Derivatives' in Lewis, A Decade On - Reforming the Financial Services Law Reforms (note that this paper was written prior to the High Court decision but the concerns discussed in the paper persist, given the narrow basis for the High Court's decision and its lack of any analysis of the scope of s761D).

Regardless, it would seem clear that the draftsperson intended the definition of "derivative" to pick up futures and futures options traded on the ASX, ASX 24 and other futures markets; ETOs, warrants and CFDs traded on the ASX and other stock exchanges; and OTC derivatives. In ASIC re Giann & Giann Pty Ltd [2005] FCA 81, the Federal Court confirmed that the definition of "derivative" captures exchange traded options and exchange traded index options. In ASIC v Stone Assets Management Pty Ltd [2012] FCA 630, the Federal Court also confirmed that the definition of "derivative" captures contracts for difference over foreign exchange, metals and indices.

 

CA s761D(3) – Exclusions from Definition of Derivative
(a)   An arrangement in relation to which:
  (i)   a party has, or may have, an obligation to buy, and another party has, or may have, an obligation to sell, tangible property (other than Australian or foreign currency) at a price and on a date in the future;
  (ii)   the arrangement does not permit the seller's obligations to be wholly settled by cash, or by set-off between the parties, rather than by delivery of the property; and
  (iii)   neither usual market practice, nor the rules of a licensed market or a licensed CS facility, permits the seller's obligations to be closed out by the matching up of the arrangement with another arrangement of the same kind under which the seller has offsetting obligations to buy;
  but only to the extent that the arrangement deals with that purchase and sale.
(b)   A contract for the future provision of services.
(c)   Any of the financial products specifically listed in s764A(1) (other than a derivative).
(d)   Anything declared by the regulations not to be a derivative.

All of these exclusions are subject to s761D(2) (ie the items in question can be prescribed to be derivatives under the regulations).

In relation to s761D(3)(a), note the anti-avoidance provisions in CA s761B, which provides that if: (a) an arrangement, when considered by itself, does not constitute a derivative, or some other kind of financial product; (b) that arrangement, and one or more other arrangements, if they had instead been a single arrangement, would have constituted a derivative or other financial product; and (c) it is reasonable to assume that the parties to the arrangements regard them as constituting a single scheme; the arrangements are to be treated as if they together constituted a single arrangement. Absent s761B, parties could structure a derivative over a commodity as a deliverable agreement under which one agrees to sell the commodity to the other at a fixed price in the future and then a further deliverable agreement under which the party receiving the goods agrees to sell a similar quantity of goods back to the supplier at market price. The two delivery obligations would effectively cancel each other out and just leave an obligation for one party to pay to the other the difference between the fixed price and the market price at the time of delivery, the economic equivalent of a derivative. As deliverable agreements over commodities, neither agreement, by itself, would fall within the definition of derivative because of s761D(3)(a). Taken together under s761B, however, they would.

Note also the limitation in s761D(3)(a) to arrangements involving the sale and purchase of "tangible property". It therefore does not apply to arrangements involving the sale and purchase of intangible property such as securities and debt instruments.

In Keynes v Rural Directions Pty Ltd (No 2) [2009] FCA 567, mentioned previously, the Federal Court also held that forward contracts for supply of grain were not "derivatives" for the purposes of the Corporations Act because they fell within the exception in s761D(3)(a). In so doing, the court rejected an argument that the fact the sellers might be liable in damages for failure to deliver the grain meant that the sellers' obligations could be wholly settled by cash:

    

"If it be assumed (as is probably the case), that a failure by a seller to deliver wheat or barley under forward contracts of the type in question in this case would ordinarily lead to an award of damages rather than an order for specific performance, then, putting to one side for the present the effect of washout provisions, it would only be in a very loose sense that it could be said that the seller's obligations could be wholly settled by cash, rather than the delivery of the property. I do not think that that is what s 761D(3)(a)(ii) means. It seems to me that the important words in the paragraph are arrangement, permit and rather than. It seems to me that those words mean that the option wholly to settle an obligation by cash must be in the arrangement, it must be vested in the seller and the alternatives of paying cash or delivering the property must be of a similar nature or standing. The "option" of paying damages is not an option provided by the arrangement, nor is it of a similar nature or standing as the obligation to deliver the property. ...

