Going “short” on independence

www.aar.com.auVISIT OUR WEB SITE

TO READ ALLIN THE MONEY EDITIONS

Carl Bicego,Senior Associate,

Corporate GovernanceTeam

Highlights

Discussion paper on s707 released

ASIC's stop order time limits

Disclosure of ethical investmentconsiderations

Corporate governance reform proposals flythick and fast post Enron

Amcor Capital raising for acquisition ofSchmalbach-Lubeca

Simpler franking

Foreign issuers mandatory EDGAR filing inthe US

Warrants secondary sale relief

New Zealand's Securities Markets andInstitutions Bill

Hutchison Telecommunications Note issuePlease visit our Capital Markets publications page to see online editions of

In the Money: www.aar.com.au/services/capmark/publications.htm

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Issue 8 July 2002

Going “short” onindependenceA key theme emerging from the HIH and Enron corporate collapses isthe extent to which some key players may have disregarded propercorporate governance practices. Conflicts of interest prevailed overproper and independent consideration of matters to the detriment ofthe company, members and the corporate community in general.

Independence is the cornerstone of good corporate governance. It isalso the topic of our feature article “Going Short on Independence” byMichael Greig, Head of CapmAARkets at AAR. Markets and industryplayers need to keep up to date with this important area. Corporategovernance is not a static process, particularly in the post HIH reformenvironment with the government announcing a review of audit regula-tion and corporate disclosure (CLERP 9). The lack of independence ofcertain directors was also a feature of the recent decision in the ASIC vAdler case in relation to certain share purchases in HIH. (See ourreport on this decision.) Our AAR Corporate Governance Team has theexpertise to advise companies, boards and individual directors on themany aspects of corporate governance.

On the deals front, AAR has recently acted for AMCOR in a A$1,235million capital raising to fund the acquisition of the PET container andclosure businesses of Schmalbach-Lubeca, a German company. This isthe second largest capital raising in Australia to date this year.

As the implications of the FSR regime are being worked out by thefinancial services industry some interesting questions are surfacing asto the extent of disclosures to investors that are now required. The newdisclosure requirements for environmental, social and ethical consid-erations are covered by Julian Donnan in his article “Disclosure ofEthical Investment Considerations”.

Finally, 2001-2002 has been another big year for CapmAARkets. Ourcapital markets team has received a number 1 ranking in Australia fromChambers in its latest Chambers Global survey of capital markets lawfirms.

Full story page 3

capmAARkets

Issue 8 JULY 2002

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Contents

FEATURE ARTICLE page 3

REGULATORY WATCH page 7

Increasing the issue size of warrants

Secondary sale relief for warrants

Cross border financial services regulationaccording to ASIC

Ten steps for reform

Finding a permanent solution to section 707

Proposal to classify hybrid securities as debt

Good corporate governance is an ongoingprocess

FSR disclosure regime and its likely industryimpact

LEGISLATIVE DEVELOPMENTS page 10

Legislative developments

Demerger tax relief

Simpler franking

CLERP 9 - audit and financial disclosurereform

AROUND THE WORLD page 12

UNITED STATES

Reform proposals fly thick and fast post Enron

“Hold” must not mean “sell” and otherchanges to address research analyst conflictsof interest·

Mandatory EDGAR filing for foreign issuers

UNITED KINGDOM

More choice for consumers of CIS mooted

HONG KONG

Retail offering of hedge funds

Cracking down on liars

MALAYSIA

Diversifying income base of distressedcompanies

E-trading of unit trust funds

SINGAPORE

Risk based capital requirement

NEW ZEALAND

Promoting confidence - the Securities Marketsand Institutions Bill

RECENT DEALS page 17

Capital raising for acquisition of Schmalbach-Lubeca

Patrick Corporation Limited placement

Note issue for Hutchison Telecommunications

Bluestone securitisation of non conformingloans

QBE LYONS issue

Starship Conduit

AVCAL standard trust deed project

AMS II Euro Fund III

Callable asset swaps for the Dragon

Macquarie Goodman Industrial Trustplacement

Funding “green” processing technology

ARTICLES OF INTEREST page 20

Undermining the rights of minorityshareholders

Making prosecution of insider trading easier -the civil penalty sanctions

Beware the limitations of electronic proxies

Characterising debentures, derivatives andmanaged investment schemes

Wagering laws and the regulation of derivatives

Reforming the financial assistance prohibitionin the United Kingdom

CASES page 22

Cases

ASIC's powers Stop order time limits

Director's duties Material prejudice is notlimited to material loss

Underwriting Related party underwriting - noton arm's length terms?

Financial services Monitoring of brokersessential

Snapshots

FSR UPDATE page29

Disclosure of ethical investmentconsiderations

Cruising down the legislative streamline

1 in 2 applications for AFS licence inaccurateor incomplete

FSR related amendments to NSW State Actsand Regulations

FSR site

OUR TEAM page 32

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capmAARkets

“The importance of a littlesoul searching is sometimesdismissed on the basis thatin any economic cycle whereinvestors lose money they willbe unhappy and seek toblame someone else.”

Feature articleGoing "short" onindependenceby Michael Greig

This article looks at corporate governance in the context ofthe capital markets. Corporate governance is used here in itswidest sense, that is, in the sense of the most desirablebehaviours to encourage in all the key players so as to max-imise benefits for all, particularly investors.

Soul searchingOver the last 12 to 24 months there has been much soul searching asregards alleged behavioural failings on the part of key players in the capitalmarkets. Most criticism tends to focus on one particular player at a time,for example, auditors. Then there will be another critique which deals withdirectors and their alleged failings in particular cases, and so on. Thisarticle seeks to provide an overview of one key common theme whichemerges.

That theme is independence.

The importance of a little soul searching is sometimes dismissed on thebasis that in any economic cycle where investors lose money they will beunhappy and seek to blame someone else. Although there is some truth inthat, cycles such as the present one do yield lessons from which the capitalmarkets can learn. If necessary lessons are not learnt by players in amarket, capital can move to other markets.

Key playersSo, who are these key players whose activities have come under scrutiny.They include two broad groups. The first group consists of players who areexpected to be impartial, “policeman” types:

• auditors (“financial policemen”);

• directors (“business judgement policemen”);

• securities analysts (“value policemen”);

• rating agencies (“credit policemen”);

• regulators (“real policemen”).

The second group are “hired guns” who are expected to pursue theinterests of their clients:

• brokers;

• financial/investment advisers including superannuation fund managers;

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moneyin thecapital markets group

• lawyers;

• investment banks eg advising on M & A deals.

Each key player in the capital markets is sometimestempted to see bad behaviour among other players but itis always harder to recognise shortcomings in one’s ownbehaviour. Lawyers can be harsh in their judgements ofauditors. Investors can be harsh in their judgements ofdirectors. Directors can be harsh in their judgements ofregulators, and so on.

The players are fiduciaries (in somesense)It is important to recognise that all the key players inthe capital markets are fiduciaries in some broad sense.By this I mean that they have powers (either as a legalmatter or a practical matter) which they are trusted bythe market to use properly. For example, as regards the“policeman” type players:

• auditors are expected to audit and review thefinancials dispassionately and not to miss anyfinancial “beans” (eg, in special purpose off balancesheet “pots”);

• directors are expected to bring their judgement tobear for the benefit of the company as a whole andnot for the benefit of individual shareholders orexecutives or themselves;

• securities analysts are expected to present their trueopinions based on expert diligent digging around;and

• rating agencies are expected to do real credit-analysis and rate issuers fairly.

As regards the “hired guns”, they are expected topursue the interests of their clients and not their own orthe interests of anyone else.

It is not necessary here to define the core jobs of all theplayers. Those roles are well known and market expecta-tions are clear, for the most part. But if it is so clear,what can go wrong?

What stops the players doing their corejobs properly?There are really 3 matters which can prevent a capitalmarkets player from doing its core job properly. The first2 are competence and diligence but they are not thesubject of this article. The third is self-interest of sometype. Self interest goes by many names such as, conflictor material personal interest or bias, but in essence the

question is whether the player concerned is subject toan extraneous influence when doing its core job, beingan influence which (if given into) can producedistorted answers or judgements (eg, by an auditor orby directors). Those influences are principally:

• personal, family or institutional financial interest;

• personal, family or institutional interest which isother than financial (eg, ego or reputation).

No player in the capital markets is immune from theseconflicting influences.

Discretionary judgements, conflictinginfluences and hindsightWhat recent regulatory investigations and cases,particularly in the United States, have shown is thatthe judgements required to be made by players in thecapital markets are often not black and white. There isa broad element of judgement and discretion indeciding, for example, whether or not to recommend astock or whether to sign off on complex accounts. Thismay appear to provide a shield for some behaviourswhich are less than desirable. In other words a personmay be tempted to think that it will be difficult toprove that a discretion vested in them was exercised ina way dictated by conflicting influences.

Hindsight, of course, ultimately shows whether thejudgement was correct or incorrect. Where hindsightshows a judgement to have been incorrect and wherethe facts establish the presence of conflicting influ-ences, then this can have a cascading effect. First,the people who have lost money either believe, or atleast argue, that the conflicting influences were thecause. Second, it is important to remember that thereis another player, the judiciary, which in turn hasdiscretions in considering whether to find someoneguilty or not guilty, or liable or not liable. Whereconflicting influences can be established, there is, ofcourse, an enhanced risk that the judge exercises hisor her discretion to infer that the conflicting influ-ences were given into.

Independence is goodThe word “independent” has very positive connota-tions. For this reason, many people seek to use it inmany circumstances. It is overworked and, somewould say, underpaid.

For these purposes, a relevant capital markets playercould be considered independent where:

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• it is not subject to any conflicting influences (whichif given into would adversely affect the quality ofthe job done by that player); or

• the relevant player is potentially subject to suchconflicting influences but demonstrably refuses togive into them.

Some people argue that independence is not the issuebut rather competence is. Of course, this is spurious asno one can really suggest that the market should haveto choose between the two. Good outcomes are pro-duced by competence, diligence and independence.Where any one of those is missing, the outcome is lessthan optimum. So, independence is not a sufficientcondition for a good job or outcome but it is a neces-sary condition, other than in those circumstances wheredisclosure of conflicting influences is thought to besufficient.

Is disclosure enough?Where a capital markets player is subject to conflictinginfluences, there are 3 possible courses of action:

• do nothing, with the attendant risks;

• restructure on the “supply” or “demand” side sothat the conflicting influences are eliminated orreduced; or

• disclose the conflicting influences.

Disclosure is certainly better than non-disclosure. Itallows other players to make a more informed decisionabout the work product before them. But it is notenough if it leaves the market without any real alterna-tive. For example, would you accept being tried by abiased judge just because he disclosed he disliked you?No, you would need the freedom to chose anotherunbiased judge.

The suggestion that investment banks restructure sothat research and investment banking are not part ofthe same organisation, is an example of a restructurestrategy on the supply side. The present trends emerg-ing from the United States tends towards a disclosurestrategy with some limited structural elements relatingto how research analysts are remunerated. The sourcingof audit and consulting services from different suppli-ers is an example of a restructure strategy on thedemand side.

