Discussion paper - Class exemption for Unit Trusts and Superannuation Schemes [1999] NZSecCom 4 (24 November 1999)

Last Updated: 2 November 2014

Discussion Paper - Class Exemption for Unit Trusts and Superanuation Schemes

24 November 1999

We have received an application from a funds manager for an exemption from section 37A(A)(1)(c)(i) of the Securities Act 1978 relating to the use of directors' certificates to "refresh" its unit trusts and superannuation scheme prospectuses. The application was subsequently extended to an application for a class exemption for unit trusts and superannuation schemes, according to the applicant, to meet the Commission's preference to receive applications for exemptions on a generic or class basis.

We have prepared a discussion paper on the matter. The paper is written in the context of the particular application.

We are interested in receiving feedback and views from you, in particular, on the questions that are raised in the paper. We also welcome any other general comments.

We would appreciate if you could send your responses in to us by no later than Monday morning 20 December 1999.

Euan Abernethy
Chairman

24 November 1999

DISCUSSION PAPER - CLASS EXEMPTION FOR UNIT TRUSTS AND SUPERANNUATION SCHEMES

Introduction

1. The Commission has received an application from a funds manager for an exemption from section 37A(1A)(c)(i) of the Securities Act 1978.
2. Section 37A(1)(c) of the Securities Act 1978 limits the life of a registered prospectus to nine months from the date of the statement of financial position contained, or referred to, in the prospectus.
3. A unit trust or a superannuation scheme manager may extend the life of the prospectus by delivering to the Registrar of Companies a directors' certificate in the form prescribed in section 37A(1A)(c)(i) of the Act. This requires the issuer to state that, in the opinion of the directors of the issuer after due enquiry by them, the financial position shown in the statement of financial position contained or referred to in the prospectus has not "materially and adversely changed" during the period from the date of the statement of financial position to the date of the certificate.
4. If the issuer is unable to give a certificate as described in paragraph 3 above, then it must prepare and register a new prospectus that contains financial statements and interim financial statements.
5. The applicant, a funds manager, wants to use the refresher certificate procedure to extend the life of its prospectus in respect of unit trusts and superannuation schemes, rather than registering a new prospectus containing interim financial statements, in circumstances where the financial position shown in the statement of financial position referred to in the prospectus has materially and adversely changed as a result, but only as a result, of either:
   1. "fluctuation in the market price" of assets of the funds administered by the trust; or
   2. redemption of units.
6. The Commission is interested in receiving feedback and views from interested parties, in particular, about:
   1. the appropriateness of an exemption for unit trusts from section 37A(1A)(c)(i);
   2. the appropriateness of the terms and conditions that have been proposed; and
   100. any other relevant issues relating to the proposed exemptions.
7. The following discussion deals mainly with questions relating to unit trusts. However, the managers of superannuation schemes are also addressing similar questions. Respondents are asked to consider whether their views are equally applicable to the superannuation industry, or any part of it, and whether it is appropriate for an equivalent exemption to be extended to the industry.

