Updated MDA Regulation Will Foster Certainty and Growth

UPDATED MDA REGULATION WILL FOSTER CERTAINTY AND GROWTH

Introduction

The Australian Securities & Investments Commission (ASIC) announced updated regulation in relation to Managed Discretionary Accounts (MDAs) on 29 September 2016.  This update has been foreshadowed for some time and follows an extensive industry consultation process undertaken by ASIC, including the issue of a consultation paper (CP 200) in March 2013 and consideration of industry feedback to the proposals included in that paper.

We don’t propose to discuss the legal minutiae of the changes here as there will be fleets of lawyers all over that in the coming days and weeks.  Rather, we will identify key themes and issues that caught our attention. Please read our disclaimer at the bottom of the page before you leave this article.  

The headlines & timetable

• ASIC has issued a new legislative instrument governing MDAs (ASIC Corporations (Managed Discretionary Account Services) Instrument 2016/968) which we presume will be soon known as ACI 2016/968.  It’s not rolling off the tongue yet but that will come!  ASIC have also issued an extensive revision to Regulatory Guide 179 (RG 179) which provides guidance on the application of ACI 2016/968.

• As widely anticipated, limited MDAs relying on ASIC’s no action position are to end, with existing LMDA operators having until 1 October 2018 to transition to an alternative solution for their clients from the range of managed account options available in the market.  Our reading of the updated Regulatory Guide 179 is that this transitional arrangement will apply to the old and new clients of existing LMDA operators.  i.e.  An existing LMDA operator will be able to add new clients after 1 October 2016 and provide services to them under the no action position until 30 September 2018 (subject to having all the processes in place to operate in compliance with the detail of the no action letter).  The key is that LMDA operators must be able to show that they first relied on the no action position before 1 October 2016.  No one will be able to start issuing LMDAs after 1 October 2016 if they have not previously relied on the no action position before that date.

• The future options for LMDA operators to provide MDA services post 1 October 2018 include applying for MDA provider authorisation under their AFSL.  ASIC has indicated that it will recognise the experience that applicants have gained operating a LMDA but have also cautioned that this does not automatically guarantee that the AFS authorisation will be granted.  We discuss the options for those who have hitherto relied on LMDAs later in this blog.

• Full MDA operators authorised to provide MDAs before 1 October 2016 have until 1 October 2017 to comply with ACI 2016/968.  Until that time the requirements of the old instrument CO 04/194 will continue to apply to them.  We take this to mean they can add new clients to their services from 1 October 2016 and still provide services to them under the old regulatory regime up until 30 September 2017.  It is also possible for MDA operators to “opt in” to the new regime early if they wish and there is a process set on in RG179 for doing so.

• MDA providers authorised after 1 October 2016 are obliged to comply with ACI 2016/968 from the date they are authorised.

• ASIC is NOT imposing the regulatory capital requirements on MDA providers it foreshadowed it might in its consultation paper.  Rather, it has indicated that it will review these requirements over the next 2 years. 

• ASIC has sought to clarify a range of open questions around the way they will regulate MDAs.  This clarity is set out in an extensively revised edition of RG 179 which is mandatory reading for anyone involved in provision of MDA services.  Many of these open questions were put to ASIC via the Consultation Paper 200 feedback process.  As such, it is arguable that many of the fresh details that come to us through RG 179 are not new regulation so much as clarification of how ASIC will interpret existing regulation.  Nonetheless, there are some material new obligations which we will discuss below.

• For sake of clarity we note that MDAs continue to be a retail concept (i.e. the MDA regulation does not apply to wholesale investors) and that the new legislative instrument and regulatory guide do not apply to managed accounts offered through a registered scheme, such as Separately Managed Account issued under a product disclosure statement (PDS).

The language

There are some new terms and use of language to become familiar with and reflect on:

• Under the new instrument MDA operators become known as MDA “providers”.  This makes sense.  ASIC has made a point of recognising the different ways that MDAs can be run and that certain functions can be outsourced.  The term “providers” reflects this reality.