So what does this mean for boards ofdirectors?There are no shortage of corporate governance reports

and charters, so I will not seek to repeat all the normalthemes here. Clearly the theme of “independence”has emerged in the context of board composition andit is considered important that the board or a fairnumber of directors are to some extent independentfrom management, from major shareholders, and fromsuppliers or customers.

Assuming that a board ends up with sufficientdirectors who are independent (in that sense) toconsider an important matter then the other aspect ofindependence is that even a large board cannot expectto have all the expertise needed to assess all propos-als. A board may have a number of directors with legalor accounting, or general industry expertise, but whenit comes to complex, technical, actuarial or financial(eg, hedging), decisions then expert advice is needed.This will generally be primarily sourced from thecompany’s management or from the external serviceproviders instructed by management. In many cases,this will be thought sufficient (having regard toconfidentiality or cost reasons), but in other cases aboard may be well advised to consider carefullywhether it requires:

• external advisers to appear before the board toanswer questions directly rather than solely relyingon ‘indirect’ advice which filters through to theboard; or

• that fresh independent advice be obtained on keyissues, being advice requested by and deliveredonly to the board.

This latter course is not yet common but there aresigns that a trend in this direction could emerge.

Recognition of independenceDo the capital markets value “independence” or isindependence only valued in hindsight when thesuggested lack of it has caused loss?

Generally, where a player in the capital markets issubject to conflicting influences, those influences arecaused by the actions of others. In many cases thoseothers are also players in the capital markets. When alisted company sees a truly independent analyst reportwhich is less than glowing as regards its performance,what is the reaction? To value the independent viewand to seek to take remedial action, or to treat theindependent (and adverse) view as an attack?

Independent assessments by capital markets players,whether they be research analysts, auditors or ratingagencies, are by definition “uncontrollable”. Of

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course, they must also be the result of competent anddiligent work but where they are and where theyrepresent an independent view, those views are wellworth having. They sanitise the capital markets as awhole, even though they can cause localised pain.Perhaps such independent views need to be valuedmore than they are presently are. If they are valuedthen there will be more demand for independent viewsand where there is more demand, as we know, therewill be more supply.

Area of inquiry/ report/ rule and country Name of inquiry/ report/ rule

Auditor’s independence (Australia) Ramsay Report

Auditor’s independence (Australia) ASIC January 2002 survey of 100companies and relationships withtheir auditors

Auditor’s independence, continuous CLERP 9disclosure and shareholder participation (Australia)

Analyst independence rule (US) NYSE and NASD rule (reported inAround the World in this edition ofITM)

Corporate governance (US) New York Stock Exchange Corporate Accountability and ListingStandards Committee report onstrengthening corporate governance (US) (reported in Around theWorld in this edition of ITM)

Non-executive directors (UK) DTI inquiry into the role andeffectiveness of non-executivedirectors (the Higgs CommitteeReview)

Corporate governance(Germany) Corporate governance code

Corporate governance (Canada) Beyond compliance: Building acorporate governance culture

Expensing of Options (International) IASB Exposure Draft (reported inAAR Focus On: AccountingTreatment of Employee Shares andOptions which is accessible fromour website: www.aar.com.au)

Set out below are some of the more recent studies and inquiries that have been or arecurrently being conducted in OECD countries on various aspects of corporate independence.

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capmAARkets

Regulatory watchDiscussion paper on s707

Frank Tearle, a Senior Associate in CapmAARkets examines the discussionpaper on s707.

The much awaited discussion paper from ASIC in relation the issuesarising from the new s707 of the Corporations Act 2001 (Cth) was re-leased on 28 June 2002.

ASIC has also agreed to extend the current interim relief under Class Order02/272 (as amended by Class Order 02/334) by 3 months from 11September 2002 to 11 December 2002 (see Class Order 02/0716). Thisextension will:

• allow for further public debate on the proposals; and

• provide flexibility for participants to adjust to any new requirementsunder the new policy.

(Eds: s707 and the interim class order relief were discussed in ITM 7).

The discussion paper contains ASIC’s proposals for permanent relief. ASICcategorises its proposals into 2 groups:

• disclosure-based relief; and

• exemption-based relief.

The disclosure-based relief essentially applies the current “Dump” cat-egory (Category 5 in Class Order 02/272) and “Same Class Prospectus”category (Category 6 in Class Order 02/272) relief to shares, debenturesand managed investment products. This proposal would therefore extendsuch relief to debentures and managed investment products, which are notcovered by the current interim class order.The exemption-based reliefbasically removes any disclosure requirement that may arise from the on-sale of financial products which were issued without a disclosure docu-ment or a PDS as a result of an exemption. This exemption includes theon-sale of the following financial products:

• the on-sale of financial products issued as consideration for a takeoverbid under Chapter 6;

• the on-sale of securities issued without disclosure under a dividendreinvestment plan or a share bonus plan;

• the on-sale financial products on the exercise of options or the conver-sion of convertible securities; and

• the on-sale of securities and other financial products issued under theASIC class order relief for share purchase plans (CO 00/194) or reliefsimilar to that class order.

This proposal is similar to relief available under the current interim classorder.

Issue 8 JULY 2002

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ASIC has not included the “Big Listed Company”exception (Category 4 in Class Order 02/272) in itsproposals. This exception applies where the issuer is inthe ASX/S&P 200 Index. ASIC accepts that the larger acompany the more research will be conducted byanalysts. However, it does not believe this is a substi-tute for an issuer keeping the market fully informed.ASIC also believes that such an exception results in a“regulatory inconsistency”. That is, it would be incon-sistent if some companies were provided with relief onthe basis of making specific disclosures, includinginformation withheld under ASX Listing Rule 3.1 (eg.the “Dump” category), while equivalent relief wasprovided to issuers that had not released such informa-tion purely because such entity is in a particular indexbecause of its size.

It is interesting to note that in the discussion paperASIC recognises there are limits to the possible reliefthat it can grant. ASIC states that law reform may bethe most appropriate means of providing a permanentsolution.

Comments on the discussion paper are requested by 8August 2002.

Increasing the issue size of warrantsIn a move to increase the potential issue size ofwarrants, ASX has introduced amendments to theBusiness Rules covering deliverable equity warrants(calls and puts). These changes came into effect on 6May 2002. The amendments:

• increase the initial issue limit to 50% from 10% ofthe underlying class of equity securities on issue ora lesser percentage set by ASX; and

• introduce a 20% limit (or lesser percentage set byASX) on the number of warrants that may expire inany two week period (starting two weeks before andending two weeks after the expiry date of thewarrant series under consideration).

The changes do not apply to covered warrants.

(Source: ASX Participant Circular, 29/04/02.)

Secondary sale relief for warrantsASIC has issued a new class order. This class order isintended to ensure that transfers of ASX quotedwarrants as a result of secondary sales are not treatedas the issue of a derivative product. This means thatthey will not be subject to the requirements to providea Product Disclosure Statement. The class order haseffect from 11 March 2002.

The AAR Warrants & Structured Products Team moni-tors all developments relating to warrants.

Cross border financial services regula-tion according to ASICHow does ASIC regulate financial services, productsand facilities offered to Australian investors byproviders located in a foreign jurisdiction? In a draftconsultation paper entitled "Principles for cross borderfinancial services regulation", a copy of which wasmade available to the Investment & Financial ServicesAssociation Limited, ASIC indicated its preliminaryview on the principles it will use to guide the regula-tion of such services. These are to:

• give the fullest recognition to foreign regulatoryregimes that are sufficiently equivalent to theAustralian regulatory regime in relation to thedegree of investor protection, market integrity andreduction of systemic risk that the regimeachieves;

• enter into effective co-operation arrangements withthe home regulators of these providers;

• ensure that its has the ability to enforce Australianlaws that apply to the provision of these services;and

• ensure that Australian investors who access theseservices have adequate rights and remedies ie,Australians must be able to access rights andremedies that provide the same level of protectionas the rights and remedies available to Australianinvestors who use Australian services that arecomparable to the services provided by foreigners.

ASIC propose to use these principles as a guide forapproving foreign regulatory authorities unders911A(2)(h) of the Corporations Act 2001.

(Source: Investment & Financial Services AssociationLimited, IFSA Regulatory Update, 28/05/02)

Ten steps for reformIn a recent speech at the 2002 CPA Congress, MrDavid Knott, Chairman of ASIC, proposed ten meas-ures about ways to "restore confidence and credibilityto accounting and audit." Some of these measuresinclude:

• development and adoption of complete andconsistent international accounting standards.These standards should address areas of disparitysuch as accounting for executive and other stockoptions, accounting for financial instruments suchas derivatives and for debt/ equity instruments;

• reintroduction of the "true and fair" qualitativestandard in the preparation of accounts accompa-nied by enforcement sanctions;

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• compulsory rotation of audit firms to counter theinfluence of any long-term service provider/ clientrelationship;

• prohibition against the provision of audit andconsultancy services to the same clients;

• protecting corporate whistleblowers; and

• ensuring that audit standards have the force of law.

According to Mr Knott, the debate must also take intoaccount the fact that auditors have to reconcile theconflict of providing a commercial service for theirclients with playing a watchdog role to the public.

(ASIC Speeches, "Protecting the investor: the regulator andaudit", 15/05/02.)

Proposal to classify hybrid securitiesas debtThe International Accounting Standards Board (IASB)has issued an exposure draft which proposes thatfinancial instruments having certain characteristics beclassified as a financial liability in the books of theissuer. The IASB proposes that the changes be appliedretrospectively.

The Australian Accounting Standards Board (AASB)has already indicated that it will seek to adopt theinternational standards by issuing the revised IAS 39Financial Instruments: Recognition and Measurementas an Australian Exposure Draft. It will also amendAASB 1033 and AAS 33 so that they are consistentwith the revised IAS 32 Financial Instruments:Disclosure and Presentation.

The implication of the changes is that certain financialinstruments, such as some reset convertible preferenceshares, that are currently on issue in Australia wouldbe reclassified from equity to financial liability. Thismay have a significant impact on the capital adequacyratios of a number of Australian financial institutionsbecause such instruments would no longer beclassified as Tier 1 capital. For other companies, thereclassification will affect their gearing ratio as well astheir bottom-lines because payments of dividend to theinstrument holders will need to be expensed.

(Source: AASB, "Invitation to Comment - ProposedImprovements to International Accounting Standards IAS 32"Financial Instruments: Disclosure and Presentation" and IAS39 "Financial Instruments: Recognition and Measurement",13/06/02.)

Good corporate governance is anongoing processThe role of a CFO has traditionally been to ensure the

financial health of the company. This role has evolvedin modern times and according to Ms Jillian Segal,Deputy Chair of ASIC, has come to embrace issuessuch as corporate governance, risk management andmaintenance of effective systems of internal control.In her address to the Financial Executives Interna-tional Luncheon, Ms Segal maintains that corporategovernance should not be viewed as conforming to achecklist. Instead, it should form part of the cultureof the business community. She suggested that goodcorporate governance in companies should provide forthe following:

• effective checks and balances and internal controlsystems;

• access and up to date financial information fornon-executive directors;

• access for directors to senior management,internal and external auditors;

• proper risk management and identificationprocedures;

• clearly defined criteria for the appointment andretirement of directors; and

• an audit committee to oversee the introductionand operation of compliance systems, accountingand financial controls.