    

The obligation to pay damages arises when the seller breaches his obligations, not when he settles them. The buyer's right to recover nominal damages in certain circumstances reinforces the point. There is also force in the submission of counsel for [one of the defendants] that it is inherently unlikely that Parliament would have intended that the application of a provision such as paragraph (ii), with all the consequences that flow therefrom, would turn on whether the discretionary remedy of specific performance was likely to be awarded."

The court also rejected a similar argument about a "washout" provision in the contract that provided that the seller could avoid the contract by paying a liquidated amount in the event their crop failed:

    

"I turn now to the plaintiffs' second submission in relation to this paragraph, namely, that the washout provisions in the forward contracts mean that they fall outside the terms of paragraph (ii) because they permit the seller's (that is, the plaintiffs') obligations to be wholly settled by cash, rather than the delivery of the property. I reject that submission because the washout provisions are of a different nature and have a different operation to a permission in the arrangement for the seller's obligations to be wholly settled by cash. First, the washout provisions in the case of the ... first forward contract only operate if the plaintiffs suffer production failure, and they only operate in the case of the [other] forward contract[s] if the seller finds that he is or will be in default. Secondly, it is correct to say that, in essence, the washout provisions operate at the option of the buyer, not the seller. Thirdly, where invoked, the washout provisions result in a measure of damages similar to that specified in s 50(3) of the Sale of Goods Act 1895 (SA) brought forward to a time at which it has become obvious to the seller that he or she will not be able to meet the obligation to deliver the goods.

    

In my opinion, it is proper to characterise the washout provisions as contractual provisions as to the buyer's remedies in the case of breach and the measure of damages or compensation payable to the buyer in those circumstances."

The court further held that evidence led by the plaintiffs that growers were able to enter into offsetting contracts to reduce or cancel out their liability on forward contracts in a financial sense, did not constitute a market practice allowing for the seller's obligations to be "closed out":

    

"It seems to me that what the plaintiffs identified is not a usual market practice permitting the closing out of the seller's obligations by the means specified. What the plaintiffs identified was a means of making a profit or capping a liability in a market where goods are readily obtainable. It is the nature of the goods, not usual market practice, which permits the seller to act in the way specified. It is also important to note that what must be closed out are the seller's obligations. It seems to me that the use of these words and the reference in matching up … with another arrangement support the contention of [one of the defendants] that the market practice referred to in the paragraph (iii) is one whereby the seller's obligations are for all practical purposes brought to an end upon the entering into of the offsetting arrangement. That, to my mind, is what the paragraph is directed to and there is simply no evidence of a usual market practice of that nature in the case of forward contracts. The market practice identified by the plaintiffs (if it is a market practice) is not of that nature."

As mentioned above, an appeal against this decision was rejected by the Full Federal Court in Keynes v Rural Directions Pty Ltd [2010] FCAFC 100.

In relation to s761D(3)(c), one of the incidental effects of this provision is that the definition of "security" takes precedence over the definition of "derivative". This means that a hybrid product that might otherwise fall within the definition of both "security" and "derivative" will be regarded as a security rather than a derivative. That has led to some drafting acrobatics for hybrid products like warrants, which we look at later in lecture 12B.

The financial products mentioned in s764A include various types of insurance. Derivatives and insurance are both financial products used to manage financial risk. This may lead to some interesting and difficult characterisation issues as to whether a particular risk management product is a derivative or an insurance product (and therefore not a derivative under s761D(3)(c) even if it otherwise falls within the definition of "derivative" in s761D).

A similar issue arises in relation to managed investment products. A product that by itself may be a derivative can easily transmogrify into a managed investment product if it is marketed to multiple investors and it involves a pooling of investment funds or a "common enterprise". It would therefore be excluded from being a derivative by s761D(3)(c).