• ASIC has clearly stated that if you contract with a client to provide an MDA they will treat you as the issuer of a financial product.  (See RG 179.16)   Having made that point very plainly, both ACI 2016/968 and RG 179 typically refer to MDAs as MDA services.  Whilst this is not something that ASIC has chosen to expand upon at any length we find it significant as it seems to us as one of the defining characteristics of MDAs.  Regulation requires that they be offered with advice and reviewed with advice. This, combined with their discretionary nature and the flexibility of form and delivery, makes them a service.  In our view, this is an important cultural issue for an industry used to dealing in investment products.  Once MDA providers fully embrace the idea of MDAs as services their potential to create a more rewarding experience for end investors starts to reveal itself.

• ASIC has clearly set out the defining features of an MDA (RG 179.1) but has not sought to provide clarity around other managed account terminology.  While they expressly state that that registered schemes are NOT MDAs (thereby confirming that managed accounts issued under a PDS and made available as a companion offer to a wrap platform are not MDAs), they recognise that some products currently described as separately managed accounts (SMAs) and individually managed accounts (IMAs) may fall within the definition of an MDA.  From this we can conclude that ASIC owns the definition of MDA and has set it out clearly, but that universal definitions for SMA, IMA, UMA etc will have to come from another source.

Important themes

Recognising diversity

There has been a sense that ASIC was playing catch up with managed account regulation.  The extent of reliance on the no action position seemed to catch ASIC off guard.  Some of the proposals in Consultation Paper 200 suggested a lack of appreciation concerning the different ways that MDAs were being structured in the market and what that might mean for their regulation. 

The new legislative instrument (ACI 2016/968) and new regulatory guide (RG 179) comprehensively addresses these issues.  Firstly, ASIC has recognised the diversity in the MDA market and has shown a thoughtful approach to regulation in this regard.  There is a 10 page chapter on “MDA services with different arrangements”.   The MDA service variations captured in the chapter headings include:

• MDA with an external MDA custodian
• MDA with an external MDA adviser
• MDA with external administration support
• MDA where the client holds the legal title to portfolio assets
• MDA on a regulated platform.
• Market participants providing an MDA to family members

The chapter clearly sets out what relief is given under each structure, as well as the conditions that apply.  This is welcome guidance and will help the MDA industry to develop with increased confidence. 

Transparency and accountability

ASIC is very clear that RG 179 applies not only to MDA providers but also agents of MDA providers and those that enter into a direct contract with the MDA client to provide some aspect of the MDA service.  E.g. an MDA custodian or an external MDA adviser.  It is equally clear that providers are responsible for the actions of their agents as if they are their own whereas those that contract directly with clients will carry responsibility for the services they provide.  This responsibility for agents includes the responsibility to compensate the client for any loss caused by an act or omission of the agent.

MDA providers must also include information about the operation of any outsourcing arrangements in their FSG including naming the entities involved and how they will be monitored.  Fee disclosure in the FSG must not only disclose management costs in the MDA but also interposed vehicles which would logically include those attributable to agents.

Whilst accountability for agents is an established principle, to this reader ASIC has sharpened its focus on these issues while at the same time recognising the diversity of MDA structures in the market a number of which involve multiple service providers combining to provide a MDA service.  Again, it makes sense that these two things go hand in hand. 

Clarification of certain compliance obligations

Fee disclosure

ASIC has confirmed that MDA fees are product fees and do not form part of the ongoing fee arrangement that needs to be disclosed in a Fee Disclosure Statement (FDS) (See RG 179.117).  They have also clarified that where MDA fees and advice fees are bundled together, the fees attributable to products such as MDAs should be deducted and the rest of the fees disclosed.  They have also explicitly warned licensees that it would be inconsistent with their licencing obligations if they were to cross subsidise the cost of providing personal advice in order to avoid a fee disclosure statement.

Best interest duty

RG 179 explicitly states that the obligation on MDA providers to act in the best interest of clients when providing MDA services is a separate and additional obligation to that of advisers providing personal advice to retail clients.  (See RG 179.62) It further notes that the duty extends to all activities undertaken in providing the MDA.  It imposes an obligation on MDA providers to have processes and procedures to ensure that their representatives comply with the duty to act in the best interests of the client.  An example provided of conduct that may breach this duty is excessive transacting on a client account relative to the objectives of the client.  What is not clear re best interest duty is whether this responsibility for representatives extends to external MDA advisers – this is an area where we will seek clarity from ASIC. 