Ms Segal also stressed the importance of improvingthe substance of governance and in recognising thatcorporate governance is not a static process but anongoing process, which must rise to meet changes inthe market conditions of the business.

(Source: ASIC Speeches, "The role of the CFO in corporategovernance", 3/05/02.)

FSR disclosure regime and its likelyindustry impactIn a recent speech to the Financial Planning andAssociation members, Mr Ian Johnston, ASIC'sExecutive Director of Financial Services Regulation,discussed the regulatory rationale behind the intro-duction of the FSR Act and ASIC's expectations of,and aspirations for, the financial services industry. MrJohnston also discussed some common mistakesmade by applicants for an AFS licence under the newregulatory regime such as the misunderstanding ofthe difference between the streamlined and compos-ite assessment procedures in relation to the applica-tion for an AFS licence.

(Source: ASIC Speeches, "The new FSR disclosure regime -likely impacts on our industry", 10/05/02.)

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Demerger tax reliefGood news for shareholders of demerging entities. The Minister forRevenue and Assistant Treasurer, Senator Coonan, has announcedthat the Commonwealth will introduce legislation to provide taxrelief for demergers. The proposal provides that demerger tax reliefwill only be available where the ownership of the demerged entity isunchanged by the demerger. Ownership interests (other thanordinary shares) acquired by employees under an employee sharescheme will be excluded from this test by a, yet to be announced,de minimus rule. Under the proposal:

• the tax relief is to apply to widely held and non-widely heldentites (other than discretionary trusts);

• shareholders or members will be entitled to capital gains tax(CGT) roll-over relief for capital gains arising from the occurrenceof a CGT event;

• the pre-CGT ownership status will be maintained;

• the original cost base of shareholders' or members' interests willbe apportioned between the original entity and the demergedentity calculated by reference to their relative market values; and

• there will be no taxable dividend subject to anti-avoidance rulesmodelled on s45B of the Income Tax Assessment Act 1936;

• no CGT will be payable by the original entity for the demerger ifit is demerging at least 80% of its ownership interests in anentity; and

• demerger tax relief will be available to resident and non-residententities, and for owners of these entites whose ownershipinterests remain subject to the Australian CGT provisions.

The tax relief will apply to demergers that take place from 1 July2002 onwards, however, transitional rules are expected to apply totransactions that have already commenced.

(Source: Minister for Revenue and Assistant Treasurer Press Release, C40/02, 6/05/02.)

Simpler frankingThe government has introduced into Parliament, the New BusinessTax System (Imputation) Bill 2002 (the Bill) to implement asimplified franking system applying to companies, corporate unittrusts, public trading trusts and limited partnerships. The Bill isexpected to take effect from 1 July 2002. Some of the changesmooted in the Bill include:

• introduction of franking periods that will allow a corporate taxentity to align their franking and income year;

Legislative developments

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• allowing a corporate tax entity to maintain itsfranking account on a tax-paid basis;

• allowing a corporate tax entity to choose theamount of franking credits allocated to distribu-tions of profit;

• the removal of the intercorporate dividend rebatefor companies in receipt of franked dividends to bereplaced with a gross-up and credit approach usedby other entities; and

• omission of complex franking rules that prescribethe method in which companies are required toallocate franking credits to a distribution theymake.

The ability of Australian corporate tax entities to passon to their members credit for income tax that theyhave paid will not be affected by the Bill.

CLERP 9 - audit and financialdisclosure reformWith the announcement by the Federal Government ofa review of audit regulation and the wider corporatedisclosure framework, CLERP 9 is now upon us. Thereview process will commence with an August releaseof an issues paper which addresses issues raised in theRamsay Report on auditor independence together withother financial disclosure issues. The issues paper willalso consider ways of further encouraging shareholderparticipation in companies.

Comments on issues and proposals will be sought untilmid-October, exposure draft legislation will be releasedfor further public comment by early December andlegislation introduced to Parliament in 2003.

We will keep you posted on the developments.

(Source: Treasurer Press Release, No. 034, 27/06/02.)

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Around the worldUnited StatesReform proposals fly thick and fast post EnronIn the wake of Enron, regulators and professional bodieshave been energetically reviewing rules and standards toaddress the deficiencies in corporate governance practicesthat the Enron collapse has so clearly exposed. In thisreform environment numbers of proposals have been putforward. We examine 2 of the recent proposals. In additionto these, the SEC has also approved rule changes designedto enhance the independence of research analysts.

A. NYSE proposal to strengthen corporate governanceand disclosure standards

The New York Stock Exchange Corporate Accountability and ListingStandards Committee submitted a report (the Report) to the NYSE Boardwhich reviews the corporate governance listing standards of the NYSE.The Report recommends that NYSE listing standards be amended so asto:

• increase the role and authority of independent directors;

• include a more stringent definition of "independent" director;

• add new qualifications for audit committees;

• require listed companies to focus on good corporate governance;

• provide shareholders with greater opportunity to monitor and partici-pate in the governance of their companies; and

• establish new control and enforcement mechanisms.

In summary, the proposals if adopted in their entirety, will require thatthe majority of the board of a listed company be comprised of independ-ent directors. To qualify as an independent director, the board mustdetermine that the person has no material relationship with the company(either directly or as a partner, shareholder or officer of an entity that hasa relationship with the company). In addition, no person who is a formeremployee of the company or its independent auditor can be appointed asan independent director of the listed company for a period of 5 years.Listed companies will also be expected to have their audit committee,nominating committee and compensation committee comprised solely ofindependent directors.

The hiring and termination of the company's independent auditors andthe approval for significant non-audit work by auditors will have to beapproved by the audit committee. As for shareholders, they will have theright to vote on all equity compensation plans. The CEO of the listedcompany will be required to certify annually that there has not been anyviolations by the company of the NYSE listing rules. In the case of listedforeign private issuers, they will need to disclose any corporate govern-

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ance practices that are significantly different fromthose followed by US companies.

B. Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB)which sets US accounting standards has issued adraft of new and stricter rules that specify whenspecial-purpose entities (SPEs) need to be consoli-dated on a company's balance sheet. Enron had useda number of SPEs to "arrange" its financial affairs.The FASB plans to publish the new rules for consoli-dation of SPEs in December 2002.

United States"Hold" must not mean "sell" andother changes to address researchanalyst conflicts of interestThe SEC has approved proposed rulechanges introduced by the New York StockExchange, Inc. and the National Associa-tion of Securities Dealers, Inc. aimed atstrengthening the independence of re-search analysts and managing conflicts ofinterest.

The changes address conflicts of interest in connec-tion with the preparation and publication of researchreports for equity securities. The changes cover bothstructural (working relationships between the analystand investment banking department) and personal.

A. Structural

Under the changes, research analysts will no longerbe supervised or controlled by a firm's investmentbanking department. Investment banking personnelcan no longer discuss pending research reports withan analyst prior to its distribution unless the commu-nication was done through the legal/ compliancedepartment as intermediaries. The company subjectto the report may not review the information exceptto check the factual sections for accuracy.

In relation to remuneration, an analyst's remunera-tion cannot be tied to specific investment bankingtransactions. Firms must also disclose in theirresearch reports if they have managed or co-managedany public offering of equity securities or:

• received investment banking compensation fromthe subject company in the last 12 months; or

• expects to receive or intends to seek compensationfor investment banking services in the next 3months from the subject company.

The practice of issuing a favourable research rating ora specific price target as consideration or inducementfor the receipt of business or compensation is nowprohibited. No reports may be issued by firms actingas manager or co-manager for a company within 40days after an IPO or 10 days after a secondary offeringof an inactively traded security.

Research reports must define the meanings used intheir rating system and these ratings must be consist-ent with the plain meaning of the rating term ie, "hold"must not mean "sell". Firms must also provide inpercentage terms, all ratings assigned with buy/hold/sell categories.

B. Personal

Analysts (and their household members) are nowprohibited from purchasing or receiving securities ofan issuer prior to its IPO, if the issuer engages in atype of business covered by the analyst. This tradingprohibition also extends to securities issued bycompanies the analyst reports on for a period extend-ing from 30 days prior to the issue of the researchreport and ending 5 days after the date of the report.

The analyst must disclose in any public appearanceand the firm must disclose in its research reports, anyfinancial interest in the securities of a recommendedcompany held by the analyst or a member of his or herhousehold.

These changes will take effect over a staggered periodranging from 60 to 180 calendar days from the date ofapproval of the proposed changes (10 May 2002).

(Source: SEC Rules, 34-459083, 10/05/02.)

United StatesMandatory EDGAR filing for foreignissuersFrom 4 November 2002, foreign issuers(companies and governments) will have tofile their SEC reports (required under theSecurities Act 1933 and Securities Ex-change Act 1934) through the ElectronicData Gathering, Analysis and Retrieval

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system (EDGAR) run by the SEC.

Foreign issuers will be required to electronically file:

• Securities Act registration statements and Ex-change Act registration statements and reports;

• statements of beneficial ownership;

• Form CB, the form used for cross-border rightsoffers, exchange offers or business combinationsinvolving the securities of a foreign non-governmentissuer if the filer is a reporting company under theExchange Act; and

• Form 6-K, the form used to submit periodic andcurrent reports with the SEC. The issuer may file apaper version of Form 6-K report if it includes a"glossy" annual report to securities holders orincludes information that has not been distributedto them or the press.

However, the rule changes do not apply to an offeringby foreign non-government issuers conducted pursuantto Rule 144A. Such offerings must still be submittedin paper format. (Eds: Rule 144A provides a safeharbour to foreign non-government issuers from theregistration requirements of the Securities Act toenable them to offer their securities for sale to quali-fied institutional buyers in the US)

(Source: SEC Press Release, 2002-63, 8/05/02.)

United KingdomMore choice for consumers of CISmootedThe Financial Services Authority (FSA) isconsidering a raft of measures to improveconsumer choice of UK authorised collectiveinvestment schemes (CIS).

To that end, it has released a Consultation Paper toexamine possible changes to the regulation of CIS as aresult of recent amendments to the European Directiveon Undertakings for Collective Investment in Transfer-able Securities. Three key areas of change are pro-posed so as to:

• extend the investment powers of fund schemes topermit investment in derivatives, money marketassets and in other CIS;

• permit funds to place a cap on the number of unitsthat can be issued to investors; and

• permit funds to use the terms "guaranteed" or"capital protected" in their names where a third

party is providing protection against the fall in thefund value.

(Source: FSA Press Release, FSA/PN/046/2002, 30/04/02.)

Hong KongRetail offering of hedge fundsAfter a period of extensive consultation, theSecurities and Futures Commission of HongKong (SFC) has approved the Hedge FundGuidelines (Guidelines) that will govern theoffering of hedge funds to the retail sector.The Guidelines have been incorporated intothe Code on Unit Trusts and Mutual Funds.

