With the prospect that a number of investment options may become illiquid, it is an appropriate time to review the obligations and options with which a responsibility entity of a managed investment scheme and a trustee of a superannuation fund are confronted.
Position where the illiquid option is held by a managed investment scheme
The first issue here is whether the scheme has become illiquid for the purposes of the Corporations Act 2001 (Cth) (Act).
As we know, section 601KA of the Act stipulates that where the scheme is not liquid, a responsible entity must not allow an investor to withdraw from the scheme otherwise than in accordance with the scheme’s constitution and sections 601KB to 601KE of the Act. Contravention is an offence of strict liability.
Under section 601KA(4) a scheme is liquid if at least 80 per cent of the value of the scheme is held in ‘liquid assets’. Conversely, if more than 20 per cent of the value of the scheme is held in illiquid assets, the scheme will be illiquid.
Certain assets are deemed liquid, including, money held with a bank, bank accepted bills and marketable securities unless the responsible entity cannot reasonably expect to realise them within the period specified in the constitution for satisfying withdrawal requests (section 601KA(5)). It should be noted that the reference to specified period in the constitution would in its normal sense refer to an actual fixed period, rather than a discretionary non-fixed period.
Other types of property will be liquid if the responsible entity reasonably expects that the property can be realised for its market value within the period prescribed by the constitution (as commented upon above – section 601KA(6)). Note that this reference to market value only applies to other types of property. Whether intentional or not, the ‘deemed’ assets referred to above will be liquid if they can simply be realised in the time specified in the constitution, regardless of the sale price achieved.
The term ‘market value’ is not defined but it would normally refer to a value which is on arms length terms having regard to the current market conditions. The responsible entity would also need to assess the ability it has in real terms in a real market for it to realise the affected investment at market value. Needless to say, if the responsible entity has not discharged this burden, there is a risk that the Act’s requirements will not be met.
The requirement relating to redemptions will oblige the responsible entity to consider the ramifications of an underlying investment becoming illiquid. An example is if the trustee of an underlying unit trust suspends redemptions or otherwise sets a redemption period which is inconsistent with the redemption period of the scheme.
In this scenario, the responsible entity of the scheme must assess whether there is any other mechanism or option available to realise the affected underlying investment. As noted above, whether the realisation must be at market value will depend on the type of property held by the responsible entity.
Next, is the position under the constitution of the scheme. If the scheme is liquid, the constitution may allow the responsible entity the ability to suspend or defer redemptions. Any such ability will be subject to:
- any express or implied restrictions in the constitution, and
- any overriding duties of the responsible entity at general law or under the Act.
This should be distinguished from the Act’s requirement not to give effect to a redemption request received while the scheme is liquid but not completed before the scheme ceased to be liquid.
One such duty of the Act which needs to be considered is the duty to act in the best interests of the investors. Another is the obligation to treat all unit holders in a class equally.
These duties would require the responsible entity to consider what impact any of its possible actions would have, not just on the redeeming investors, but also on the remaining investors in the scheme. It should also be noted that the responsible entity may be constrained by timing considerations imposed by the constitution such that it cannot invoke a suspension or deferral of its redemption where the time period for redemption of requests already submitted by certain investors has already passed. This proposition was affirmed in the recent Basis decision of the Supreme Court of New South Wales (28 July 2008).
Another issue facing responsible entities in difficult market conditions and/or where redemption requests indicate a trend towards illiquidity is whether to exercise ‘reserve’ powers available under the constitution. Depending on the relevant drafting, the responsible entity may have the power to suspend redemptions, refuse to accept redemption requests or partially meet redemption requests. In each case the responsible entity must only exercise its powers subject to its statutory and common law duties, for example the duty to act in the best interests of members and to treat members of the same class equally.
In some cases the responsible entity or one of its related parties will have invested substantial seed capital in a scheme operated by the responsible entity. This may have been to launch the fund or to demonstrate alignment with the interests of investors. Either way a potential conflict may arise if the responsible entity seeks to withdraw some or all of the seed capital in conditions that are trending towards illiquidity. In these cases the responsible entity must again have regard to its duties, in particular the duty to prefer the members’ interests in the case of a conflict between those interests and its own.
Position where the illiquid option is held by a superannuation fund
The legal considerations for the trustee of a superannuation fund in terms of its duties under the governing rules of the fund will be similar to those canvassed above.