Addressing anomalies

The new regulation deals with some existing regulatory positions that caused consternation in the market.  A good example is the “no pooling” provision which seemed to be potentially at odds with bulk transacting and the way platforms hold assets in custodial accounts.  These issues have been addressed at RG 179.36 to RG 179.38 and RG 179.192 to RG 179.194 respectively.  The upshot is that bulk transacting is allowed and that the pooling typically carried out by platforms is also accepted.  Again, this provides comfort and certainty via a common sense approach.

Outstanding questions and issues

Responsibility for the work of external MDA advisers

Notwithstanding that ACI 2016/968 has provided clarity in a number of areas, we feel the water has been muddied on responsibility for advice provided by external MDA advisers.

We paraphrase here some relevant elements of ACI 2016/968:

• An MDA has an external MDA adviser if someone other than the MDA provider enters into a direct contract with a client to prepare and review an investment program; and the investment program is, or is intended to be, included in the MDA contract between the client and the MDA provider (RG 179.167).
• The adviser must hold an AFS licence with an authorisation to give financial product advice to retail clients (RG 179.169).
• The regulatory guide states that the requirements regarding external MDA advisers are designed to ensure that a client clearly understands that a person other than the MDA provider is directly responsible to them for the suitability of the investment program (RG 179.172).
• If you, as an MDA provider include in the MDA contract a MDA program prepared and reviewed by an external MDA adviser....you do not need an AFS licence authorisation to give financial product advice to retail clients in relation to general advice contained in any offer document.

Our lay person’s interpretation of that is if another licensee is contracting with the client to provide personal advice regarding the investment program and its suitability, then the MDA provider is responsible for other aspects of the MDA services, including ensuring that the holdings are consistent with the investment program, but is clearly not the party providing the personal investment advice and that is fine with ASIC.  So far so good. 

However, it then goes on to say in RG 179.174:

“If you, as an MDA provider, include in the MDA contract an investment program prepared by an external MDA adviser, you must:

(a) review the SOA given in relation to that investment program before entering into the MDA contract, and not enter into the contract if you have reason to believe that the MDA is not appropriate to the client’s relevant circumstances;”

And shortly after that in RG 179.175:

“We do not envisage that an MDA provider needs to undertake a comprehensive review of the investment program to form a view under RG 179.174(a). By forming this view, the MDA provider does not endorse the investment program or the review report.”

If taken as a whole, the guidance appears to suggest that:

• The MDA provider is not responsible to the client for the personal investment advice
• Nonetheless the MDA provider has to review the investment program the external MDA adviser has recommended for the client and not enter into a contract unless the MDA provider is comfortable with that advice (even though the MDA provider may be not licenced to provide personal advice and may not have the competencies within its organisation to review the advice).
• Notwithstanding the above, ASIC does not expect MDA providers using an external MDA adviser to take a comprehensive review of the investment program, just form a view on whether it is suitable to the client based on reviewing the SOA.   

This aspect of RG 179 does not seem logical to us.  It puts the MDA provider in the position of having to second guess the work of the external MDA adviser and their licensee and compliance staff, notwithstanding the MDA provider may not have the competencies for personal advice or be licensed to provide it, and will likely lead to some disputes between these parties as to what is appropriate advice.  It will undoubtedly slow service down and lead to increased costs to provide MDA services.  It will also create some ambiguity around responsibility for advice and will be unsettling to professional indemnity insurers.  In aggregate, it appears to undo some of the good work that the new regulatory guide has done on clarification of accountability.

How will ASIC assess MDA provider applications from LMDA operators?

Obtaining authorisation from ASIC to operate a MDA has been extremely difficult in the past 3 years.  We are not aware of specific past commentary from ASIC on this topic, but have interpreted this “raising of the bar” as reflecting ASIC’s concern that discretionary portfolio management should require specialist skills and resources. 

For existing LMDA operators applying for authorisation to be a MDA provider ASIC states in RG 179.191, 

"When we assess an application for the AFS licence authorisations relevant to the MDA services you provide, we will take into consideration the experience gained by the AFS licensee under the no-action position for regulated platform MDAs, to the extent that it is equivalent to the MDA business proposed to be undertaken by the licensee."