Background

8. We are asked to exempt unit trusts and superannuation schemes from section 37A(1A)(c)(i) in circumstances where the financial position shown in the statement of financial position referred to in the prospectus has materially and adversely changed as a result of "fluctuation in the market price" of assets or the redemption of units. The exemptions, the applicant proposes, would be subject to certain conditions and additional disclosures and assurances to be given in the directors' certificate.
9. The applicant contends that its unit trusts and superannuation schemes face a practical problem with respect to complying with section 37A(1A)(c)(i). The applicant's unit trusts and superannuation schemes invest in a number of funds. Each fund, in turn, invests in a number of asset classes, structured to meet the different needs and preferences of its investors. The funds are not separate unit trusts but are stated to be different classes of units within a particular unit trust/scheme. Investors invest in units of the funds. While it is intended that unitholders will only share in the profits and losses of the fund(s) in which they invest, the assets of any of the funds are available to meet the liabilities (including contingent liabilities) of another fund in the event that the assets of the other fund is unable to meet its liabilities (including contingent liabilities). In addition, the trustee is able, subject to the law, to allocate tax liability between the funds in a manner considered equitable. The applicant produces annual financial statements for each of its funds and for each of its unit trusts/superannuation schemes.
10. It appears that the structure of the applicant's trusts/schemes means that where the financial position of only one of the funds has materially and adversely changed, then the financial statements of each trust/scheme that invests in the affected fund would need to be updated. This is in addition to updating the financial statements of each affected fund within the trust/scheme. Presumably, because some investors may have limited their investment to the funds which have suffered a material adverse change in financial position, financial statements at the fund level would need to be issued even if the aggregate position of the trust/scheme may not, as a whole, have materially and adversely changed. It is, however, not clear to us what the legal obligations of the applicant manager are in relation to publishing the financial statements of the funds given that the liabilities of the funds do not appear to be limited to its particular group of assets, that is, they do not appear to be "separate funds" in accordance with section 9A of the Financial Reporting Act 1993. It is considered by the applicant that the additional costs incurred in preparing the interim financial statements do not justify the benefits to be derived from them.
11. We think that the structure described above may not be typical in the industry. In deciding whether the exemption should be granted, consideration will need to be extended to structures where each fund is a separate unit trust or scheme. For this purpose, it would be useful for respondents to consider, in making their comments, whether the exemption and the proposed terms and conditions are applicable to both types of structures.

Discussion

12. The policy of the law is that, where the financial position of an issuer has materially and adversely changed from that reflected in the statement of financial position contained or referred to in the prospectus, the refresher certificate procedure is not available to extend the life of the prospectus. Instead, a new prospectus has to be issued to contain updated information, in particular, interim financial statements.
13. The following reasons have been put forward why a unit trust should be allowed to use the refresher certificate procedure to extend the life of the prospectus despite there being a material and adverse change in the financial position of the trust as described above:
    1. unit trusts with readily marketable assets issue daily unit prices for their funds/trusts that are more up-to-date and relevant to investors than the information in historical interim financial statements;
    2. notwithstanding that most unit trusts are actively managed, they are similar to group investment index funds (GIIFs) in that their assets are invested in accordance with set objectives and policies, allocated among diversified investments in accordance with set guidelines and "do not rely on market timing for results";
    100. where the financial position of a fund/trust materially and adversely changes immediately prior to the expiry of the life of a prospectus, there may not be sufficient time for the necessary interim financial statements to be prepared; and
    4. investors will bear the cost of preparing and publishing interim financial statements and renewing the prospectus so that the interims are contained in the prospectus as required by the law.
14. The circumstances in which of any proposed exemption from the section would apply include:
    1. investors have readily exercisable rights to redeem their units in the funds/trusts;
    2. the redemption rights are not currently suspended;
    100. there are no redemptions currently outstanding;
    4. in the view of the directors of the manager or trustee, the funds/trusts involved have no solvency problems; and
    5. unit prices are publicly available, at least weekly.