In addition to the regulatory approach taken by theSFC of authorising the offer of hedge funds, the SFCwill work with industry practitioners to educate thepublic on hedge funds. In considering whether toapprove a fund, SFC will examine the:

• the choice of asset class;

• the use of of alternative investment strategies suchas long/ short exposures;

• the amount of assets under management; and

• the risk management systems of the managementcompany.

In addition, the Guidelines also require that:

• an initial subscription by each investor of at leastUS$50,000 in a fund, in the case of a fund ofhedge funds, a minimum initial subscription ofUS$10,000 and finally, no minimum subscriptionvalue for a hedge fund with capital guarantee;

• the liability of investors be limited to their invest-ment in the scheme;

• the investment and borrowing parameters of thefund be clearly spelt out in the constitution;

• the offer document set out a full and clear disclo-sure of the methodology for calculating perform-ance fees; and

in the case of fund of hedge funds:

• such funds must invest in at least 5 underlyingfunds and not more than 30% of its total net assetvalue be invested in any one underlying fund; and

• such funds are not entitled to invest in anotherfund of hedge funds.

(Source: SFC Press Release, 2/05/02.)

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Hong KongCracking down on liarsIn a move to enhance the disclosure bylisted companies, the SFC will introduce theSecurities and Futures (Stock Market List-ing) Rules (Rules) to crack down on "personswho lie to or mislead the public" in listingdocuments or company announcements.

The proposed changes will apply to both listed compa-nies and applicants seeking listing on the stockmarket. Public companies that disseminate informa-tion to the public will be required to file a copy of thedisclosure with the SFC. This will, pursuant to s384 ofthe Securities and Futures Ordinance (5 of 2002),enable the SFC to investigate and gather evidence onwhether there has been an intention to provide false ormisleading information.

Applicants for listing will also be required to file a copyof their prospectus and any other listing documentswith the SFC. The information and listing documentsmay be filed through the Stock Exchange of HongKong if the company or applicant has authorised theStock Exchange of Hong Kong to file these informationwith the SFC.

(Source: SFC Press Release, 6/05/02.)

MalaysiaDiversifying income base ofdistressed companiesIn a move it describes as providing dis-tressed companies "...with more options toacquire quality assets to diversify theirincome base", the Securities Commission ofMalaysia (SC) has eased some of the restric-tions on the injection of foreign equity intodistressed Malaysian listed companies. TheSC has also relaxed the minimum localequity content rules so that multinationalsmay now seek listing on the stock exchangevia a reverse take-over or a back-door listingof a distressed Malaysian listed company.

Effective from 8 May 2002, Malaysian listed compa-nies may now acquire foreign assets (owned either byMalaysians or foreigners) that exceed the 25% thresh-old (calculated by reference to the ratio of the consid-

eration: i) for the foreign assets against the NTA of theacquiror; or ii) for the foreign assets against the aggre-gate market value of all the ordinary shares of theacquiror; or iii) for the shares to be issued against theequity share capital of the acquiror) by issuing securi-ties. Such acquisitions must:

• be financed entirely through the direct issue of newsecurities as consideration to the vendor of thethese assets;

• not result in a net outflow of funds from Malaysia fora period of 3 years from the date of completion ofthe acquisition; and

• bring benefits to the acquiror and the country.

In addition, multinational companies with establishedpresence in Malaysia seeking to list on the stockexchange via a reverse take-over or back-door listing ofthe distressed Malaysian listed company are no longerrequired to meet the 30% Bumiputera equity participa-tion requirement.

(Source: SC Press Release, 8/05/02.)

MalaysiaE-trading of unit trust fundsAs part of the liberalisation foreshadowed inthe Capital Markets Masterplan, the SC willpermit online trading of unit trust funds andthe provision of other online services pertain-ing to unit trust schemes. The SC has issueda Consultation Paper to assist in the formula-tion of guidelines to persons intending toundertake these activities.

According to the SC, the guidelines will be formulatedon the basis of medium neutrality ie, that activities willbe uniformly regulated irrespective of whether theactivities are conducted via paper-based or electronicmedia.

A. Online trading of unit trust funds

To enable online trading, an electronic prospectus mustbe made available on the web-site of the unit trustmanagement company. A paper copy of the electronicprospectus must also be registered with the SC prior tothe posting of the electronic prospectus. An electronicapplication form must accompany the electronicprospectus and access to the application form mustonly be given to a prospective investor after they havebeen given access to the electronic prospectus.

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B. Other online services

Unit trust fund management companies (UTFMC) cannow distribute their annual, interim reports and otherinformation relating to fund performance (including thereports and other information of those funds managedby the UTFMC) by electronic means.

(Source: SC Press Release, 3/04/02.)

SingaporeRisk based capital requirementA new capital requirement based on the riskarising from the activities undertaken by acapital markets services licence holders willbe introduced by the Monetary Authority ofSingapore (MAS).

The capital requirement consists of 2 limbs:

• minimum capital requirement; and

• minimum financial resources requirement.

Licence holders are required to meet both the mini-mum capital requirement and the minimum financialrequirement.

A. Minimum capital requirement

The minimum capital requirement will depend on thestatus of the licence holder. A clearing member mustmaintain a capital of at least $5 million while a non-clearing member must maintain a capital of at least $1million.

B. Minimum financial resourcesrequirement

A licence holder will also be required to maintain asum not less than its total risk requirement (TRR). TheTRR is a sum of the following risks:

• counterparty risk;

• position risk;

• large exposure risk;

• underwriting risk; and

• operational risk.

No detail has been provided on the weighting to begiven to each risk category or how each risk is to becalculated by reference to the minimum financialresources requirement.

In addition to the new capital requirements, licenceholders are also required to notify MAS and theSingapore Exchange Limited when their financialresources falls below 120% of the TRR.

(Source: Monetary Authority of Singapore Press Release,17/04/02.)

New ZealandPromoting confidence - the SecuritiesMarkets and Institutions BillIn a move to overhaul the regulation ofsecurities markets in New Zealand to meetinternational standards, the New Zealandgovernment has introduced the SecuritiesMarkets and Institutions Bill (the Bill) whichwill amend the Securities Act 1978 andTakeovers Act 1993.

The changes proposed by the Bill include:

• requiring public listed companies to comply with astatutory continuous disclosure regime;

• giving the Securities Commission (SC) powers tomonitor and enforce the new regime;

• requiring directors to disclose their securitiesdealings at the time they occur;

• obligating stock exchanges to assist the SC byproviding information;

• enlarging the powers of the SC to include thepower to:

• undertake civil enforcement for breaches ofinsider trading and continuous disclosurerequirements; and

• issue directions to stock exchanges;

• permitting the implementation of mutualrecognition agreements that recognise overseasregulatory requirements; and

• increasing some of the penalties imposed.

The Bill is currently before the Finance and Expendi-ture Select Committee of the New Zealand Parliamentwhich is due to report on the Bill sometime in July.

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Recent dealsCapital raising for acquisition ofSchmalbach-LubecaAAR is advising Amcor on the funding package for the acquisi-tion of the PET container and closure businesses of Germany’sSchmalbach-Lubeca for A$2.875 billion. The acquisition willbe funded through a combination of new equity, debt and thesale of Amcor’s 45% interest in Kimberly-Clark Australia. Theequity raising will include a placement of new shares, entitle-ment offers to shareholders and a new issue of hybrid securi-ties. The equity raising (including hybrids) will total in excessof A$1,235 million. This is second largest capital raising inAustralia to date this year.

AAR’s equity team includes Bob Santamaria, Robert Simkiss,Paul Cantale, Jane Nosworthy, Cathy Heeley, Joanne Chin andFelicity Hiller and the debt team includes Steve Spargo, StuartWeir, James Darcy and Richard Bartlett.

Patrick Corporation Limited placementAAR recently advised Patrick Corporation Limited on a $260million placement of shares to institutional investors. This wasthe first listed company placement after the commencement ofthe Financial Services Reform Act 2001 (Cth) and relied onthe on-sale class order (CO 02/272) relief from prospectusdisclosure for certain secondary sales.

The AAR lawyers on the deal were David Robb, Andrew Clarkeand Peter Tillman.

Note issue for HutchisonTelecommunicationsAAR has acted for Hutchison Telecommunications (Australia)Limited in relation to its May 2002 pro rata renounceablerights issue of convertible notes to raise $600 million. Therights issue was underwritten by Hutchison's major share-holder, Hutchison Whampoa Limited. The money raised is tobe used by Hutchison to partially fund its 3G mobile networkin Australia. Hutchison is building this network together withTelecom Corporation of New Zealand, and intends to be thefirst network operator to launch a commercial 3G network inAustralia. Significantly, the transaction involved obtainingshareholder approval in relation to the relevant interest ofHutchison Whampoa, prior to the issue of the prospectus.Although shareholder approval is not normally required for arights issue of ordinary shares underwritten on an arm's lengthbasis by a major shareholder, shareholder approval wasrequired in this instance to enable the future conversion byHutchison Whampoa of the convertible notes into ordinaryshares.

Issue 8 JULY 2002

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The AAR team included Michael Greig, WarwickPainter, Frank Tearle, Andre Wierzbicki, JulianDonnan, Regina Kho and Alex Lee.

Bluestone securitisation of nonconforming loansAAR was involved in a recently completed A$450million securitisation in the "non-conforming" homeloan market involving the use of complex tranchingstructure (similar to that used on the Kensingtonstructure in the United Kingdom). The "non-conform-ing" home loan market includes people who lackedsubstantial credit, self-employed or recent arrivals toAustralia. These loans were initially financed ("ware-housed") by Nomura International plc and BarclaysBank plc, Australian branch. AAR prepared thefinancing documents and servicing documents andestablished the trust and warehouse structure withAustralian Mortgage Securities Limited as servicer ofthe mortgage portfolio.

The AAR lawyers on the deal were Andrew Jinks andOlivia Zaniboni.

QBE LYONS issueAAR acted as Australian counsel to QBE InsuranceGroup Limited in the issue of up to A$570 million ofdebt-based Liquid Yield OptioN™ securities (LY-ONS). The LYONS™ have a 20 year term and arezero coupon instruments. This was an offering to US-based investors under a Rule 144A Offering Memo-randum which was structured to take advantage ofthe low interest rate environment (implied yield of2.625%) while ensuring that any issue of shares byQBE on conversion, redemption or purchase tookplace at a minimum 24% premium (to the prevailingQBE share price at pricing).

The AAR lawyers on the deal were Ewen Crouch, AlexDing and Tom Story.

Starship ConduitAAR acted in the establishment of "Starship" conduit,a special purpose vehicle set up by Zurich CapitalMarkets Australia to issue CP Notes and MediumTerm Notes. The "Starship" structure was specificallydesigned to provide Zurich Capital Markets Australiawith the ability to issue several series of notes in thefuture and have them backed by different assets.

The AAR team included Andrew Jinks, CharlesArmitage, Gaibrielle Germanos, Michelle Staggs, Mary

Jane Harvey and Michelle Koong.

