Equitiloan Pty Ltd and Australian Securities and Investments Comm Ission
[2003] AATA 367
•24 April 2003
Administrative
Appeals
Tribunal
DECISION AND REASONS FOR DECISION [2003] AATA 367
ADMINISTRATIVE APPEALS TRIBUNAL )
) No Q2001/1178
GENERAL ADMINISTRATIVE DIVISION )
Re EQUITILOAN PTY LTD Applicant
And
AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION
Respondent
DECISION
Tribunal Mr B J McCabe, Member Date24 April 2003
PlaceBrisbane
Decision The Tribunal sets aside the decision under review and remits the matter to the respondent for reconsideration in accordance with the Tribunal’s reasons for decision. (Sgd) B J McCabe
Member
ADMINISTRATIVE APPEALS TRIBUNAL )
) No Q2001/1178
DIVISION
)
Re EQUITILOAN LIMITED Applicant
And
AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION
Respondent
ORDER TO AMEND DECISION
Tribunal Mr B J McCabe, Member Date15 September 2003
PlaceBrisbane
WHEREAS the Tribunal made a decision in this matter on 24 April 2003, and it has come to the Tribunal’s attention that there were errors in that decision;
AND WHEREAS the Tribunal wishes to amend the decision so as to rectify the errors with the least cost and inconvenience to the parties;
THE TRIBUNAL ORDERS, pursuant to section 43AA of the Administrative Appeals Tribunal Act 1975, that the name of the applicant on the front page of the decision be changed from "Equitiloan Pty Ltd" to "Equitiloan Limited".
(Sgd) B J McCabe
MEMBER
CATCHWORDS
CORPORATIONS LAW – securities and investments – regulation – managed investment scheme – proposal to offer differential rates of returns to investors and to give fund managers a discretion to waive withdrawal fees – whether proposal is in contravention of section 601FC of the Corporations Act 2001 – whether proposal results in creation of different “classes” of investors – whether investors must be treated equally
Corporations Act 2001 s 601FC
Re Lepine [1892] 1 Ch 210
Clements Marshall Consolidated Ltd v ENT Ltd (1988) 13 ACLR 90Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspaper and Printing Co Ltd [1987] Ch 1
Welton v Saffery [1897] AC 299
Lorenzi v Lorenzi Holdings Pty Ltd (1993) 12 ACSR 398REASONS FOR DECISION
24 April 2003 Mr B J McCabe, Member Introduction
1. Equitiloan Limited, the applicant, is the responsible entity for the Equitiloan Income Fund (“the Fund”). The Fund is a registered managed investment scheme regulated under the Corporations Act 2001 (“the Act”). The Australian Securities and Investments Commission (“ASIC”) is the responsible regulator, and the respondent to these proceedings. Equitiloan proposed introducing different classes of investment in the Fund so that it might offer different rates of return to different investors. Alternatively, Equitiloan proposed a differential return arrangement that allowed it to pay different investors a different rate without establishing a class system. Equitiloan also proposed that it have the discretion to impose or waive the imposition of a fee on an investor who made an early withdrawal of his or her investment.
2. The practices proposed by Equitiloan might constitute a technical breach of s 601FC of the Act. But s 601QA permits the regulator to grant exemptions from the provisions of Chapter 5C (which includes s 601FC) or declare that it operates in a particular way in relation to a person. Equitiloan approached the regulatory policy group within ASIC seeking formal policy acceptance of the proposals. That would lead to exercise of the discretion under s 601QA. ASIC rejected the application, and Equitiloan has appealed to the Tribunal.
The Material Before the Tribunal
3. The Tribunal was provided with the documents required under s 37 of the Administrative Appeals Tribunal Act 1975. That bundle includes the terms of the applicant’s original application to ASIC, correspondence between the applicant and the respondent, and the respondent’s reasons for decision. Mr Mark McIvor gave evidence on behalf of the applicant, and his statement was tendered in evidence. Mr McIvor is the managing director of Equitiloan (now Equititrust Ltd). The Tribunal also heard evidence from Mr Paul Vincent, a chartered accountant, and Dr John Fallon, an economist. Mr Vincent’s report was put into evidence. A bundle of prospectuses published by other funds was also put into evidence by the applicant. The respondent called Mr Ken Cooper, an accountant, and tendered his report.
4. The applicant was represented by Mr David Jackson, QC. The respondent was represented by Ms Elaine Ford.
The Facts
5. Equitiloan is a merchant bank based on the Gold Coast. It manages the Equitiloan Income Fund. The Fund takes money on deposit from individuals who acquire units in the Fund. The investment period is twelve months. Equitiloan makes loans out of the Fund that are secured by first mortgages over property. The loans are generally short-term loans, although Mr McIvor suggested in his oral evidence that longer-term loans to large property developers had some attraction because the money was usefully employed for a longer period. As the Fund got bigger, he said, there was a challenge to find appropriate destinations for its money. Mr McIvor said large property developers were attracted to the Fund because it had superior lending policies and was less bureaucratic than other financial institutions.
6. Mr McIvor explained in his statement that Equitiloan provides investors in the Fund with an interest warranty. Under the terms of the warranty, Equitiloan guarantees the investor will receive the interest rate offered at the time of their investment in the Fund for twelve months. If the Fund is unable to pay the agreed rate of return, Equitiloan is required to contribute money to enable the Fund to meet obligations to investors.
