Australia: Revised AFSL financial requirements: Making custody safer

Last Updated: 10 December 2012
Article by Matthew Daley and Vanessa Pallone

There has been substantial regulator focus in recent months regarding the safety of assets held by custodians, the duty of care custodians exercise and whether custodians have appropriate internal controls to ensure the safety of assets held for others. Much of this concern has been borne out of events such as the collapse of Opes Prime and Trio/Astarra. Earlier this year, the Australian Securities & Investments Commission (ASIC) released Report 291: Custodial and depository services in Australia, which resulted in the identification of a number of key risks to the safety of client assets within the Australian custodial and depository services industry.

ASIC has also recently focused on the financial requirements applying to Australian financial services (AFS) licensees over the past 12 months more generally, which has seen ASIC issue revised financial requirements for operators of registered managed investment schemes and issuers of retail OTC derivatives. With so much activity and enquiry, it then comes with little surprise that on 14 November 2012, ASIC released Consultation Paper 194: Financial requirements for custodial or depository service providers (CP 194).

CP 194 contains a number of proposals for the introduction of new financial requirements for AFS licensees which provide custodial or depository services and responsible entities of registered managed investments schemes (which build up on the NTA requirements introduced in November of this year) and platform operators that hold scheme property or other property and assets.

Arguably the most significant ASIC proposal contained in CP 194 and the focus of this article, is the introduction of the requirement that providers of "incidental custodial or depository services" (an incidental provider) hold a required level of net tangible assets (NTA). These proposed new requirements will be of particular interest to trustees of unregistered managed investment schemes who currently do not hold any NTA on the basis that they provide custodial or depository services "incidentally" to other financial services.

What are the proposed NTA requirements for incidental providers?

Currently certain AFS licensees (excluding responsible entities and IDPS operators) that provide custodial or depository services "incidentally" to another financial service provided by the AFS licensee or a related body corporate are excluded from the requirement to meet the NTA requirements that would otherwise apply.

Pursuant to CP 194, incidental providers will be required to hold a minimum level of NTA equal to the greater of:

  • $150,000; or
  • 10% of "average revenue".

Relevantly, an AFS licensee provides an "incidental custodial or depository service" if:

  • the custodial or depository services are a need of the client because of, or in order to obtain, the provision of other financial services by the AFS licensee or its related bodies corporate;
  • the custodial or depository services do not form part of an investor directed portfolio service (IDPS); and
  • the revenue of the AFS licensee and its related bodies corporate reasonably attributable to the custodial or depository services (which at least includes the cost of providing those services) comprise less than 10% of the total revenue derived from the financial services business of the AFS licensee and its related bodies corporate in the last financial year.

Practically, this definition of "incidental custodial or depository service" proposed in CP 194 will likely capture:

  • trustees of unregistered managed investment schemes (other than operators of IDPSs), given the custodial functions are performed incidentally to the investment management function;
  • providers of nominee services which are provided in conjunction with stockbroking, given the limited role undertaken by the nominee service; and
  • carbon market participants providing a custodial or depository service, where those services are provided incidentally.

What are the requirements where an incidental provider appoints an external custodian?

There interestingly, is nothing in CP 194 which suggests that an incidental provider's NTA requirements will decrease in circumstances where a separate custodian is appointed to hold the relevant financial products (separate Custodian). In fact, ASIC states in CP 194 that the proposed minimum NTA for incidental providers recognises that a lower minimum NTA is suitable for these providers, in the same way that responsible entities that appoint a separate Custodian have a reduced NTA on the basis that it would otherwise be unreasonably costly in circumstances where a separate Custodian is appointed.

Without any further clarity provided by ASIC, the position seems to be that incidental providers will be required to meet the NTA requirements set out in CP 194 regardless of whether a separate Custodian is appointed. As a practical example, this means that a trustee of an unregistered managed investment scheme that qualifies as an incidental provider and that has appointed a professional third party custodian will still be required to hold the incidental provider minimum NTA.

What are the other requirements proposed by CP 194?

Disclosure and reporting requirements

An incidental provider that does not have at least the NTA required of a 'normal' or 'non incidental' provider of a custodial or depository service (Custodian) as set out in CP 194 (and as described below in paragraph 4) is required to disclose that it is a provider of "incidental custodial or depository services" and as such is not required to, and may not, meet the financial requirements applicable to Custodians generally.