AVCAL standard trust deed projectAAR has drafted a standard private equity fund trustdeed for the Australian Venture Capital AssociationLimited (AVCAL), a wholesale private equity trust,which will be the trust deed endorsed by the peakAustralian private equity/venture capital industrybody. The deed, drafted by AAR partner, SusanBurns, will consists of standard provisions (whichare intended to be largely non-negotiable) and aseries of schedules containing provisions which are,customarily, negotiated between managers andinvestors. Schedules attached to the deed allow forcustomisation of things such as fees, investmentobjectives and corporate governance protocols. Thedeed is now available to AVCAL members andshould significantly speed up the fund raisingprocess.

AMS II Euro Fund IIIAAR acted for Australian Mortgage SecuritiesLimited (AMS) in the establishment of their EuroFund III and the raising of over A$1.2 billionthrough the issue of mortgage backed securities inthe United Kingdom and Australian debt capitalmarkets.

The AAR lawyers on the deal were MatthewAllchurch and Nicky Andrews.

Callable asset swaps for the DragonAAR is acting for St. George in a number of callableasset swap transactions. The two most recenttransactions involved:

• a deal with Deutsche Bank in which St. Georgepurchased US$20 million convertible bonds ofVerizon Global Funding Corporation and swappedthe fixed coupon payment rate for a floating ratepayment linked to LIBOR until the bonds maturein 2005; and

• a deal with Deutsche Bank in which St. Georgepurchased US$14.5 million convertible bonds ofNabors Industries Inc. and swapped the fixedcoupon payment rate for a floating rate paymentlinked to LIBOR with an option to put the bondsback to Nabors at the expiry of the swap in2006.

Both swap deals have been specifically tailored to

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allow the separation of the coupon payment and theconversion right where Merrill Lynch and Deutsche havethe option to call the bonds and the asset swap fromSt. George by way of notice prior to the expiry of thefacility.

The AAR team includes David Clifford and AdrianChiodo.

Macquarie Goodman Industrial TrustplacementAAR acted as legal adviser to Macquarie GoodmanFunds Management Limited on two placements of unitsfor Macquarie Goodman Industrial Trust and aUnitholder Purchase Plan for unitholders of the Trust.About A$90 million was raised from the two place-ments and an estimated A$10 million from theUnitholder Purchase Plan.

The AAR lawyers on the deal were Stuart McCullochand Gabrielle Bell.

Funding "green" processing technologyIntec Limited (Intec), based in the University ofSydney's Department of Chemistry, developshydrometallurgical processes whereby base metals areproduced from sulphide ore concentrates. AAR recentlyadvised Intec on its initial public offering (IPO) andChapter 6D issues. This issue is interesting because itwill fund the development of "green" metals processingtechnology. Intec has a range of international licenseesfor its technology which uses unique chloride leaching,purification and electro-winning for the recovery of baseand precious metals from sulphide ore bodies.

The AAR team included Michael Greig, David Maloneyand Andre Wierzbicki.

Issue 8 JULY 2002

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Undermining the rights of minority shareholdersThe changes made to the role of shareholders in recent years as a result ofthe amendments to the Corporations Law has seen the erosion of thepower of minority shareholders according to Vanessa Mitchell, the authorof this article. These changes coupled with the trend towards increasingreliance on shareholders to supervise the company have resulted in thesupervisory role falling increasingly on majority shareholders. The changesconsidered by the author include the introduction of the statutory businessjudgment rule, the abolition of the common law right to bring a derivativeaction and the introduction of Part 6A.2 which allows for general compul-sory acquisitions and buy-outs. The effect of these changes on companiesis examined.

Ms Mitchell argues that the changes will not be to the benefit of thecompany as a whole and erodes the power of minority shareholdersvis-a-vis management. She cites a number of reasons why this is the case.First, the associated costs involved in monitoring and taking action againstabuses by management rest predominantly on the shoulders of majorityshareholders (who are these days, institutional investors). However, mostmajority shareholders find it easier to sell down their shareholding than totake corrective action. Secondly, there is a potential conflict of interestthat arises from majority shareholders diversifying their risk and investingin a large number of companies. Finally, the interests of majorityshareholders are often different from those of the minority shareholders.

(Source: V Mitchell, "Has the Tyranny of the Majority Become Further Entrenched",(2002) 20 Co & S LJ 74)

Making prosecution of insider trading easier - thecivil penalty sanctionsThis article by Simon Rubenstein examines the regulation andenforcement of insider trading provisions in Australia, the difficulties inenforcement and considers whether the recent extension of the civilpenalty regime to the insider trading provisions will overcome thesedifficulties. There have not been many successful prosecutions for insidertrading and Mr Rubenstein attributes the lack of success to the complexityof the insider trading laws, the inconsistent judicial treatment of theseprovisions and the difficulties in investigating such conduct. The authorargues that the civil penalty regime may assist in overcoming some of thedifficulties faced by regulators in using criminal proceedings to enforcethese laws because of the lower burden of proof (civil penalty proceedingsare treated as civil proceedings).

(Source: S Rubenstein, "The Regulation and Prosecution of Insider Trading inAustralia: Towards Civil Penalty Sanctions for Insider Trading", (2002) 20 Co & S LJ89)

Beware the limitations of electronic proxiesElectronic lodgement of proxies is being used increasingly by companiesthrough online shareholder registry services such as Computershare as ameans of accepting proxies. The validity of using such a method for

Articles of interest

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lodging proxies and the effect of a forged proxy isconsidered in this article. At issue is whether theCorporations Act 2001 (Cth) (the Act) or any otherState or Federal legislation recognises the use of such amethod of lodgement. The author, James McConvill,contends that as the Act is now Federal legislation, theissue of validity turns on whether the Commonwealthlegislation which regulates electronic transactions theElectronic Transactions Act 1999 (Cth) (the ETA)applies to electronic transactions under the Act. Heconcludes that the ETA does not apply to the Act andthat the validity of electronic proxies will turn on theinterpretation of the relevant provision of the Act -namely s250B(3).

A related issue concerns the ease with which suchproxies may be forged and the effect of forged proxieson company resolutions passed relying on theseproxies. Mr McConvill argues that the resolution of acompany relying on forged proxies would not beeffective. An interested party could seek to utilise theremedial provisions in the Act and invoke the assist-ance of the court to cure such a defect.

(Source: J McConvill, "Electronic proxies and the CorporationsAct", (2002) 30 Australian Business Law Review 141)

James McConvill is an articled clerk of AAR.

Characterising debentures, derivativesand managed investment schemesWhen the obligation of an issuer to repay principal issubject to a contingency, is the financial product inquestion a debenture, derivative or an interest in amanaged investment scheme? This article by JulianDonnan examines these 3 types of instruments in lightof the FSR Act and a number of recent cases in thisarea. Such a determination is important becausedifferent regulatory requirements apply to debentures,derivatives and managed investment schemes. Thearticle concludes that a determination of the nature ofthe instrument must take into account:

• the precise terms and conditions of the instrument;

• whether it is marketed to the retail or wholesalemarket; and

• the underlying substance of the instrument,especially where the managed investment schemeregime may apply.

(Source: J Donnan, "Debentures, Derivatives and ManagedInvestment Schemes - the Characterisation and Regulation ofInvestment Instruments", (2002) 13 Journal of Banking andFinance Law and Practice 28)

Julian Donnan is a solicitor in the capmAARkets group at AAR.

Wagering laws and the regulation ofderivativesUntil recently, gaming and wagering laws have beenused by courts to invalidate financial and non-financialderivatives. This article by Tony Ciro examines thehistory of regulation of derivatives in the United Statesand Australia. Mr Ciro is opposed to the use of anti-speculation laws to regulate the trading of derivatives.He argues that contrary to popular perception, specula-tion improves market liquidity and the use of derivativesassists in the proper functioning of the market byfacilitating the distribution of risk from the risk averse tothe risk-taker. The origins of gaming and wagering lawsindicate that they were intended more to regulaterecreational activities and were not intended for genuinecommercial transactions. The author applauds theintroduction of the FSR Act which removes the applica-tion of gaming laws to financial markets.

(Source: T Ciro, "Anti-speculation Laws and Financial MarketsRegulation in Australia and the United States", (2002) 13Journal of Banking and Finance Law and Practice 15)

Reforming the financial assistanceprohibition in the United KingdomThe author, David Cabrelli, examines the prohibitionagainst the giving of financial assistance by a companyor its subsidiaries to another person to purchase its ownshares. He also examines the proposals put forth by theUK Department of Trade and Industry (DTI) for reform ofthe provision.

In the case of public companies, the author supportsthe proposal to expand the exemptions from the prohibi-tion and to move to the position of making transactionsentered into in contravention of the prohibition voidableinstead of void. Under the DTI's proposal, the giving offinancial assistance by a company to a person for thepurchase of its own shares will not be unlawful wherethe pre-dominant reason for entering into the transac-tion was not the provision of financial assistance.According to Mr Cabrelli, the prohibition should notapply to private companies due to the high cost ofcompliance and that financial assistance should not besingled out in the circumstances as a "special class ofpotential abuse" that warrants legislative intervention asthere are general remedies available against such formsof abuse.

(Source: D Cabrelli, "In Dire Need of Assistance? Sections 151-158 of The Companies Act 1985 Revisited", [2002] Journal ofBusiness Law 272)

Issue 8 JULY 2002

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Stop order time limitsThompson v ASIC (Federal Court, 26 April 2002, [2002] FCA512)

ASIC's power to issue stop order - offer of securities under a prospectus -offer had closed - Corporations Act ss92, 727 and 739

ASIC's power under s739 to issue a stop order does not cease with theclosing of the offer period. ASIC's powers continue until it is no longerpossible for any relevant offers, issues or sales or transfers of the relevantsecurities to be made under the disclosure document.

The applicant, Mr Thompson, is one of two shareholders in WorldAudioCommunications Pty Limited (WAC). In November 2001, the shareholdersof WAC entered into an agreement with International Media Management(Holdings) Ltd (IMM) to sell their shares in WAC to IMM. The completion ofthe purchase of WAC was conditional on the successful public shareoffering by IMM. The IMM prospectus for the share offer was lodged withASIC. The share issue was oversubscribed and was subsequently closed byIMM. After the close of the offer but prior to the issue of any shares, thedirectors of IMM were advised by ASIC that it had received informationsuggesting that a third party had a prior claim on an asset being used byWAC. The IMM directors took the view that the claim was not materiallyadverse to the interests of investors.

ASIC however issued an interim order under s739(3) preventing the offer,issue, sale or transfer of securities in IMM relating to the share offer ascontained in the prospectus.

Thompson and WAC applied to the Court to set aside the interim ordermade by ASIC on the grounds that:

• ASIC may only make an order under s739 against a person who waseither offering, or proposing to offer securities under a disclosuredocument. Once an offer is closed and no further applications ac-cepted, the issuer is no longer making any offer as required by s739.IMM was not at the date of the interim order, a person offering securi-ties. Section 739 referred to an "offer" of securities that would contra-vene s728 and not an "issue" of securities; and

• the proper provision to deal with a deficient disclosure document afterthe offer had closed is s724.

Held: The judge dismissed the application, finding that ASIC’s power toissue a stop order in relation to the offer of securities under a deficientdisclosure document was not limited to the offer period but continued untilit was no longer possible for any of the things a stop order may interdict totake place in respect of the offer to which that disclosure documentrelated.