Unit prices versus interim financial statements

15. The assumption of the law is that interim financial statements provide useful information to new investors, particularly where there has been a material and adverse change in the financial position as shown in the statement of financial position that is contained or referred to in the prospectus.
16. We understand that the unit trusts to which the exemption is intended to apply calculate daily unit prices for their funds/trusts. These are available by telephone to investors and are published at least weekly in the major newspapers. It is contended that these daily unit prices are more current and relevant to investors and are easier to understand than the information in historical interim financial statements. We are informed that, in general, unit prices will reflect well the financial performance and change in the value of the assets and liabilities of the funds/trusts. In calculating unit prices, we are informed, it is practical, and usual, to use up-to-date market-determined valuations of assets and liabilities and, where necessary, up-to-date accrued or estimated operating performance data. In addition, interim financial statements are only accessible when investors request a copy of the prospectus.
17. The interim financial statements to be included in a prospectus are required to be prepared as if they required registration under the Financial Reporting Act 1993, except that they need not be audited. In the case of interim financial statements, assets must be revalued at the interim balance date (although this does not apply to superannuation schemes). Where valuations are done frequently and unit prices take into account updated independent valuations of its assets, it is argued that the unit price provides investors with more useful and more up-to-date information.
18. Daily unit prices are calculated for the redemption or repurchase of units. They may take into account transaction costs, where applicable. In that case, the transaction costs, even if fixed and disclosed, will, depending on their size, affect the extent to which unit prices reflect the net asset position of the funds/trusts. The purchase prices will be enhanced by the addition of the entry costs while the redemption prices will be depressed by the deduction of exit costs. In addition, unit prices, in reflecting a net position of a fund/trust, do not reflect the size of the assets or of the liabilities of the fund/trust as a whole. Daily unit prices will also not reflect the proportion or types of assets and liabilities of the fund/trust. 19. While the trust deeds of unit trusts will set out the necessary formula or procedure for calculating the daily unit prices of the funds/trusts, the pricing practices and procedures for each of the fund/trust managers are likely to be different. By comparison, there is a commonality between unit trusts in the need to prepare financial statements under the Financial Reporting Act 1993 and in the standards to be observed. In addition, investors in active funds/trusts are likely to be interested in realised gains and losses, which are disclosed in financial statements. (It should be noted here that GAAP does not require superannuation schemes to disclose realised gains and losses separate from unrealised gains and losses.) These give a measure of the performance of the fund/trust and of its managers.
19. Most funds/trusts hold some level of liabilities. These may include:
    1. liabilities for unsettled purchases (which, we are informed could potentially be large depending on trade volumes);
    2. taxation liabilities (both current and deferred tax provisions);
    100. accrued expenses and fees;
    4. obligations under various derivative contracts;
    5. any short-term borrowing to provide fund liquidity.
20. We understand that these liabilities form part of the day-to-day operations of a fund/trust and, in most instances, are low, even though they may fluctuate from time to time. However, some trust deeds give the managers powers to borrow and some funds/trusts may have substantial liabilities. In such cases, even where the liabilities do not change, a change in the value of assets or a series of redemptions could materially adversely affect the financial position of the fund/trust.
21. The applicant proposes that the exemption apply in respect of material and adverse changes to the financial position as a result of:
    1. "fluctuation in the market prices" of the assets of the funds/trusts; and
    2. redemption of units in the funds/trusts.
22. From an investor's perspective, these are quite different reasons for the material and adverse change to the financial position of the fund/trust. They may also be triggered by different events or actions.
23. The unit price of a fund/trust is unlikely to indicate to the investor what caused the adverse and material change in the financial position of the fund/trust. In contrast, GAAP requires interim financial statements to include, among other things, explanations and descriptions of items of such incidence and size, or of such nature, to enable the items to be understood. It also requires a description of each material event that occurred post-interim balance date including, where possible, its financial effect.
24. A material and adverse change in the financial position of an actively managed fund resulting from the fluctuation in the market prices of the assets of the funds may be due to:
    1. changes in market prices of all assets resulting from a general national and/or international downturn in all sectors; or
    2. changes in the prices of sectoral assets of the fund/trust resulting from a downturn in the particular sector; or
    100. changes in the prices of specific assets of the fund/trust; or
    4. poor investment decisions by the manager of the fund/trust.
25. Where redemptions are concerned, investors may redeem their investments for different reasons. A material and adverse change in the financial position of an actively managed fund as a result of redemptions, in the absence of other changes affecting its financial position, may not necessarily mean that the investment in the fund is undesirable or that the performance of the managers is in question. Also, for redemptions to affect the financial position of a fund/trust, they would have to be substantial. Moreover, most trusts have rights to suspend redemptions in the interests of all investors in a fund/trust. These, in themselves, may be material events that require disclosure.
26. Where the financial position of a unit trust or an individual fund within a trust has materially and adversely changed, are there circumstances in which daily unit prices of each fund/unit trust are a good substitute for interim financial statements of the individual fund or unit trust?
27. Is it material to your answer that there is no prescribed industry standard on the calculation of unit prices?
28. What is meant by "fluctuation in the market prices" of the assets?
29. Is it desirable for any exemption from section 37A(1A)(c)(i) to be available in respect of material and adverse changes to the financial position of a fund/unit trust as a result of either "fluctuation in the market prices" of the assets of the funds/trust or redemption of units invested in the funds/trusts?

