Five issues to consider when converting wholesale funds to retail funds

Any engagement with ASIC about the licensing regime is likely to be the most costly and time-consuming work item in a conversion of a wholesale scheme to a retail (registered) scheme. An application to obtain an Australian Financial Services Licence (AFSL) to act as a RE of registered schemes, or even to vary an existing AFSL so that a trustee of unregistered schemes can act as a RE of registered schemes, is likely to be a significant project. The applicant will need to demonstrate to ASIC that it has the necessary resources to operate registered schemes, including nominating responsible managers who have adequate knowledge and skills in managing registered schemes. There will also be additional considerations relating to holding of regulatory capital (in the form of net tangible assets), maintaining adequate professional indemnity insurance, and composition of a compliance committee that meets the requirements of Chapter 5C of the Corporations Act.

A simpler (and certainly faster) option may be to come to an arrangement with a professional provider of trustee services. There are several providers for whom acting as RE of a registered scheme is part of their core business, so they are set up to manage the engagement with ASIC and have processes in place to engage with service providers and prepare disclosure materials. Subject to appropriate due diligence, they are generally comfortable appointing a third party ‘sponsor’ of the fund as the manager of the scheme under an Investment Management Agreement or similar management agreement. They may also be willing to appoint the manager as their corporate authorised representative for the purpose of the manager giving any general advice about the scheme or to deal in the assets of the scheme. Coming to an arrangement with a ‘trustee for hire’ can allow a wholesale trust to be converted to a registered scheme in a more cost-effective way.

It is not unusual to see terms in the trust deed for an unregistered scheme that will facilitate the scheme’s registration and ensure that it is in ‘registrable form’ when it is lodged with ASIC. If those provisions are not already contained in the trust deed, significant amendments may need to be made to the trust deed. If the amendment power in the trust deed provides for the trustee to make such amendments as are necessary for the scheme to be registered, any such amendments should be consistent with the trustee’s power to amend the trust deed. However, if the amendment power is not so permissive, the trustee would need to consider carefully whether it could make the necessary amendments unilaterally, or whether the amendments ought to be approved by the members at a properly constituted meeting.  

We strongly recommend tax and stamp duty advice be sought as to whether there could be any adverse consequences from the making of any necessary amendments, irrespective of whether they are consistent with the existing amendments powers in the trust deed, or the amendments are approved by members. There have been recent decisions relating to land-holding trusts that suggest that any changes to the structure of the trust or trustee that are other than trivial should be closely considered from a stamp duty perspective. In any event, if a third-party entity is going to act as RE of the trust once it is registered, lodgements with revenue authorities upon the change of legal ownership of the fund assets may be required, so advice should be taken on these matters.

Even though the trust deed for the trust might confer powers on the trustee to convert the unregistered trust to a registered scheme, the disclosure made to investors over time should be reviewed to ensure the trustee or manager has not represented to investors that the fund would only ever be offered to wholesale investors. This can raise complex legal issues as to whether a valid exercise of powers by the trustee under the trust deed could nevertheless expose the trustee to claims of misleading and deceptive conduct, with any subsequent loss in the value of the assets following the conversion to a registered scheme exposing the trustee (or RE) to claims from aggrieved investors. 

This issue is particularly important for illiquid funds, or funds where the assets may have to be sold at a discount to their book value to fund redemptions, as offering the existing wholesale investors the opportunity to redeem their interests upon the conversion of the fund to a retail fund is a potential risk mitigation strategy. 

In our experience, many trustees and managers underestimate the amount of work required to convert the disclosure in the Information Memorandum for a wholesale trust into a form that will result in the Product Disclosure Statement (PDS) for the fund being compliant with retail product disclosure requirements. This is understandable, given fund sponsors often choose to not enter the retail fund market because of the requirement to provide granular disclosure about fees and costs under the prescribed (and often confusing) requirements in Schedule 10 of the Corporations Regulations and ASIC’s Regulatory Guide 97. 

However, fees and costs is just one aspect of retail product disclosure: there may be other mandated disclosure that is required in the PDS for the fund, particularly if it is a mortgage fund (with benchmark and mandated disclosure principles required under ASIC’s Regulatory Guide 45), or if the fund meets ASIC’s definition of a hedge fund (in which case the benchmarks and disclosure principles in ASIC Regulatory Guide 240 will apply). This can require compiling and examining data that the trustee and manager either haven’t had access to, or haven’t had to consider too closely, when the fund was not registered. This data might need to be ‘backfilled’ with policies and procedures that allow it to be updated and verified as part of the fund’s ongoing disclosure obligations.

Conversion of an unregistered scheme to a retail fund will bring products issued from the fund within the design and distribution (DDO) framework in Part 7.8A of the Corporations Act. Among other product design and governance obligations, the DDO framework requires issuers of products to make a ‘target market determination’ (TMD) for the product that describes the ‘class’ of retail clients comprising the target market for the product. Converting an unregistered wholesale scheme to a registered retail scheme suggests there has been some change to the demographic the fund was designed for since its inception.   The fund trustee (and fund sponsor, if different to the trustee) must therefore prepare and issue a TMD that (at least) includes a description of the likely objectives, financial situation and needs of consumers in the target market, a description of the product, including its key attributes, and an explanation of why the product, including its key attributes, is likely to be consistent with the likely objectives, financial situation and needs of consumers in the target market.  

As the product distribution conduct obligations that underpin the DDO regime only apply to distribution of the product to retail clients, ongoing dealing in the product to the existing wholesale clients in the fund should not cause the fund trustee to breach its obligation under DDO to take reasonable steps to ensure any retail product distribution conduct is consistent with its TMD. However, it is clearly desirable for the key attributes of the product, and the likely objectives, financial situation and needs of consumers in the ‘target market’ for the product, to be the same whether the consumer is an existing wholesale member of the fund or a new retail customer. The drafting of the TMD should therefore try to reconcile the way these issues are communicated to the old and new cohorts of fund members.