Was s739 intended to limit ASIC’s power?

Branson J firstly considered the predecessor provision to s739 (s1033 of

Cases

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the Corporations Law) and found that s1033 clearlygave ASIC the authority to issue a stop order even afteran offer had closed, provided that there were securitiesavailable to be issued. As the Explanatory Memoran-dum to the Act did not evince any legislative intentionto substantively change the ambit of the new provisionfrom the old s1033, her Honour held that s739 wouldalso give ASIC the authority to issue the stop ordereven after the close of the offer. The Court howeverrejected ASIC's submission that s739(1) gave ASIC thepower to issue a stop order at any time.

Branson J also considered the phrase “offers, issues,sales or transfers” in s739(1), and held that thisphrase indicated that the power of ASIC to issue a stoporder under s739 did not end until it was no longerpossible for a company to make any relevant offers,issues, sales or transfers of the securities. In particular,the fact that an ASIC stop order could extend totransfers of securities indicated that the legislatureintended ASIC to be able to issue stop orders irrespec-tive of whether the offer in respect to those securitieshad closed. As the issue of securities was a critical partof the fundraising process, a construction of s739 thatwould exclude ASIC's power would be inimical to thepurpose underlying s739.

Does s724 "cover the field"?

In relation to the argument that s724 was the properprovision to deal with deficient disclosure documents,the Court took the view that the very existence of s739was indicative of legislative recognition that s724 onits own provided insufficient protection to an applicantfor securities under a deficient disclosure document.Therefore, the ambit of s739(1) must be at least aswide as that of s724 in order to sufficiently protectpotential investors, and would therefore extend beyondthe closing of the relevant offer.

On a related point, Branson J also held that ASIC couldnot make an interim order under s739(3) where itmerely holds a suspicion that an offer would be madeunder a deficient disclosure document. In order toissue an interim stop order under s739(3), ASIC mustbe satisfied to the degree required to issue an orderunder s739(1).

Material prejudice is not limited tomaterial lossASIC v Adler (Supreme Court, NSW, 14March 2002, [2002] NSWSC 171)

Directors of company- payment of money by companyto an intended unit trust associated with a director -money used to buy shares in parent company - no

ratification by board of payment - whether breach offinancial assistance and related party benefit provi-sions in Corporations Act - whether breach of director'sand officer's duties in ss180, 181, 182 and 183 -construction of "financial benefit" and "arms length" -Corporations Act ss180, 181, 182, 183, 208, 209,210, 228, 229, 260A, 260B, 260C & 260D

In construing what is material prejudice for thepurposes of the financial assistance provisions, regardmust be had to the totality of the transaction andconsequences that are likely to result from the transac-tion. The nature of the transactions contributed to thefinding that the director had not acted in good faithnor for a proper purpose and was entered into tobenefit his position as a substantial shareholder.

This case dealt with a number of legal issues but forreasons of brevity, this case-note will only concentrateon the breach of:

1 director's duties;

2 financial assistance for the purchase of shares; and

3 related party benefit

provisions of the Corporations Act 2001 (the Act).

The defendants, Mr Adler (A), Mr Williams (W) and MrFodera (F) were directors of HIH. A was a non-executive director of HIH while both W and F wereexecutive directors of HIH. They were also directors ofHIHC, a subsidiary of HIH although A denied beingthe director or officer of HIHC. ASIC sought declara-tions that the defendants had contravened variousprovisions of the Act. The contraventions arose from apayment of $10 million by HIHC to PEE, a trusteecompany of a unit trust (AEUT). According to ASIC,the money was utilised in the following manner:

• to purchase shares of HIH on the stock market:

• at the instigation of A;

• with the agreement and under the direction ofW; and

• with the assistance of F to shore up the HIHshare price;and

• to purchase at cost from Adler Corp (a companyassociated with A) shares in various unlistedcompanies;

• as unsecured loans by AEUT without adequatedocumentation to companies or funds associatedwith A and/ or Adler Corp.

ASIC argued that the $10 million payment by HIHC toPEE:

Issue 8 JULY 2002

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• amounted to the giving of a financial benefit to arelated party of HIH without obtaining HIH share-holders' approval (see s208);

• breached the financial assistance provisions as thepayments were materially prejudicial to theinterests of HIHC and HIHC's shareholder (HIH)due to the diminution of the value of HIHC's stakein PEE reflected by actual loss suffered on thepurchase of HIH shares, loss of use of the funds forother business purposes and exposure to a diminu-tion in the value of HIHC's stake in PEE in theevent of a fall in the share price of HIH (sees260A); and

• was a breach of the defendants' duties as directorsof HIH and HIHC (and in the case of A, to PEE).

Finally, ASIC also alleged that A by his conduct hadbreached his duties as a director in relation to HIH,HIHC and PEE.

Held: Santow J found, inter alia, that HIH and HIHChad contravened ss208 (related party) and 260A(financial assistance) and that since A, W and F were"involved" in the contraventions, they were themselvesin breach of s209(2) and 260D(2) respectively. TheCourt also held that A had breached his duties as adirector owed to HIH, HIHC and PEE as a result of the$10 million payment to AEUT and its subsequentinvestment in:

• HIH shares;

• share in various unlisted companies; and

• loans to entities associated with A.

Giving of financial benefit to a related partywithout obtaining approval of HIH members

The defendants had argued that as the shares in HIHwere purchased with money held on trust by PEE forHIHC this meant that HIH was holding shares in itselfthrough HIHC. Since HIHC was getting an asset worthno less than what was paid by HIHC, no financialbenefit was in fact provided to the defendants havingregard to s229. This defence was rejected by the Courton the grounds that it was not supported by theevidence. Furthermore, the wording of s229 requiresthat the term "financial benefit" be given the broadestinterpretation. The transaction arising from thepurchase of the shares was not on "arms length terms"because it was not reasonable for the transaction toinvolve a purchase of shares in the parent by its whollyowned subsidiary without any legal documentation orany security given for the loan. Also under s259B,HIHC could not have taken security over those sharesto protect its interest nor could it have obtained a valid

transfer of those shares pursuant to s259C. HisHonour also concluded from the evidence that A and Wwere involved in the contravention (as defined in s79)of s208 (the related party provision).

Financial assistance to purchase shares inHIH

At issue was whether the giving of financial assistanceby HIHC to purchase shares in HIH was materiallyprejudicial to the interests of HIHC and its share-holder, HIH. In determining whether the transactionwould materially prejudice the interests of the com-pany or its shareholders, one should examine the wholetransaction constituted by the assistance to acquirethe shares. According to Santow J, the principleunderlying s260A is the "impoverishment" doctrine asopposed to the "prophylactic approach (which askswhether the dominant intention of the company was tofacilitate the acquisition of shares, whether or not thecompany's assets were reduced)." Under s260A, thedefendant had the onus of proving that the transactiondid not result in a material prejudice.

The defendants contended that the time for determin-ing whether the giving of financial assistance materi-ally prejudiced the interests of HIHC and HIH was atthe time the assistance was given. It should not extendto a period of three and a half months when the shareswere sold or actually realised. This argument wasrejected by the Court. In assessing material prejudice,all the interlocking elements giving rise to the financialassistance must be taken into account in order todetermine whether the net balance of the financialadvantage lies with the giving of the financial assist-ance. In the present situation:

• the money was lent to a trust which HIHC did notcontrol;

• to a person with inherent conflict of interestwithout proper safeguards to ensure that thisconflict was resolved in favour of HIHC; and

• the money was used to support the HIH share pricethereby benefiting A (as a company associated withA held substantial shares in HIH).

The fact that the loss was ultimately realised simplyreflected the working out of the consequences thatwere inherent in such a structure. The Court foundthat HIHC suffered material prejudice as a result of thefinancial assistance by exchanging cash for unsecuredindebtedness or alternatively equitable rights by way ofresulting or other trust for the HIH shares that werepurchased contemporaneously. The material prejudicelay not only in the fact that the HIH shares wererealised at a loss but also from the lack of safeguards

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and disadvantageous terms of the structure whichrendered the investment in the HIH shares inherentlylikely to give rise to the loss that ultimately occurred.

Breach of director's duties

I A's duty as a director

The Court found that A by causing or procuring thepayment of $10 million by HIHC to PEE to beapplied in purchasing HIH shares had failed tosafeguard the interests of HIH and HIHC and hisconduct fell short of the standard expected of areasonably competent person in his position andfamiliar with investment practices. Santow J alsofound that A:

• did not act in good faith nor for a properpurpose and that he was in fact promoting hisown benefit as a substantial shareholder of HIH;and

• had used his position as a director to supportthe share price of HIH so as to benefit his ownholding of HIH shares.

Santow J also held that A had breached ss180-183in relation to the purchase of the shares in theunlisted companies and the making of unsecuredloans by the trust to companies associated with A.

II. W's duty as a director

In the case of W, the Court found that he hadbreached s180 (duty of care and diligence) ands182 (use of position of director to gain an advan-tage for himself or others). However, W had notbreached s181 (duty to act in good faith and for aproper purpose).

The Court held that W was not entitled to rely on Ato make investments which conformed with the lawand were not detrimental to the interests of HIHwithout making sure that there were proper safe-guards in place including independent appraisal ofthe investment. In fact, W had also failed to followthe safeguards laid down by the Investment Com-mittee of HIH. As W did not exercise any businessjudgment, he could not rely on the businessjudgment defence.

III. F's duty as a director

The court found that F had failed to exercise thedegree of care and diligence required from himunder s180 due to his failure to submit the pro-posal to pay the $10 million for approval to theInvestment Committee.

Related party underwriting - not onarm's length terms?Westgold Resources NL v Precious MetalsAustralia Ltd (Supreme Court, WA, 10 April2002, [2002] WASC 85)

Entitlement issue - underwriting by related party - noprior approval of shareholders - whether omission inprospectus misleading and deceptive - application forinterlocutory injunction by shareholder to restrainissue of shares - Corporations Act ss210, 229, 724and 728

The fact that an underwriting agreement by a relatedparty may be substantially on the same terms as thoseof a third party underwriter does not of itself establishthat the related party underwriting was reasonable anda "dealing at arm's length" for the purposes of s210(exception to the need to obtain shareholder approval).

