KEY TAKE OUTS
- Product issuers need to focus on how current information about indirect costs is being captured and may need to be disclosed in light of the updated ASIC guidance and Class Order.
- There remains complexity with regard to the treatment of some of the core concepts which underpin the requirements around indirect costs.
- Issuers will therefore need to work through the remaining complexities (individually and collectively) to settle an approach that is compliant.
The industry is assessing how to implement ASIC’s revised guidance and Class Order in relation to fee and cost disclosure requirements. The clarifications to these requirements were the subject of broad consultation and engagement for a significant period of time and while a number of the key concepts and complexities have been clarified in the revised guidance, a number of fundamental issues remain which will need to be worked through.
In December 2014, ASIC released the first incarnation of Class Order 14/1252. The Class Order at that time was intended to address issues arising from an inconsistent approach to the fee and cost disclosure obligations in PDS’s and periodic statements for managed investment and superannuation products.
These issues had been earlier highlighted in ASIC’s 2014 report into fee and cost disclosure practices (Report 398). In that report ASIC identified specific issues concerning variations and under-disclosure of fees and costs, particularly in relation to underlying investment vehicles, performance fee reporting and incorrect treatment of management costs as transaction costs.
At the time of the release of Class Order 14/1252, ASIC also announced its review of Regulatory Guide 97: ‘Disclosing fees and costs in PDS’s and periodic statements’ to reflect the effect of the Stronger Super reforms and the Class Order.
During the course of industry engagement, ASIC broadened the consultation to accommodate submissions on refinements to the Class Order to address key issues and comments raised by the industry. This process culminated in the release of the updated RG 97 and amendments being made to the Class Order in November 2015.
Working back from 1 February 2017 as the hard start date for the updated requirements, product issuers now need to focus on how information about indirect costs is being captured and may need to be disclosed.
ASIC’s stated objective in updating RG 97 and the Class Order was to provide guidance and clarify existing requirements and not to create new policy or materially change disclosure obligations. However, the broad impact of the updates and the technical nature of the new commentary has in practice raised a variety of issues to consider from a compliance perspective.
The Class Order adopts definitions which are complex and challenging to navigate. However, among those definitions are a few core concepts which, once understood, provide a basis on which to implement the requirements. Those core concepts are:
- Indirect costs. Indirect costs must be calculated and disclosed for superannuation products and managed investment products. For superannuation products, the indirect costs are disclosed separately. For managed investment products, indirect costs are disclosed as part of management costs.
For these purposes, an ‘indirect cost’ is any amount that the issuer knows, reasonably ought to know or, where this is not the case, may reasonably estimate will directly or indirectly reduce the return on the product or option that is paid from, or the amount or value of, the income or property attributable to:
- The product or option; or
- An ‘interposed vehicle’ in or through which the property attributable to the product or option is invested
Generally, the fees disclosed in the fees and costs template are the current ones and those intended to apply on an ongoing basis. However, except for new products, indirect costs should be calculated based on the indirect costs paid in the previous financial year.
This is relevant for both completing the fees and costs template and also the worked example in a PDS. For new products, the issuer will need to reasonably estimate the indirect costs that will apply for their current year, adjusted to reflect a 12-month period.
- Interposed vehicles. When calculating and disclosing indirect costs based on the above definition, issuers must therefore account for the costs of investing through an ‘interposed vehicle’. This includes where further investments are made by that vehicle through other interposed vehicles. The assessment as to whether an investment is made through an interposed vehicle is based on three main tests:
- A platforms test: in specified circumstances, if securities or interests in an entity are acquired through a platform, the entity is not treated as an interposed vehicle on the basis that they are selected by the investor.
- An assets test: an entity will be treated as an interposed vehicle if the issuer believes or has reasonable grounds to believe that the vehicle has more than 70% of its assets by value invested in relevant securities and financial products. In calculating the 70% threshold, certain financial products can be ignored: listed real estate and infrastructure entities; and financial products that confer control of another entity, unless the other entity has more than 70% by value of its assets invested in qualifying financial products.
- A PDS test: an entity will be treated as an interposed vehicle if, based on the PDS, it could reasonably be regarded as the means by which the benefit of investments by or through the entity is obtained, rather than the investment of the fund.
- Reasonable estimates. In determining indirect costs, issuers need to identify indirect costs which they know or ought to know, and reasonably estimate any indirect costs that are unknown when it is not reasonable to know the cost.
The challenges associated with estimating costs that are not known for these purposes were highlighted in industry submissions. This issue is particularly relevant where layers of interposed vehicles are involved and/or offshore managers are not compelled to provide cost information.
ASIC has clarified that in making a reasonable estimate of a cost, it will accept an estimate that the issuer believes is their best estimation, if the issuer has taken ‘reasonable steps’ to formulate it. Factors relevant in determining whether reasonable steps have been taken include the cost or effort involved in undertaking the investigation as well as the likelihood of the steps resulting in a materially different result to what would otherwise have been estimated.
Importantly, for certain OTC derivatives and similar financial products, specific provisions apply if the indirect costs arising are not known, ought not to be known and cannot reasonably be estimated (see below).
- Treatment of OTC derivatives. OTC derivatives have been identified as means by which investment exposure can be obtained to other assets, in a similar manner to how interposed vehicles can be used. For this reason, ASIC’s updated guidance confirms that the costs of obtaining these exposures through OTC derivatives should be counted as management costs (for managed investments) or fees or costs (for superannuation products). For these purposes, exchange traded derivatives and derivatives used by registered schemes for hedging purposes are not included.
Other than for options, the costs of OTC derivatives are to be measured as the difference between the underlying return on the reference asset and the actual return that the issuer has received over the relevant period. For options, the cost for inclusion is the lower amount of the premium and the difference between the acquisition price and the price to dispose of the derivative financial product immediately after its acquisition.
Where the indirect costs arising are not known, ought not to be known and cannot reasonably be estimated (for OTC derivatives other than options) the issuer should use the greater of a minimum default amount of 0.1% p.a. of the value of the reference asset pro-rated over the relevant period and the minimum amount the issuer is reasonably able to estimate. In the case of options, the amount to be counted as indirect costs is capped at the amount of the premium.
In addition to the core concepts, the updated Regulatory Guide raises a variety of ancillary disclosure considerations. By way of example, whether the issuer needs to update costs disclosed in a PDS will depend on whether changes occur to the amounts known or reasonably estimated of the costs incurred during the previous financial year.
Where new information comes to light, the issuer will need to consider whether the PDS needs to be updated and, if so, by what method. ASIC’s updated regulatory guide acknowledges that the updating Class Order [CO 03/237] may be relied on for releasing updated costs information if the difference identified in the costs disclosed in the PDS is not materially adverse from the viewpoint of the investor. However, in practice issuers will need to consider carefully the extent to which the updating Class Order can be relied on in this context.
The updated Regulatory Guide and amended Class Order responded in various ways to industry’s concerns regarding the level of complexity around some of the core concepts which underpin indirect costs. This included graphics to demonstrate the approach to interposed vehicles and illustrative examples.
However, in Report 457: Response to submissions on draft RG 97 ASIC encouraged further work to be done by industry to develop a consistent approach to disclosure, including common standards.
While ASIC has signalled its willingness to continue its dialogue with the industry to help with implementation, this largely puts the ball in the court of issuers to work through the remaining complexities and (individually and collectively) settle an approach that is compliant.