The issues caused by the interplay between the definition of "derivative" with the definition of other financial products is explored further in section 3B of Lewis, A Decade On - Reforming the Financial Services Law Reforms.

 

CA s761D(4) – Exclusion for CPI Clauses
An arrangement under which one party has an obligation to buy, and the other has an obligation to sell, property is not a derivative for the purposes of Chapter 7 merely because the arrangement provides for the consideration to be varied by reference to a general inflation index such as the Consumer Price Index.

Again, this exclusion is subject to s761D(2) (ie the item in question can be prescribed to be a derivative under the regulations).

CR r7.1.04 - Derivatives
(1)   For s761D(1)(b), the prescribed period is:
  (a)   for a foreign exchange contract - 3 business days; and
  (b)   in any other case - 1 business day.
(2)   For s761D(2), an arrangement is declared to be a derivative if the following conditions are satisfied in relation to the arrangement:
  (a)   the arrangement is not a foreign exchange contract;
  (b)   under the arrangement, a party to the arrangement must, or may be required to, provide at some future time (which may be less than 1 day after the arrangement is entered into) consideration of a particular kind or kinds to someone;
  (c)   the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, for example, one or more of the following:
    •    an asset;
    •    a rate (including an interest rate or exchange rate);
    •    an index;
    •    a commodity.

CR r7.1.04(1) defines the prescribed period for working out whether a derivative has been entered into as 3 business days for foreign exchange contracts and 1 business day for all other derivatives and then r7.1.04(2) effectively gets rid of that requirement for everything that is not a foreign exchange contract. The net effect of all of this is basically to replace the s761D definition of "derivative" with the definition in CR r7.1.04(2)(b) and (c), and to exclude from the definition of "derivative" spot foreign exchange contracts, which in accordance with market practice are settled 2 business days after entry.

CR rr7.1.04(4)-(7) provide similar carve outs to the extended definition of "derivative" in CR r7.1.04(2) to those contained in CA s761D(3) and (4).

Return to Outline


Licensing and Disclosure Requirements

Licensing and Disclosure Requirements
•     Persons who carry on a business of advising on, or dealing in, derivatives need a financial services licence authorising them to provide that service or to be an authorised representative of such a licensee.
•     If they deal with retail clients, they need:
  •     Financial Services Guide
  •     Statement of Advice for any advice given
  •     Product Disclosure Statement for any products provided or recommended
  •     To act in the best interests of the client
  •     To avoid conflicted remuneration and comply with ongoing fee requirements
  •     To warn if giving personal advice based on incomplete or inaccurate information or if giving general advice
  •     Dispute resolution systems
  •     Compensation arrangements

ASIC has imposed standard financial requirements for Australian financial services licensees who issue over-the-counter (OTC) derivatives to retail clients, including contracts for difference and margin foreign exchange to ensure that they have adequate financial resources to operate their business in compliance with the Corporations Act and to carry out supervisory arrangements. Such licensees are required to have an NTA of the greater of $1 million or 10% of average revenue, with 50% of the required NTA held in cash or cash equivalents and 50% held in liquid assets. They are also be required each quarter to prepare projections of cash flows over at least a 12 month period based on their reasonable estimate of revenues and expenses over that term, which must be certified as reasonable by the issuer’s directors.

These requirements are outlined in ASIC Regulatory Guide 166 Licensing: Financial requirements and have been implemented through Class Order CO 12/752 Financial requirements for retail OTC derivative issuers.

CA s761E - Definition of Issue and Issuer
•     As a general rule, a derivative is issued to a person when the person enters into the legal relationship that constitutes the derivative (s761E(3)).
•     Each person who is a party to a derivative that is not entered into, or acquired, on a financial market is taken to be an issuer of the product (s761E(5)).
•     Where a derivative is entered into, or acquired, on a financial market, the issuer is taken to be:
  •     if the product is entered into, or acquired, on the market through an arrangement made by a financial services licensee or an authorised representative of a financial services licensee acting on behalf of another person - the financial services licensee; or
  •     otherwise - the market operator (s761E(6)).