Similar to GIIFs?

30. Notwithstanding that most unit trusts are actively managed, it is argued that they are similar to GIIFs in that their funds are invested in accordance with set objectives and policies, allocated among diversified investments in accordance with set guidelines and "do not rely on market timing for results".
31. The Commission has approved an equivalent form of exemption in the case of certain group index funds. Clause 4 of the Securities Act (Group Investment Index Funds) Exemption Notice 1997 provides an exemption so that the refresher certificate is available where the financial position has not materially and adversely changed, "other than as a result of fluctuation in the market price of assets of the fund or the redemption of securities".
32. The policy basis for the exemption is that the assets of these funds are determined by reference to an index and the primary purpose of these funds is to passively track the index. Its managers do not purport to actively manage the GIIF in order to outperform the index. Therefore, the concept of "fluctuation in the market price" of assets is understandable and a decline in the prices of its assets (resulting from a decline in the share prices of the companies that make up the index) is secondary to the aim of tracking the index and does not represent a failure of the investment. In fact, its success is measured largely by its ability to track the index, notwithstanding that its overall financial position may be affected adversely by any decline in the prices of the assets. In any event, as group investment index funds are participatory securities for the purposes of the Act, section 37A(1A)(d) requires 6 monthly interim financial statements to accompany the refresher certificate (except that they need not be audited) and this requirement has not been modified by the 1997 Notice.
33. Unlike the group investment index fund managers, unit trust managers normally actively manage the funds/trusts, notwithstanding that they may invest in accordance with set guidelines and policies. While passive funds may not rely on "market timing" for results, "market timing" may affect the decisions of actively managed unit trusts, for example, their hold or sell decisions.
34. In addition, unit trust managers invariably market their abilities and skills. The aim is to persuade investors to invest in particular funds/trusts in the belief that the manager is able to outperform the market or other similar investments. It would seem that any deterioration in the financial position of an actively managed fund/trust as a result of the fluctuation in the market price of assets of the fund/trust or the redemption of securities would be crucial to investors as a means of judging the performance and ability of the manager. To waive the obligation to report on the fluctuation in the market price of assets of the fund/trust or the redemption of securities may be construed as downplaying the need for the manager to be accountable for its investment decisions. Without the information, it may be difficult for investors to understand the reasons for the decline in the price of the units and compare it with the performance of other funds/trusts or other similar investments.
35. The applicant contends that whilst a single unit price may not be a good source of information for judging the performance of an actively managed fund, the historical performance of the unit price will provide that information. It proposes that the directors' certificate provides not only the current unit price but also a historical statement of unit prices so that investors can track price movements and trends over the period since the last audited financial statements.
36. Do you agree that a unit trust, by investing in accordance with set guidelines and policies, is similar to a GIIF?
37. Do you agree that daily unit prices (whether current and/or historical) are a good means for judging the performance of an actively managed fund/trust and its managers?