Westgold Resources NL (Westgold) brought an appli-cation for an interlocutory injunction pursuant tos1324 of the Corporations Act 2001 (the Act) torestrain Precious Metals Australia Limited (PMG) fromissuing any shares to shareholders or the underwritersunder a 1 for 1 non-renounceable partly underwrittenentitlements issue. At the time of hearing, Westgoldwas the seventh largest shareholder in PMG. Accord-ing to the prospectus and supplementary prospectus,the proceeds from the entitlement issue would beused to:

• defend an unrelated litigation brought by Westgoldagainst PMG;

• complete PMG's environmental obligations inrespect of the decommissioning of a gold mine;and

• repay loans and capitalised interest and fees totwo shareholders who were associated withdirectors of PMG and to pay those directors theiremployee entitlements

Three companies (the Underwriters) each controlledby a director of PMG (two of whom being the directorsreferred to above) were to conditionally underwrite thepart of the issue together with other parties. Theunderwriting fees due to the Underwriters were to beset-off against their underwriting commitment. Also tobe set-off against this commitment were the amountof the loan repayments and employee entitlementsdue to parties associated with the Underwriters (seelast point above). In seeking to restrain the issue ofshares by PMG to shareholders, Westgold raised threemain arguments:

Issue 8 JULY 2002

26

(a) the Underwriters were related parties of PMG forthe purposes of the Act and that shareholderapproval for the entry into the underwriting arrange-ment was required;

(b) the prospectus contained misleading and deceptivestatements and omissions; and

(c) since the issue of the prospectus, there had been amaterial adverse circumstance which required PMGto deal with all applications in accordance withs724(2) (ie, repay application monies or issue asupplementary prospectus and/ or give applicants aright to withdraw and be repaid).

Held: White AUJ found that there was a seriousquestion to be tried in relation to the underwritingagreement and compliance with the related partybenefit provisions and the defective statements in theprospectus. The balance of convenience favoured thegrant of an interlocutory injunction.

Underwriters were related parties of PMG

Under Chapter 2E of the Act, in order not to fall foul ofthe provisions relating to the giving of financial benefitto a related party:

• the approval of the company's members must beobtained; or

• the giving of the benefit must fall within an excep-tion as set out in ss210 - 216.

It was not disputed by PMG that the Underwriters wererelated parties of PMG for the purposes of the Act.PMG sought to rely on an exception under s210 whichpermits financial benefits to be given without share-holder approval if the benefits are given on terms thatwould be reasonable if the public company and therelated party were dealing at arm's length or on lessfavourable terms.

Westgold argued that the agreements with the Under-writers were not on arm's length terms on the basis thatbecause of the substantial set-off arrangements, themaximum cash outlay the Underwriters would have tomake under the underwriting agreements was substan-tially reduced and in some cases no funds were payableby the Underwriters. This meant that the underwritingcould not be characterised within the ordinary meaningof underwriting as "assuming the risk that the intendedinvestors will not take up an offer of securities". Inresponse to this assertion, PMG stated that the sumsowed to the Underwriters were owed bona fide and hadto be repaid by PMG. The terms of the underwritingagreement were substantially similar to that negotiatedwith a third party save for the right of set-off in favourof the Underwriters.

Despite the fact that the underwriting agreementcontained substantially similar terms to that negoti-ated with a third party, White AUJ was of the viewthat, in all circumstances of the case, this did notestablish that the terms would necessarily be reason-able if PMG and the related parties were dealing atarm's length.

Misleading and deceptive statements, andomissions

Westgold raised various complaints that the informa-tion in the prospectus was misleading and deceptive,and omitted material information. It was argued, interalia, that the prospectus failed to:

• provide details about the repayment of loans andemployee entitlements to some of the directorsand Underwriters;

• provide essential terms of the loans such as theinterest rates, repayment date and the like; and

• make an assessment of the likely outcome of thelitigation brought by Westgold in a prospectus thatseek to raise funds for such a litigation.

The Court held that there was a serious question to betried in relation to whether the prospectus wasdefective in omitting to include an assessment of thelikely outcome of the Westgold litigation.

Was there a material adverse circumstance

The prospectus for the entitlements issue was issuedbefore the issue of the half yearly financial report ofPMG. The audit report in the prospectus had identi-fied that there was "inherent uncertainty" on whetherPMG could continue as a going concern. The subse-quent half yearly financial report mentioned that therewas a significant write-down in the value of a miningproject - a substantial asset of PMG (PMG was paid aroyalty by the owner of the project) and stated thatthere was "significant uncertainty" as to whether PMGcould continue as a going concern. It was asserted byWestgold that PMG should have issued a supplemen-tary prospectus to inform shareholders of this write-down and its effect in the books of PMG.

White AUJ rejected the proposition that this raised aserious question to be tried. In his Honour's view,there was little distinction between the form of wordsused in the prospectus and the half yearly financialreport. In addition, PMG had explained in the Notes tothe half yearly financial statement that it was not privyto the calculation by the owner of the mining project.

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capmAARkets

Monitoring of brokers essentialAli v Hartley (Supreme Court, VIC, 16 April2002, [2002] VSC 113)

Trading in shares and derivatives - allegation of breachof agreement and negligent supervision of employee -was there a breach of fiduciary duty - whether breachof ss846 and 851 of Corporations Law and ASXBusiness Rules by broker as a result of actions ofemployee - Corporations Law ss846 & 851, ASXBusiness Rules 3.3, 3.4.1(1), 3.4.2, 3.4.3, 3.4.4,3.10, 8.14.1 and 8.14.2 and ASX Business RuleGuidance Note 13/97

A stockbroker has an obligation to exercise reasonablecare by taking all reasonable steps to have all neces-sary information from its client before embarking on atrading or investment program.

The plaintiff Rahmat Ali (A) brought an action againstthe defendant, Hartley Poynton Limited (HPL) allegingthat HPL had through its broker, Christopher Martin(M):

• breached a trading agreement entered into with A(the trading agreement had been entered into byA's son as his agent);

• been negligent in its supervision of M whichresulted in A suffering losses; and

• breached its fiduciary duty in relation to the tradingconducted by M.

There were also claims of false and misleading conductand misrepresentation by M in relation to the positivereturns that M claimed he would generate for A. Therewere also allegations that M had engaged in unauthor-ised trading of shares for the purposes of generatingcommissions.

Held: The Court found that HPL was negligent in itssupervision of M and that it did not have an adequaterisk management system in place to monitor the wayits brokers were carrying out their trading activities.

Was there a trading agreement?

A argued that the agreement with HPL consisted of 2parts. The first concerned the creation of a retainer andthe agreement to trade in shares. According to A, itwas an implied term of the agreement that HPL wouldsupervise its employees to ensure compliance with therules of ASX, exercise reasonable control over thetrading activities undertaken by its employees andadvise A of the risk involved in investing in derivativeswith funds borrowed from HPL through margin lending.The plaintiff also claimed that there was an agreement

with HPL that HPL would use funds provided by A toachieve a target return in the order of $10,000 to$15,000 weekly. However, this was subject to therequirement that HPL not purchase or sell any sharesor derivatives without the agreement or authority of Aexcept where such an investment would contributetowards the promised rate of return or would result ina loss that was less than or equal to the stop loss limit.

The existence of the implied terms were denied byHPL. HPL contended that there was no bindingagreement with A that HPL would act as A's stockbroker and investment adviser at all times. Insteadaccording to HPL, a binding agreement arose eachtime a transaction was undertaken and at all othertimes, there was merely an incomplete arrangementbetween the parties. In the event A instructed orratified action taken by M, a contract would then arise.

HPL's argument was rejected by the court. It con-cluded from the evidence that there was a retaineragreement, the terms of which were partly oral andpartly in writing. Smith J also held that there was anoverarching agreement in which HPL, through M, wasinvested with a discretion to buy or sell subject to anycontrary instructions from A.

Breach of fiduciary duty

Smith J found that the relationship between A andHPL was fiduciary in nature. This was because A didnot engage HPL merely to execute his orders but toadvise and conduct trading on behalf of A and exercis-ing HPL's discretion. A had placed his reliance onHPL.

HPL did not dispute that there was an implied term ofthe retainer that the stockbroker would in performingits obligations under the retainer, exercise suchreasonable care, skill and diligence as might beexpected of a reasonably competent stockbroker. Thisduty extended to each of the professional activitiesundertaken for A including any advice and recommen-dations for buying and selling shares and any decisionby the broker to buy and sell shares in the exercise ofhis discretion.

Was M negligent and was HPL negligentin its supervision of M?

The plaintiff cited numerous instances as proof that Mfailed to exercise due care in discharging his duty to A.Some of these included:

• failing to apply stop loss rules;

• holding on to losing trades for too long;

• having no consistent or rational exit method;

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• failing to control risk through appropriate sizingtrades;

• failing to balance the portfolio between blue chipstocks and stocks with higher risk; and

• short selling warrants.

Even though the account maintained for A wasdiscretionary, A argued that M had been negligent tohave implemented and embarked on the tradingprogram without ascertaining the financial position ofA. In his defence, M claimed that A had chosen not tosupply him with the relevant information. This defencewas rejected by the Court. In the Court's opinion, Mhad an obligation to exercise reasonable care by takingreasonable steps to have all necessary informationbefore embarking on a trading or investment program.While M had some information about A's financialposition, this was insufficient. To discharge thisobligation, it was essential that M have all the informa-tion that would be required to advise A on the risks ofthe proposed program of trading and investment.

Smith J also found that HPL had been negligent infailing to exercise reasonable supervision over M. HPLhad argued that it was not under a contractual obliga-tion to supervise and control M. Neither could such anobligation be implied by law from the retainer contract.This argument was dismissed by Smith J on thegrounds that where the stockbroker is an organisationemploying brokers, it cannot discharge its duty toexercise reasonable care and skill without exercisingreasonable care in supervising and controlling itsbrokers. The Court found that there was a history ofnon-compliance by M with the risk managementpolicies of HPL. While a stockbroker could not beexpected to supervise each dealing made by itsbrokers, it could set policies and systems with ad-equate supervision to enforce these policies from timeto time. Based on the evidence, the court found thatHPL did not have an adequate system to monitor orsupervise the way M carried out his trading activities.

The Court also found that M had failed to comply withss846 (short selling of securities) and 851 (reasonablebasis for recommendation) of the Corporations Law andASX Business Rules 3.4.1, 3.4.4 (which dealt withoperation of discretionary accounts), 8.14.1 and8.14.2 (which dealt with the trading of warrants).

SnapshotsHere is a snapshot of some other recent decisions

1) Sole director who is the directing mind ofunregistered managed investment schemealso guilty

ASIC v Pegasus Leveraged Options Group PtyLtd (Supreme Court, NSW, 24 April 2002,[2002] NSWSC 310)

ASIC sought declarations that the defendants (Pegasusand its sole director, Mr McKim) had breached numer-ous provisions of the Corporations Law including foroperating an unregistered managed investmentscheme. Mr McKim promised investors (numbering inexcess of 89 people) a rate of return that varied from2%-8% per week. The Court held that both Mr McKimand Pegasus carried on an unregistered managedinvestment scheme and ordered that Pegasus bewound up on the just and equitable ground for investorprotection. Mr McKim was caught by the prohibitionagainst operating an unregistered managed investmentscheme since he formulated, directed and was activelyinvolved in the day to day operation of the scheme.

2) Proxy need not be a member of the company

The New South Wales Henry GeorgeFoundation v Booth (Supreme Court, NSW,5 April 2002, [2002] NSWSC 245)

The plaintiff sought a declaration that the appointmentof the defendants as directors and secretary of theplaintiff at its annual general meeting by the defend-ants exercising powers of attorney granted by some ofthe members of the plaintiff was invalid. The Courtheld that even though the Corporations Act (Act) doesnot expressly refer to voting by power of attorney, theword "proxy" in ss250A & B is wide enough to includean attorney. Gzell J also held that the Act does notprescribe that a proxy has to be a member of thecompany.