As mentioned in Lecture 1, the concepts of who is the issuer of a financial product and when a financial product is issued to a person are important ones, since issuing a financial product may not only give rise to a need to have an AFSL, it may also be the trigger point for a requirement to give a Financial Services Guide, Statement of Advice or Product Disclosure Statement.

For OTC derivatives, both parties to the transaction are regarded as the product issuer and therefore technically both could be required to give a PDS to the other party. However, the retail/wholesale distinction and the precondition for the product disclosure requirements to apply that a product must be issued in the course of a business of issuing products will generally ensure that at most only one party is subject to the product disclosure requirements. Where both parties are wholesale, neither will be required to disclose, while if one party is wholesale and the other is retail, only the wholesale party will be required to disclose. In the unlikely event that both parties are retail, the business test may operate to ensure that only one has an obligation to disclose.

In relation to derivatives that are traded on a licensed market, where a financial service licensee is involved in the transaction, they will be regarded as the issuer and required to prepare the PDS. It is open to the financial market operator to offer assistance to licensees in preparing the PDS if it so wishes, but each licensee is responsible for the content of the PDS. Where there is no intermediary involved in a derivatives transaction on a market, the market operator will be regarded as the product issuer and responsible for the preparation of the PDS. This provision anticipates the possibility that developments, for example, in electronic trading systems may enable clients to enter into transactions directly on a market without the involvement of an intermediary.

ASIC has granted general relief from the PDS provisions of the Corporations Act for financial services licensees who are deemed to be issuers of exchange traded derivatives by s761E(6) of the Act so that consumers only receive a single PDS (see Information Release IR 06-43).

CR r7.1.04D - Meaning of Issuer for Certain Derivatives
(1)   This regulation applies in relation to a financial product that:
  (a)   is a derivative; and
  (b)   is entered into, or acquired through a facility conducted in accordance with:
    (i)   the Corporations (Exempt Futures Market - National Wholesale Electricity) Declaration 1999; or
    (ii)   the Corporations (Exempt Futures Market) Declaration 2001.
(2)   Each person who is a party to the financial product is taken to be an issuer of the financial product.
(3)   Ss761E(5) and (6) of the Act do not apply to the financial product.

These markets are OTC wholesale markets that operated outside the previous CA licensing regime through ASIC exemptions (hence the reference to exempt futures market declarations). As they are exclusively wholesale markets, no PDS requirements apply to derivatives issued on these markets.

CR r7.9.07B – Modification of PDS Requirements for Market-traded Derivatives
Where:
(a)   the standard terms and conditions relating to a type of derivative are specified by the market operator and made generally available to the public;
(b)   the financial services licensee in relation to the derivative is taken to be the issuer of the derivative under s761E(6); and
(c)   a retail client for the derivative has agreed to the terms and conditions as applicable to the financial product or products that are the subject of the transaction,
s1013D(1) is modified in its application to the derivative as if the information required by ss1013D(1)(b), (c), (d) and (f) were required to be included as general information about the type of derivative, including, for example:
(A)   general information about exercise prices for the type of derivative;
(B)   general information about expiry dates for the type of derivative; and
(C)   general information about exercise styles for the type of derivative.
In addition, the following information may be taken into account for s1013F:
(D)   information that is, or is required to be, disclosed to the market in relation to the underlying thing from which a derivative derives its value, including information published by a market operator in relation to financial products (including derivatives and types of derivatives) in the form of market data or educational material which is generally made available to the public by the market operator;
(E)   other information that a market operator is required to disclose to the market, in accordance with the Act, including:
  (i)   information that was required to be disclosed to the market operator; and
  (ii)   information that the operator was required to disclose in order to meet its obligations under the Act; and
(F)   information that is generally made available to the public by a market operator in relation to financial products, including information published about derivatives and types of derivatives in the form of market data or educational material.