Time available to prepare interims

38. The policy of the law is that interim financial statements are important in disclosing the financial position, performance and cash flows of an issuer, particularly where the financial position has materially and adversely changed.
39. It is contended that where the financial position of the fund/trust materially and adversely changes immediately prior to the expiry of the life of a prospectus, there may not be sufficient time for the necessary interim financial statements to be prepared. A difficulty may arise where, in the period leading up to the "refreshment" date, there is good reason to believe that the fund/trust can renew a prospectus by completing a section 37A(1A) certificate and there is no need to incur the expense of preparing updated interim financial statements. However, if the financial position changes significantly prior to the certificate being signed, the manager will be unable to complete a certificate. There may not be enough time to prepare updated financial statements before the prospectus expires and the fund/trust will not be able to be offered until they are completed. It is considered that, to avoid this situation, a fund/trust will need to prepare interim financial statements prior to every renewal date regardless of whether the financial position has materially and adversely changed. That is, a fund/trust will incur the cost of preparing interims even if it uses the refresher certificate procedure. We are informed that while most unit trusts' internal systems are set up to calculate daily unit prices, the systems are not set up to extend this into the preparation of external financial statements.
40. In the case of equity, debt and participatory securities, the directors' refresher certificate is required to be accompanied by interim financial statements even where the financial position has not materially and adversely changed. As such, issuers of these securities have certainty in the requirement to prepare interims. This requirement is clearly different from that applying to interests in unit trusts, superannuation schemes and life insurance policies. This difference will be reviewed in the course of the present review of the Securities Regulations.
41. In addition, we understand that not many investors request a copy of the relevant prospectus. Investors may also not read or understand the financial information. It is contended that the costs related to the preparation of interims will not be money well-spent and will ultimately be passed on to investors.
42. It could be argued that a sudden and unexpected fall in market prices (whether resulting from a general or sectoral downturn or from a decline in the price of specific assets) or a request for redemption of a size and nature that is capable of affecting the financial position of a fund/trust in a material and adverse manner are not common occurrences. If such an event occurs and affects the ability of a fund/trust to prepare interims in time for inclusion in a prospectus, might it be preferable to consider the matter at the time the event arises, for example, for the Commission to grant a temporary exemption, rather than to grant an exemption relieving a trust or a class of trusts from the obligation to include interims, whether or not there is sufficient time to prepare and include such interims?
43. Alternatively, it may be practical for the exemption as requested to be granted on the additional condition that interim financial statements be available on request to investors within one month of the signing of the refresher certificate and for the interims to be lodged with the Registrar of Companies. This would be in keeping with the policy of the law about interim financial statements. It would also help to overcome any timing problem faced by the managers of funds/trusts in cases where there was a sudden and unexpected change to the financial position of the fund/trust immediately prior to the signing of the refresher certificate.
44. Do you consider that, where there is a sudden and unexpected fall in market prices or a request for redemption that affect the fund/trust in a material and adverse way, it would be impractical to prepare interims in time for inclusion in a prospectus? Would it help if the Commission considered such matters on an individual basis as they arise on the basis of a clear predetermined policy?
45. Alternatively, if the exemption as requested was granted, should it be subject to the additional condition that interim financial statements be available on request to investors within one month of the signing of the refresher certificate and that the interims be lodged with the Registrar of Companies?

Inclusion of interims in prospectuses

46. Section 37A(1)(c)(i) makes provision for a prospectus to contain or refer to a statement of financial position or interim statement of financial position in accordance with Regulations. Clause 16(1) of Schedule 3A (applying to unit trusts) requires a reference to the latest financial statements of the unit trust registered under the Financial Reporting Act 1993 (but not the interims). Clause 16(3) allows for financial statements including interims to be included in a prospectus but imposes no obligation to do this. It appears that the Act, in particular, section 37A(1)(c)(i) may have intended to allow for a reference in a prospectus to interim financial statements "in accordance with regulations" but the Securities Regulations make no provision for this. It seems then that the only option open to the applicant, if it is unable to give a section 37A(1A)(c) certificate, is to register a new prospectus containing interim financial statements. An exemption will be necessary if this obligation is to be avoided.
47. However, section 37A(1)(b) provides that no allotment of a security offered to the public for subscription shall be made if, at the time of the allotment, the registered prospectus is known to be false or misleading in a material particular by reason of failing to refer, or give proper emphasis, to adverse circumstances. There are equivalent provisions applying to the investment statement. There is no suggestion that we grant an exemption from these provisions. Indeed it is doubtful that we could do so in isolation as they are offence provisions rather than compliance provisions. The manager would need to be satisfied, even if the Commission granted an exemption from section 37A(1A)(c)(i), that it was not in breach of section 37A(1)(b), that is, that the prospectus and the investment statement were not false or misleading .
48. Can a distinction be drawn in practice between the circumstances in which section 37A(1A)(c)(i) applies and the circumstances in which section 37A(1)(b) applies?
49. Is it desirable, even after allowing for section 37A(1)(b), to grant an exemption from section 37A(1A)(c)(i)?

