When you place a bet on a horse in a horse race, you know that you might lose your money. When your horse finishes nowhere, you might be disappointed, but you go into it with your eyes open and accept that there was always a risk that this might happen.
Investors who have lost money in investment schemes in recent times were not merely disappointed, but were upset because they felt that their money was exposed to risks that they didn't properly understand.
That might be the fault of the promoters, or the fault of investment advisers, or the fault of people who operated the investment schemes, or even the regulator may be to blame.
However, an additional complaint that has been voiced is that product disclosure statements (PDSs) are meant to help investors understand what they are getting into, and are failing to do the job.
This article looks at why that might be so and what could be done to improve the situation. (The discussion is about the principles as they affect PDSs in general, not with particular reference to any particular PDSs or schemes).
What Does The Law Require?
The Corporations Act (the Act) requires that a PDS contain specified information, including information about any significant benefits to which an investor will or may become entitled and the circumstances in which and the times at which those benefits will or may be provided, as well as information about any significant risks associated with holding the investment (paragraphs 1013D(b) and (c)).
A punter will usually be clear about the amount of the benefit (whether for a win or a place), that the chosen horse has to finish first (or in a place) and that any winnings will be paid on presentation of a winning ticket after the race is over. The punter will be equally clear that if the horse fails to win or get a place, he will receive no financial benefit. As with investing, the benefits and the risks are intimately related.
Importantly, the Act provides that in addition to the required information, a PDS 'may also ... include other information.' There is really no limitation on the extent or nature of the 'other information' that may be included.
ASIC has issued some guidance, aimed at ensuring that the 'required' information is not swamped by 'other' information that isn't required. However this stops short of being a legal requirement.
The Act specifically requires that the information included in a PDS is 'worded and presented in a clear, concise and effective manner' (section 1013C(3)). This requirement makes no distinction between 'required' and 'other' information. So it isn't actually the PDS as a whole that needs to be concise, rather it is whatever information the issuer decides to include that must be presented in a clear, concise and effective manner.
Notwithstanding this legal requirement, there are complaints that PDSs are too lengthy and that much of the information is not presented in a helpful fashion.
Why Be Concise?
Road signs have to be brief because often they have to be read, understood and acted upon in a short time. One word, such as 'Stop' is more effective than a paragraph or two. The fewer words there are, the more likely that the sign will be effective.
It is the same with a PDS. It is natural for potential investors to avoid reading a PDS that is long, dull, and mostly about matters that are not critical to the investment decision.
So there is recognition of the need to keep PDSs short. Not quite as short as a road sign, although there have been cases where the single word 'Stop' would probably have been appropriate!
Particular Problems With Risk Disclosure
It is pretty much standard practice that a description of the risks is set out in a 'Risks' section of a PDS in general terms.
For example, market risks (the potential for the prices of assets in the fund portfolio to fall as well as rise), currency risks, derivatives risks, gearing risks, the risks that the investment manager may make poor choices of assets for the fund portfolio, risks that individual investments in the fund portfolio might fall in value due to reasons affecting that specific investment, interest rate risks, risks due to one person's investment in a fund being affected by what other investors in that fund do, particular risks of acquiring or lending on property for development, where the development costs may escalate and the price may fall.
These general risk disclosures have an abstract feel about them. Their aim seems to be to be comprehensive, but not to tie down the particular risks affecting the particular nature of the investment being offered.
For example, it might go over your head that the investment you are about to make has lower priority than money borrowed from lenders holding first and second ranking securities.
Nor do you pick up that because the securities are over development properties, the properties on completion of the development might sell for less than their total cost, in which case some or all of the money you invested will be lost.
There seems to be a good argument for changing the present practice, so that the explanation of risks is located in the same place in the PDS as the description of the investment being offered and the possible benefits that might be available.
That does not rule out including anything the issuer wants to say about strategies for minimising the risks as long as that doesn't give the impression that the risks can therefore be ignored.
Clear, Concise And Effective
So how does it come about that PDSs are not more concise?
Several factors mitigate against conciseness.
- As we have seen, the Act doesn't actually require that a PDS be concise. What it requires is that the information it contains, both required information and any other information the issuer chooses to include, is worded and presented in a clear, concise and effective manner. It can be and often is a lengthy document even if worded and presented in a clear, concise and effective manner.
- However there are other problems. The PDS tries to do too many things. The usual PDS is not just a disclosure document.
- For example, a PDS generally serves as an invitation to invest. It has a promotional flavour, prepared by marketing people. The information is not presented in a neutral fashion, rather the emphasis is on presenting the investment options in the most favourable light. More than that, there is an expectation that a PDS will be a document of substance. Anything too slim might suggest that it doesn't relate to a serious investment.