(Emphasis added by Philo Consulting)

Earlier in the regulatory guide, ASIC sets out how it assesses applications for authorisation in RG 179.52 through to RG 179.55.  In RG 179.53 it says,

"In addition, in considering whether to grant an authorisation to issue a financial product limited to MDA services, we will consider whether you have the capacity to provide the MDA efficiently, honestly and fairly, and in compliance with the requirements in ASIC Corporations (Managed Discretionary Account Services) Instrument 2016/968.

The general thrust seems to be that if an LMDA operator applies for authorisation to operate the same sort of service they do today their past experience operating under the no action position will be considered, but that there are still fundamental requirements around understanding all of the legal and compliance obligations, and investment and operational issues, relating to the products and services involved in providing a MDA service. 

What all this will ultimately mean when applications are considered by ASIC remains to be seen.  Our counsel to LMDA operators would be to not take granting of authorisation under ACI 2016/968 for granted.  i.e. If you intend to seek authorisation, seek it early so you know where you stand with sufficient time to take alternative action if your application is denied.

Are MDAs more or less attractive under revised regulation?

Our simple answer is that the updated regulation makes them relatively more attractive than before, not because of any material change to regulation, but because there is greater certainty around them from the clarity that ASIC has delivered.  This does not mean that MDAs are the right option for all business needs.  We have always liked the flexibility of the MDA regime and what ASIC has done is made it clear that this flexibility will be supported with tailored regulation.  Some of the strategies that MDA supports include:

• Running one managed account service over multiple platforms
• Having more say in how new services or technologies are integrated into your managed account service
• Having greater control over investment selection
• Outsourcing different elements of your managed account service to different service providers

For some businesses this will be attractive, while for others the benefits of registered schemes, such as the ability to be sold without advice and the greater clarity around the issue of regulatory capital, will make them the more attractive option.

Required authorisations to advise on MDAs

RG 179.209 notes that if a person makes recommendations or statements of opinion about investing in a MDA they will be providing financial product advice and must hold an appropriate authorisation, or be a representative of an AFS licensee with an appropriate authorisation, to give that advice.  As far as we can see, the regulatory guide does not spell out what that authorisation is.  At present a specific authorisation is required to give advice on MDAs.  We will be querying ASIC as to whether there is any change in this regard.

The Verdict

Overall, ASIC have done a good job with their review of regulation concerning MDAs.  Through their consultation with the industry they have developed a more detailed understanding of the level of innovation occurring around MDAs and have sought to support this by clarifying how regulation will be applied under various models.  They have even gone as far as tailoring the relief offered under different MDA structures along with the conditions of that relief.  They have taken a common sense approach to seeking consistency between the approach taken in registered and unregistered schemes and have been transparent in their reasoning.  Further, they have published a paper summarising the feedback they received in relation to Consultation Paper 200 and have provided some insight on why they elected to embrace or ignore the suggestions received.  Having read the documents, the residual feeling is that ASIC has a far more confident understanding of the MDA market, has listened carefully and has acted from a clear set of principles.  In our view ASIC deserves significant credit for this. 

While our overall views are positive, there are one or two issues that we will seek clarity on from ASIC in the coming weeks.  In addition, experience tells us that further issues will emerge as licensees ready themselves to be compliant with ACI 2016/968.  There is nothing like the process of turning theoretical obligation into practical execution for driving out further “wrinkles”!

What should practitioners do?

For LMDA users

LMDA users have 2 years to fully execute their transition to a new solution.  This seems a generous timeframe, particularly when put alongside the 12 months given to full MDA providers to comply with ACI 2016/968.  However, there are good reasons why LMDA users should start work on their transition now. 

If the transition is to be successful, and risks are to be managed appropriately, there is a great deal to do.  Briefly, LMDA users need to:

• Understand and assess their options for transitioning away from LMDA for discretionary client account management which include:
  • Becoming authorised as an MDA provider
  • Becoming an external MDA adviser to an MDA provider
  • Becoming licensed to a dealer who is an MDA provider
  • Setting up a private label managed account service offered as a registered scheme
  • Using a standard managed account service offered as a registered scheme
  • Setting up your own range of unit trusts
• Potentially make an application for MDA provider authorisation and do so early enough to still have time to take alternative steps if authorisation is denied (this is a material risk)
• Review vendors of relevant services, be they platforms, administrators, custodians, MDA providers, responsible entities as relevant
• Design their new managed account service within the confines of the managed account execution method chosen
• Set up new procedures and documentation for new services
• Make adjustments to practice management systems where needed
• Undergo due diligence concerning your investment management processes as relevant
• Train staff
• Promote the updated service and execute with each and every investor

Ideally, all this should take place in the context of a review of your strategy.  Making changes to your managed account service is a significant change to your business and if you want that to get the very best outcomes possible for you and your clients, it is worth taking the time to ensure that your goals are clear so that your updated service is a true reflection of where you are going rather than where you have been. 