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Disclosure of ethical investment considerationsFrom 11 March 2002, the Financial Services Reform Act 2001 (FSRA)requires issuers of financial products with an investment component todisclose the extent to which labour standards, or environmental, social orethical considerations are taken into account in the selection, retentionor realisation of the investment. This legislation has considerablepotential to impact on many of the financial institutions that currentlyparticipate in the $1 billion-plus ethical investment market through theoffer of super or managed funds with ethical or environmental selectioncriteria.

1. What is ethical investment?

From a consumer perspective, ethical investment involves an attempt toalign one’s personal values and social concerns with investment objec-tives. This strategy is also termed “socially responsible investment”,“social investing” or “value-based investment”, and generally assumesone of three forms: engagement, best-of sector or screening.

• Engagement refers to an informal process whereby funds managersseek to influence the ethical, social or environmental performance ofa company by entering into dialogue with the particular company;

• A best-of-sector approach involves a commitment to invest in a rangeof companies that have the best ethical and social performance ofthose companies competing in that sector, for example, mining,media, information technology, biotechnology and manufacturing.

• Screening of investments according to ethical criteria is either on apositive or negative basis. Negative screening generally involves ablanket prohibition on investment in companies carrying on businessactivities in certain fields regarded as contrary to the fund’s invest-ment criteria, such as manufacture of armaments or the sale oftobacco or alcohol. Positive screening assesses a company’s perform-ance according to ethical or social criteria, often developed by a thirdparty, such as a university or environmental organisation. Thosecompanies that perform the best under this type of rating system areselected by the investment manager.

2. What are the ethical investment disclosure requirementsunder the Corporations Act 2001?

The FSRA provides that if a financial product has an investment compo-nent, a Product Disclosure Statement must contain a statement andinformation on:

the extent to which labour standards or environmental, social orethical considerations are taken into account in the selection,retention or realisation of the investment.

The Corporations Regulations elaborate on this disclosure obligation byproviding that a product issuer must state whether it does, or does not,take into account labour standards and environmental, social or ethicalconsiderations for the purpose of selecting retaining or realising theinvestment. Furthermore, if labour standards or environmental, social or

FSR update

“From a consumerperspective, ethicalinvestment involves anattempt to align one’spersonal values andsocial concerns withinvestment objectives.”

Issue 8 JULY 2002

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ethical obligations are taken into account, the productissuer must outline those standards or considerationsand the extent to which they are taken into account.

3. What are the risks confronting ethicalfunds?

Uncertainty versus flexibility

There is no definition in the Corporations Act 2001 orthe Corporations Regulations of the words “environ-mental”, “social” or “ethical". The Australian Securi-ties and Investments Commission (ASIC) has statedthat the wording used in the section will ensure thatproduct issuers have the flexibility to consider thewidest range of matters that could be considered to belabour standards or environmental, social or ethicalconsiderations; and to then determine which of thosematters will be factored into their decision-makingprocesses.

However, uncertainty about the usage of such termsand the amount of disclosure required to informinvestors of the methodology of fund managers compli-cates the issue. Most notably, the term “ethical” mayhave one connotation for the fund manager andanother for each investor. Will the courts be calledupon to adjudicate if the fund managers are alleged tohave contravened an “ethical” standard?

Misleading and deceptive conduct

A recent survey into the practice of ethical fundmanagers revealed certain anomalous practices,including: investments by one ethical fund in aparticular pharmaceutical company which usedanimals for testing drugs and personal care products,notwithstanding that the fund contained a negativeanimal cruelty screen; and another fund invested in aparticular retail company which sold tobacco productsdespite the fund’s negative screen on tobacco sales.There is a risk for funds managers that allegations ofmisleading and deceptive conduct could be made ifthere is incongruence between the stated “ethical”criteria of the fund and its underlying investments.

Fiduciary duties of fund managers and supertrustees

A fundamental principle of the law of trusts is that atrustee must act in the best interests of the beneficiar-ies to the trust. This means that a trustee should notact according to extraneous considerations but mustact, according to their powers, to further the objects ofthe trust.

In a UK case, Martin v City of Edinburgh DistrictCouncil it was held that the trustee who realisedvarious investments of the Edinburgh District Councilin South Africa was in breach of trust for not expresslyconsidering whether its investment policy was in the

best interests of the beneficiaries. Similarly, in Bishopof Oxford v Church Commissioners the court reiteratedthe general principle that trustees have an obligation toseek the maximum return under the terms of the trust.The Vice Chancellor noted that this generally involvesthe application of well-established investment criteria,including diversification, the need to balance incomeagainst capital growth and the need to balance riskagainst return

For fund managers, selecting companies in which toinvest according to ethical, social or environmentalconsiderations may limit the diversity of companies inwhich a trustee may invest. There is a risk that this maynegatively impact on the risk profile of the fund, createssystemic bias and threaten to contravene the fiduciaryduties of a trustee not to fetter his or her discretion andto maximise the financial return on investments.

Advising Retail Clients

From 11 March 2002, when advice is provided to retailclients by providers of financial services, the providingentity must determine the relevant personal circum-stances of the client in relation to giving the advice andmake reasonable inquiries in relation to those personalcircumstances. The expression relevant personalcircumstances is defined as such objectives, financialsituation and needs of the investor as would reasonablybe considered to be relevant to the advice. An issue forfinancial advisers is whether the term “relevant personalcircumstances” requires the adviser to make inquiries ofnon-financial considerations of the retail investors and,more particularly, any environmental, social or ethicalissues or labour standards likely to influence theirdecision on whether or not to make an investment. Thelegislation does not qualify the word “objectives” tomean only “financial objectives”. If a person has anethical stance in relation to investment, this may be anobjective which is “relevant” to the provision of advice.

The inclusion of the words “reasonable” in the defini-tion of relevant personal circumstances in s761A and“reasonable person” in the definition of personal advicein s766B(3) import a degree of objectivity. Viewedagainst the background of the increasing availability ofethical investment products and the number of peoplewho either currently invest in such products or whopossess a willingness to do so, a reasonable person mayconsider that any personal advice he or she receivetakes into account their ethical or social views oninvestment (to the extent that any such views are held).Essentially, there is a risk that advisers who do notundertake such an inquiry risk breaching s945A.

4. What can financial product issuer do tominimise risk?

ASIC has informed the market that it is currentlyconsidering what type of regulation should accompany

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capmAARkets

the ethical investment disclosure provisions introducedby the FSRA. It is cognisant of the fact that most fundmanagers desire some form of guidance from theregulator rather than the prescription of mandatorystandards. In the interim, fund managers can minimiserisk through the following steps:

• clearly articulating the type of methodology theyadopt when selecting investments;

• monitoring the performance of the companies theyhave selected to ensure that they continue tocomply with the fund’s stated ethical, social orenvironmental criteria;

• ensuring that fiduciary duties are observed byadopting an ethical selection criteria which: doesnot lower the expected return of the fund’s assets;permits adequate diversification; does not involveunacceptable risk exposures and burdensomeadministrative procedures; enjoys a wide degree ofacceptance by members; and is consistentlyapplied and recorded; and

• to the extent that it engages financial advisers,implement measures to ensure that retail clientsnon-financial objectives are ascertained andconsidered as part of that client’s personal circum-stances.

This article was written by Julian Donnan, a solicitor inthe CapmAARkets group.

A more detailed analysis of this subject can be foundin Julian Donnan’s essay entitled “Regulating EthicalInvestment: Disclosure under the Financial ServicesReform Act”. That essay was recently named as one ofthe two joint-winners of the 2002 legal writing re-search prize offered by the Banking and Financial LawAssociation. The essay will in due course appear on theAssociation’s website, and is expected to be publishedin a forthcoming issue of the Journal of Banking andFinance Law and Practice.

Cruising down the legislativestreamlineAre you a holder of a pre-FSR licence? Are you plan-ning to apply for an Australian Financial Services (AFS)licence? Then the new ASIC Guide may be of interestto you or your organisation. The Guide outlines theassessment processes that ASIC will use to determinewhether an applicant is able to "legislatively stream-line" their application for an AFS licence. Legislativestreamlining is a procedure that simplifies the applica-tion process for a holder of pre-FSR licence in relationto certain regulated activities. Under this process, anapplicant with a pre-FSR licence will not be required tomeet some of the tests set out in s913B of the Corpo-rations Act 2001 (Cth) for the issue of an AFS licence

(such as the good fame and character test). The Guidesets out the type of pre-FSR licence that will permitthe holder to obtain the benefits of legislative stream-lining.

(Source: ASIC Media Release, MR02/128, 15/04/02.)

1 in 2 applications for AFS licenceinaccurate or incompleteThinking of putting in an application for an AFSlicence? According to ASIC, since the commencementof the FSR Act (11 March 2002), it has received morethan 100 applications for AFS licence. Around 50% ofapplications have either been returned or withdrawndue to inaccuracy or incompleteness. Below are ASIC'shandy hints on how to avoid the pitfall of submittingincomplete or inaccurate applications:

• study the FSR policy statements and guideincluding the AFS Licensing Kit;

• check with your relevant industry body of the effectof FSR on your business;

• have a clear understanding of the type of authori-sations that you will need; and

• obtain professional advice.

(Source: ASIC News, Issue 48, May 2002.)

FSR related amendments to NSWState Acts and RegulationsThe Financial Services Reform (Consequential Amend-ments) Act 2002 (NSW) (the NSW Act) was passed bythe NSW Parliament on 12 June 2002 but has not atthe date of publication of ITM, received royal assent.The NSW Act makes consequential amendments tovarious pieces of NSW legislation which still refer tothe previous Chapters 7 and 8 of the Corporations Act2001 (Cth) (the Act). It also amends the legislation toreflect terms and concepts now contained in the Act.Some of the NSW State Acts that will be effectedinclude:

• Duties Act 1997;

• Legal Profession Act 1987; and

• Co-operatives Act 1992.

In addition, the NSW Act also amends the Corpora-tions (Ancillary Provisions) Act 2001 (NSW) byauthorising the making of regulations which specifyhow references in NSW legislation to Commonwealthcorporations legislation are to be construed when theCommonwealth corporations legislation is amended bythe Commonwealth.

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Our Capital MarketsteamThe AAR Capital Markets Group draws on theexpertise and resources of more than 100 lawyersin Australia and the South-East Asian region. Thegroup is led by Michael Greig, backed by deputyleader Craig Henderson.

We operate as one cohesive group covering the corporate andfinance law and tax aspects of the issuance of debt, equityand hybrid securities. As well as securities issuance, wecover the entire capital markets field, including capitalmanagement, trading systems, trading behaviour regulationand corporate governance.

This is achieved in part through smaller product focussedteams such as:

• the Convertibles Team

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• Securities Issuance Team

Each Team has regard not only to Australian law and practicebut also to law and practice in the South-East Asian regionand in the key developed capital markets of the US and theUK. We can do this because many of our lawyers havestudied, trained or worked in one or more of these countries.In this way we can provide in depth coverage of the wholecapital markets field.

Going “short” on independence

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