CA s1013D(1) ordinarily requires a PDS to contain:

(b)  

information about any significant benefits to which a holder of the product will or may become entitled, the circumstances in which and times at which those benefits will or may be provided, and the way in which those benefits will or may be provided;

(c)  

information about any significant risks associated with holding the product;

(d)  

information about:

 

(i)  

the cost of the product;

 

(ii)  

any amounts that will or may be payable by a holder of the product in respect of the product after its acquisition, and the times at which those amounts will or may be payable; and

 

(iii)  

if the amounts paid in respect of the financial product and the amounts paid in respect of other financial products are paid into a common fund - any amounts that will or may be deducted from the fund by way of fees, expenses or charges; …

(f)  

information about any other significant characteristics or features of the product or of the rights, terms, conditions and obligations attaching to the product; …

Requirement (c) in the slide above is a little vague. How do you show agreement by a retail client to the terms and conditions applicable to a market traded derivative? Does this mean you have to explain all of the detailed terms and conditions of the product to the client and get their express agreement? Or is it sufficient that the retail client has simply placed an order to buy or sell the derivative and can therefore be taken to have agreed to its terms.

CA s1013F provides that information is not required to be included in a PDS if it would not be reasonable for a person considering, as a retail client, whether to acquire the product to expect to find the information in the PDS. Factors that can be taken into account in that regard include the extent to which the product is well understood by the kinds of person who commonly acquire products of that kind as retail clients and the kinds of things such persons may reasonably be expected to know.

 

CR r7.9.07C – No Right to Return Certain Derivatives in Event of No or a Defective PDS
Financial products that are derivatives are excluded from s1016F if the operating rules of a licensed financial market or a licensed CS facility permit the closing out of the derivatives by the matching up of the arrangement with another arrangement of the same kind under which a person has assumed an offsetting position.

CA s1016F ordinarily provides that if a financial product is issued or sold to a client under a defective PDS, the client has the right to return the product and to have the money they paid to acquire the product repaid.

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Confirmations

CR r7.9.63A(2) - Persons Who Must Confirm Transactions
A transaction:
(a)   that is not the issue of a financial product (other than a derivative that is not a warrant);
(b)   in which a financial services licensee deals in the financial product on behalf of the holder of the financial product; and
(c)   by which the holder acquires or disposes of all or part of the financial product;
must be confirmed by the financial services licensee.

 

CR r7.9.63A(3) – Confirmation of Issues
A transaction:
(a)  to which CR r7.9.63A(2) does not apply; and
(b)  by which a financial product is issued to a holder;
must be confirmed by the issuer of the financial product.

Under CA s1017F(2), the issuer of a product is generally responsible for the confirmation of a transaction in that product. However, where a financial services licensee acts on behalf of a client to acquire (other than by way of issue), or dispose of, a financial product, CR r7.9.63A(2) effectively displaces the general rule in s1017F(2) and requires the licensee, rather than the product issuer, to issue the confirmation. By reason of the parenthetical words in r7.9.63A(2)(a) above, this rule also applies where a financial services licensee acts on behalf of a client to acquire, by way of issue, a derivative that is not a warrant – ie the licensee must issue the confirmation for the issue of the product rather than the product issuer.

Hence, the combined effect of the words in italics in CR r7.9.63A(2) and CR r7.9.63A(3) is that where a non-warrant derivative is issued, or any derivative is sold or purchased, through a licensee, the licensee must confirm the transaction. Any other transaction in a derivative must be confirmed by the issuer.

For completeness, where a warrant or any other type product that is not a derivative is acquired by way of issue, r7.9.63A(2) does not apply. Instead, r7.9.63A(3) reiterates the general rule in s1017F(2) that the product issuer must issue the confirmation for the issue of the product.

It has to be said that r7.9.63A(2) is appallingly drafted. Para (a) contains a triple negative and is one of the worst examples of non-plain English drafting I have ever come across. When you combine r7.9.63A(2) with r7.9.63A(3)(a), you end up with a quadruple negative!

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