The sorts of questions a strategic review should examine include:

• What are the key competencies of my business and what are my competitive strengths?
• How do I create value for my clients? Does it align to their needs?
• What is my value proposition to investors and is it consistent with my core skills and the ways I create value?  Is it sustainable?
• What can be done to enhance value delivery and the overall service experience for my clients?
• Am I happy with how operational and compliance risk is managed within my practice?
• Am I outsourcing the right things and if not, what are the implications and options?
• Is my pricing strategy / fee structure appropriate?
• Am I maximising the value of my practice?

Addressing these issues should ensure that you transition to a managed account solution that will serve you well for many years to come.

Once the workload associated with the above tasks is considered, and remembering that you must be fully transitioned by 1 October 2018, 2 years is not long. 

LMDA users that require expert assistance with any or all elements of their transition are invited to contact Brett Sanders of Philo Consulting for a no obligation discussion using the contact details found here.

For full MDA operators

Existing MDA operators are no doubt relieved that they are not confronted with regulatory capital requirements, but there is still much detail to be managed.  One of the challenges of ACI 2016/968 and the revised RG 179 is that it is not always clear what is a new requirement, versus what is a clarification that may require action, versus what is simply just a new way of saying the same thing.  As mentioned above, it is usually only when you get to implementation of new requirements that the full implications of seemingly innocuous statements become clear or the statement that at first blush seemed clear starts to reveal ambiguity.  That pleasure awaits us all! 

MDA operators will now need to carry out a thorough audit of their key documents and processes.  The list of documents should include, as a minimum, the following:

• FSG
• Investment program templates
• MDA contract
• SOA template
• Operational and compliance procedures, including approach taken to:
• On boarding new clients
• Fee disclosure statements
• Annual investor statement and audit report, including understanding how your auditor has interpreted the new regulations as this will influence their controls audit in 2018
• Annual review of the MDA contract and investment program
• Advice policy manual
• Compliance policies / manual
• Staff training materials

For some, the clarifications provided via RG 179 may give rise to a review of the structure of their MDA service.  For example, whether to use external administration support or an external MDA custodian.  Others may go further and possibly outsource MDA services and simply operate as an MDA adviser themselves.  

The impact of these new changes from a client’s perspective is likely to be modest for businesses that retain their current service structure.  If however the MDA provider does decide to change the structure of their service, then the lead time to implement this change will be greater and it may be easier to bring their existing service to compliance first and then introduce changes to their service structure after that. 

For those yet to decide on their managed account offering

Organisations that want to offer their clients managed account services but are yet to do so effectively have the same options available as those listed above for LMDA users.  Deciding which option will suit your business and clients best is a key task that should be tackled in a structured fashion.  Given you do not currently offer an MDA service there is not a regulatory deadline to meet – you just need to ensure your managed account service, in whatever form you ultimately choose, is compliant from the day you launch it.

Our general advice regarding the design of your managed account service is to start with the needs of your customer base and the strengths and weaknesses of your business and work back from there.  Getting clarity on the services you would like to provide and what elements of the service you would like to have in house is important.  This will make it so much easier to assess the service providers than may be able to assist you.

The decisions made around the design of your managed work service are some of the biggest decisions a financial planning firm will make and will be lived with for years to come.  If you require expert assistance with this undertaking please do not hesitate to contact Brett Sanders of Philo Consulting using the contact information found here. 

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Disclaimer:  This document has been prepared by Philo Consulting and is confidential and must not be copied, either in whole or in part, or distributed to any other person without our written consent. The information in this document does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information recipients should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any commercial or financial investment decision. To the extent permitted by law, neither Philo Consulting nor any of its related parties accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this document. Philo Consulting is not a law firm and that the author of this article is not a lawyer. Nothing in this article is legal advice and you should confer with a qualified lawyer before acting or relying on this article.