Circumstances in which exemption would apply

50. It is assumed that if an exemption was to be given, it would apply only if:
    1. investors have readily exercisable rights to redeem their units in the funds;
    2. the redemption rights are not currently suspended;
    100. there are no redemptions currently outstanding;
    4. the funds involved have no solvency problems; and
    5. unit prices are publicly available, at least weekly.
51. It is considered that for an exemption to apply, investors should have rights of redemption of their units at the quoted daily price. In addition, at the time of taking advantage of the exemption, such rights should not be suspended and the fund should not have redemptions outstanding.
52. There should also be no solvency issues arising, in particular, that the material and adverse changes in financial position of the fund/trust would not affect the solvency of the trust. These conditions would be applicable through all the levels of funds and where there are inter-fund investments.
53. The Regulations appear to give some recognition to the argument that, in the case of unit trusts, life policies and superannuation schemes, a relevant assessment for determining the financial position of these entities is an assessment of the scheme's assets relative to its liabilities and its ability to pay debts as they fall due. The statement by the directors of the manager in the prospectus covering the period between the balance date of the latest financial statements referred to in the prospectus and the date delivered to the Registrar for registration requires "a statement as to whether-
    1. The value of the unit trust's assets relative to its liabilities (including contingent liabilities); and
    2. The ability of the unit trust to pay its debts as they become due in the ordinary course of business-

has materially and adversely changed."

54. Do you agree that these are the circumstances in which the exemption might apply? Are there other circumstances that should be included?
55. Do you consider that it may be desirable for a similar solvency statement to be used in relation to the refresher certificates?

Proposed terms and conditions

56. If an exemption is granted from section 37A(1A)(c)(i) of the Act, the applicant proposes that the directors' certificate includes the following:
    1. information about the performance of the fund/trust since the date of the statement of financial position contained or referred to in the prospectus, that is, a historical statement of the changes in unit price over the period since the last registered financial statements;
    2. the size of the fund/trust;
    100. up-to-date unit prices;
    4. a statement that the daily unit prices are determined in accordance with the trust deed and, directly or indirectly, by reference to valuations that do not exceed:
       1. listed or independently determined market prices of the assets of the funds/trust; and/or
       2. valuation by an appropriately qualified independent valuer;
    5. an explanation of the method of calculation of the unit price; and
    6. a statement by directors that the liabilities of the funds/trusts have not, to the best of their knowledge, materially increased above the levels shown in the previous registered audited financial statements.
57. A draft of a possible directors' certificate as proposed by the applicant is attached.
58. A question also arises as to which point in the offer should the directors' certificate be brought to the attention of new investors. The investor must be aware that the financial position of the fund/unit trust has materially and adversely changed and that there is a refresher directors' certificate available setting out the additional information.
59. Do you agree with the proposed additional disclosures in the directors' statement:
    1. size of the fund/trust in the form of the value of its assets and liabilities?
    2. dates and frequency of the valuation of the assets and liabilities and how they are determined?
    100. performance of the funds/trusts, specifying the type of information that should be disclosed?
    4. formula/procedure for calculating daily unit prices?
    5. a statement by directors about the fund's/trust's liabilities?
    6. types of assets and the fund's/trust's proportion or percentage investment in them?
    7. a statement of changes in units?
    8. other (specify)?
60. How should the refresher directors' certificate be brought to the attention of new investors?

Superannuation schemes

61. If the Commission decided to grant an exemption for unit trusts, it will proceed to consider whether there should be an equivalent notice for superannuation schemes. There may be special considerations applying to superannuation schemes and the circumstances in which unit prices are published may need to be carefully considered. The Commission is interested in receiving comments about this and about the utility of an exemption for superannuation schemes subject to the type of conditions referred to above for unit trusts, for example, the timing of redemptions and the marketability of the interests in the superannuation schemes.
62. Do you agree that the issues facing unit trusts with regard to compliance with section 37A(1A)(c)(i) of the Act are also applicable to some/all superannuation schemes? Specify.
63. Is it desirable that an equivalent exemption be extended to superannuation schemes? If not, state your reasons.
64. Are there other issues/circumstances unique to superannuation schemes that would require special or different conditions or pre-conditions to be imposed? If so, specify.