Such disclosure must be provided in each Financial Services Guide relating to the custodial or depository service and any Statement of Advice which relates to financial products that involve the provision of the custodial or depository service, which is given by the incidental provider to its retail clients (if these documents are required to be given).

In addition, an incidental provider that does not meet the financial requirements applying to a Custodian will be required to lodge with ASIC a statement in the audit report provided on the AFS licensee's accounts for each financial year in which the incidental provider was authorised to provide custodial or depository services stating that, having reviewed the financial statements of each related body corporate of the AFS licensee, the auditor has no reason to believe that the incidental provider did not meet part (c) of the definition of incidental custodial and depository services for the relevant financial year.

Cash flow projections requirements

ASIC sees cash flow projections as an important tool to identify potential risk to a business. In this regard, ASIC proposes to introduce a requirement for longer cash flow projections for incidental providers, such that incidental providers will be required to prepare, amongst other things, cash flow projections based on a reasonable estimate of its revenue and expenses over at least 12 months. Such cash flow projections will also need to be approved at least quarterly by the directors of the incidental provider and must be made available to ASIC on request.

A tailored audit requirement will also apply based on the cash flow projections requirement, on a corresponding basis to that now applying to responsible entities, as set out in Class order 11/1140: Financial requirements for responsible entities, which currently requires the lodgement of a report by a registered company auditor each financial year.

NTA liquidity requirements and reporting

ASIC propose that at least 50% of the required NTA held by an incidental provider be held in "cash or cash equivalents", with 100% being held in "liquid assets". "Cash or cash equivalents" includes short-term, highly liquid investments that are readily convertible to known amounts of cash that are subject to an insignificant risk of changes in value and also includes the value of any undertaking provided by an "eligible provider".

An incidental provider affected by this proposal will be required to report its NTA position, together with detailed workings, to ASIC as part of its annual submission of Form FS70.

New NTA requirements

CP 194 also sets out a number of other requirements, which are proposed to apply to Custodians, responsible entities and operators of IDPSs. Most notably, CP 194 seeks to increase the NTA requirements for Custodians, responsible entities and operators of IDPSs. Currently:

  • Custodians and IDPS operators that hold property or other assets of the IDPS, are required to have at all times at least $5 million NTA; and
  • responsible entities that have not appointed a separate eligible Custodian to hold scheme assets, are required to hold a minimum NTA of the greater of $5 million and 10% of the responsible entity's revenue with no maximum NTA.

CP 194 proposes to increase the current NTA requirements to the greater of $10 million or 10% of "average revenue" in respect of:

  • Custodians and IDPS operators that hold property or other assets of the IDPS (unless the operator arranges for the IDPS property to be held by a separate Custodian or an eligible custodian (such as an Australian ADI)); and
  • responsible entities holding scheme property or assets (other than "special custody assets" or "Tier $500,000 assets") (unless the responsible entity appoints a separate Custodian or an eligible custodian (such as an Australian ADI)).

CP 194 does not specify the NTA requirements applicable to responsible entities that appoint a separate Custodian. Given CP 194 is silent on this issue, it is assumed that the reduced NTA requirements described in Regulatory Guide 166: Licensing: Financial Requirements (RG 166), applicable where a responsible entity of a managed investment scheme appoints a separate Custodian, will continue to apply.

It is also worth noting that for those operators that to date have relied on the "incidental" carve-out, but which will not be a provider of "incidental custodial or depository service" as that term is defined in CP 194, the higher NTA requirements applicable to Custodians will apply to those operators (meaning that such operators will now be required to hold the greater of $10 million or 10% of "average revenue"). This may have a significant impact on those operators.

Commencement and transition period

Comments on CP 194 are due by 14 January 2013, and ASIC expect to update RG 166 to reflect any necessary changes by April 2013. ASIC proposes that the reforms be effective for new providers as of 1 July 2013 and in respect of existing incidental providers, Custodians, responsible entities of managed investment schemes and IDPS operators, ASIC proposes to implement a transition period of 12 months until 1 July 2014.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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