- Then, there is another purpose served by the PDS. It (along with the scheme constitution) regulates the legal relationship between the investor and the issuer. It explains all kinds of things such as how units are priced, applied for and how your money is redeemed, tax, how managed investments work, the scheme constitution, distributions, fees and charges, conditions attaching to telephone, facsimile and internet communications and disclaimers of one kind or another. A good deal of this information is not there to assist an ordinary investor to make an assessment of the merits of the proposed investment purely as an investment. We can call this the 'terms and conditions'.
- Sometimes PDSs are written in a bland form of 'plain English' that can be quite long winded and leave the potential investor not much the wiser about the realities of the situation. That can be contrasted, for instance, with the sharp tongue of a capable financial analyst who can point out that low ranking loans in respect of real estate development are high risk. It may be unrealistic to expect issuers to provide this kind of perspective. In theory this is the role of the adviser or independent analysts writing in investment newsletters or the general press.
- it takes extra effort to express a PDS in language that is truly easy (and interesting) for the ordinary investor and is truly concise.
Short Form PDSs
In recognition of the problem, provision for a 'Short-Form PDS' was introduced by regulation in 2007 (regulation 7.9.61AA introducing Division 3A of Part 7.9).
An issuer must first prepare a full PDS.
The issuer may then prepare a Short-Form PDS containing a summary of those parts of the full PDS that provide the name and contact details of the issuer, benefits, risks, price, fees and charges, commissions, dispute resolution and cooling-off.
The Short-Form PDS must also make clear that a retail client may ask for a copy of the full PDS.
Although use of the Short-Form PDS may reduce the size of the document placed in a retail client's hands, it seems unlikely that it will be any more successful than the longer form in bringing the client's attention to the risks affecting the financial product concerned.
It can serve a purpose for issuers, however, by placing a relatively short document in the hands of the investor, while ensuring that the investor is bound by terms and conditions set out at length elsewhere.
Incorporation By Reference
Another method now available to issuers for reducing the size of a PDS is incorporation by reference (regulation 7.9.15DA).
Essentially, written statements or information that are publicly available in documents other than the PDS need not be set out in the PDS but instead the PDS may include sufficient information to enable a person to decide whether to obtain a copy of the full document and read it. The issuer must provide a full copy to anyone who asks.
That can be useful to save setting out full copies of documents such as annual reports, for instance.
However this does not go to the heart of the problem – ensuring that the attention of potential investors is drawn to the important risks affecting the product.
- In 2002, the Investment and Financial Services Association (IFSA) established a working group to develop models of concise PDSs. Considerable time and effort was devoted to this task and some excellent models were produced. The Australian Securities and Investments Commission also provided much helpful input to the process. It may be timely to resurrect these models and make issuers more aware of them.
- It would make sense to put the 'terms and conditions' matters into a part 1 of the PDS, as a document physically separate from the descriptions of the proposed investments, their benefits and risks. In effect, that 'terms and conditions' document would be like a contract between the investor and the issuer. This would include matters such as minimum investment amounts, withdrawal restrictions, distribution reinvestment arrangements, fees and charges, the application instructions and other product features and would attach the application form.
- For many investments the description of the product and risks could be done on a single page (a part 2 'product sheet' or where several financial products are offered, several product sheets). The descriptions of risks should be included on each single page in plain words, as part of the description of the investment and possible benefits.
- To insist that each investment description include a tailored description of the risks applicable to that investment. For example:
- that your loan is to a company that is using the money to carry out real estate development, that the development may not be completed if the costs increase or the developer runs out of money, and when completed, the sale price may not be enough to pay back your investment once the first and second priority lenders have been paid;
- in the case of an international shares fund, unhedged, that if the Australian dollar rises relative to the currencies of the shares held, that will have the effect of reducing the portfolio value in $A terms.
- in the case of hedge funds, that the performance depends on the ability of the investment manager to predict events – consequently losses or reduced performance may result if the predictions turn out to be wrong.
- Again, hedge funds may rely on unofficial markets continuing to be viable – if those markets become illiquid, the fund may be unable to dispose of assets or fund liabilities, with consequent losses.
- the statement in the case of funds offering a product that invests across a range of sectors will need to refer to the important risks affecting the assets of each sector.
The point is to enable an ordinary investor to be sufficiently informed so that if the risks occur, they wouldn't be able to say 'I didn't realise that this could happen'.
Of course none of these measures will ever entirely solve the problem. Horses will still finish nowhere. Investors will lose money. But at least they won't find it so easy to blame the PDS.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.