Different statutory considerations however arise in the superannuation context to those outlined above in relation to managed investment schemes.
The trustee is obliged under Superannuation Industry (Supervision) (SIS) Regulation 6.34 to redeem a member’s investment and transfer it (or effect a rollover of it) to another superannuation vehicle generally as soon as practicable and, in any case, within 30 days of the request (or such longer period allowed for by the regulation, which includes the ability of the trustee to require information from the member and/or to apply to APRA for a suspension or variation of its redemption obligation).
Therefore, if the member requests the transfer or rollover of a preserved amount or a non preserved amount, the trustee must address this requirement. If the member requests the payment of a non preserved amount to him or her directly (as opposed to requesting a transfer or rollover), this requirement will not apply.
Where the requirement does, however, apply, that is not the end of the matter. Regulation 6.34(6) provides that if the relevant investment was made before 1 July 2007 and it was illiquid immediately before 1 July 2007 and, in summary, the trustee informed the member before 1 July 2008 of:
- the nature of the illiquid investment
- the impact of the investment on the portability of the member’s interest, and
- the period within which the investment can be rolled over to another fund, then the trustee is not required to effect the transfer or rollover within the 30 day period.
The availability of this route therefore depends on the specified notification having being given before 1 July 2008. It should also be noted that this regulation only applies where all or part of the investment was illiquid immediately prior to 1 July 2007. It does not apply if the investment became illiquid on or after 1 July 2007.
Regulation 6.34(7) is also relevant. In summary, if a member makes an investment choice on or after 1 July 2007 and the investment strategy is illiquid, then the trustee is not required to effect the member’s transfer or rollover within the 30 day period, provided the trustee informs the member of:
- the effect of the above sub-regulation before the member makes the investment choice
- the reasons why the investment was illiquid at the time of the investment, and
- the maximum redemption period.
In addition, the trustee must obtain written consent from the member that he or she understands and accepts a period longer than 30 days because of the illiquid nature of the investment.
Several observations need to be made in this context.
First, there is a substantial gap in the operation of Regulation 6.34. This is where an investment was made before 1 July 2007 but only became illiquid on or after 1 July 2007. Regulation 6.34(6) does not apply in such a situation and therefore the 30 day redemption rule applies, unless APRA suspends or varies the trustee’s redemption obligation. Moreover, in such a scenario, the trustee cannot utilise the route contemplated in Regulation 6.34(7) by obtaining the consent of the member. In other words, in such a situation, a trustee cannot extend the 30 day period by obtaining member consent.
Second, the operation of Regulation 6.34(7) is ambiguous in a critical respect insofar as it refers to where ‘a member makes an illiquid choice under Regulation 4.02, and the investment strategy chosen is an illiquid investment …’
This language is again consistent with the strategy being illiquid when the investor selects it and it not catering for a situation where the investment strategy is liquid when selected but which subsequently becomes illiquid.
This position could be seen to be reinforced by sub-regulation (a) which requires the trustee to inform the member of the effect of the sub-regulation before the member makes the selection (paragraph (a)(i)) and also why the investment is illiquid (paragraph (a)(ii)).
These first two issues call for amendment of this regulation and we have requested modification to address these points.
Third, the operation of Regulation 6.34(7) will depend on critically:
- making relevant disclosure to the member before he or she makes the investment, and
- obtaining the consent of the member which must be in writing.
The trustee therefore faces the need to now implement these stipulations if it wishes to avail itself of the relief provided for in Regulation 6.34(7). It will not be sufficient to inform the member only at the time redemption is requested.
Fourth, in a practical sense, it will be difficult to get written consent from a member at the time of redemption. This suggests that a trustee should be seeking consent at an earlier stage, such as when a person becomes a member of the fund or, for an existing member, at some other consent point.
Finally, the trustee should consider the operation of section 155 of the Superannuation Industry (Supervision) Act 1993 (Cth) and whether this provision would allow/compel it to effectively suspend redemptions on the statutorily prescribed basis that the redemption (or issue) price under the governing rules of the fund cannot be reasonably ascertained, or is not fair and reasonable.
Conclusion
The above discussion illustrates that the above issues need to be carefully considered by a responsible entity/trustee not just after one or more of the underlying investments of their fund becomes illiquid. Importantly, these issues need to be considered before such an eventuality to enable the responsible entity/trustee to assess whether and what pre-emptive action can be taken to ameliorate the position under the constitution/trust deed and relevant legislation.
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