Equitiloan’s Investors
7. Mr McIvor said in his statement that many of the Fund’s investors were self-funded retirees who were attracted to the prospect of a fixed-income investment that offered a higher rate of return than the banks. Paragraph 20 of Mr McIvor’s statement sets out the investor profile:
“Amount Invested No of Investors Total of Funds Under
Management$10,000-$99,999 451 $ 16,320,023
$100,000-$249,999 179 $ 24,630,000
$250,000-$499,999 84 $ 28,610,000
$500,000 and over 55 $ 53,147,727
TOTAL 769 $122,707,750”
8. Mr McIvor said Equitiloan preferred larger investors because they made it easier to increase the size of funds under management. Ms Ford asked Mr McIvor in cross-examination whether he had considered imposing a higher minimum investment, but he said Equitiloan was reluctant to do that because it risked offending smaller investors. Mr McIvor’s evidence left me with the strong impression that Equitiloan’s attraction as an investment was at least partly attributable to the emphasis on maintaining strong personal relationships with the Fund’s investors.
Equitiloan’s Borrowers
9. The bulk of Equitiloan’s loans are made to property developers to fund development projects. Mr McIvor says at paragraph 53 of his affidavit that Equitiloan “tends to make project loans mainly in relation to residential development to experienced developers”. Mr McIvor says 59% of the loans (by value) are development loans.
10. While these loans must be more carefully assessed and monitored, Mr McIvor says developers tend to be more professional, borrow larger sums (which reduces transaction costs) and are prepared to pay higher interest rates. He said at paragraph 55 that “[t]hese types of loans are typically priced at 0.5-0.75% higher than smaller loans”.As a result, these loans tend to be more profitable than other kinds of loans made by Equitiloan, and it is therefore possible to achieve higher rates of return for all the investors.
11. Mr McIvor emphasised (at paragraph 47 of his statement) that Equitiloan could only participate in the lucrative “development lending market” if it had a “critical mass”. In other words, the Fund had to be of a sufficient size to provide the larger loans that developers require without unduly increasing its risk. A larger fund was also more likely to be liquid, he said (at paragraphs 62-63).
Equitiloan’s Costs
12. Equitiloan’s costs are recovered out of the Fund. Equitiloan is also entitled to keep any surplus of the Fund in a given year (that is, the amount that exceeds what is required to satisfy the obligations to investors) provided that amount does not exceed 5% per annum of the gross asset value or gross income of the Fund: see paragraph 30 of Mr McIvor’s statement. Paragraph 44 of Mr McIvor’s statement explains the interest rate warranty is calculated on the basis that Equitiloan’s administration costs and an appropriate margin for profit would be accounted for in advance. In other words, Equitiloan would not warrant that it would pay a larger return to investors than it anticipated being able to pay after providing for costs and profits.
13. Equitiloan’s administration fees and costs are explained in more detail in paragraphs 43-46 of Mr McIvor’s statement. Mr McIvor said the costs included marketing costs, maintaining investor records, compiling statements and communicating with investors in person through seminars and through the mail in the form of reports and other correspondence. He says those costs are “relatively fixed irrespective of the amount invested by each investor”: at paragraph 43. He acknowledged in his oral testimony that there was some variation in costs between investors – some individuals were more demanding, and would make more phone-calls and drop by the office and require more attention. But he suggested that these minor differences in cost were the product of personal habits, rather than a function of the size of the investment. He suggested some small investors were demanding while others were more passive. The same was true, he said, of large investors. He also said in his oral testimony that the rates of brokerage do not vary according to the size of the investor, although he added Equitiloan preferred not to use brokers.
14. Ms Ford cross-examined Mr McIvor about the allocation of costs as between investors. She also questioned Mr McIvor about the allocation of costs to borrowers from the Fund. Mr McIvor acknowledged that the discussion of costs in paragraphs 43-46 of his affidavit was principally concerned with fixed costs of administering the Fund. He did not refer to any variable costs. Equitiloan’s accounting system did not allocate those costs between investors, nor did it allocate the costs of lending and administration amongst firms that borrowed money from the Fund. Mr Vincent in his report suggested it would be impractical to allocate costs to borrowers, even if it were theoretically desirable to do so.
15. There was a lengthy and detailed discussion at the hearing over the process of cost allocation. Mr Cooper’s report had criticised (at paragraph 7.10) the methodology and conclusions of Mr Vincent’s report. Mr Cooper concluded at paragraph 7.13 that if one corrected the methodology, one would arrive at substantially different calculations about the appropriate rate of return. The calculations are set out at Appendix 4 of Mr Cooper’s report. Mr Vincent responded in his oral testimony. He acknowledged some defects in the methodology but insisted that even if the methodology was altered so as to bring about a clearer allocation of costs amongst investors, the result would not change and the rates of return proposed by Equitiloan were still valid. Mr Vincent insisted that any differences in the rate of return as between investors were economically justified.
16. It is probably unnecessary to undertake a detailed allocation of costs for the purposes of this exercise in any event. If one accepts – and I do - that the actual cost of servicing each investor was roughly equal, with minor differences in cost explained by the idiosyncrasies of the individual investor rather than as a result of the size of their investment, the costs per dollar invested were almost certainly quite different. It stands to reason that if the costs per investor are roughly constant, the costs per dollar for larger investors will be lower than the costs for smaller investors. In other words, if the costs of a servicing each investor were around $100 and one individual invests $100,000 and a second invests $500,000, the cost per dollar of investment incurred in respect of investor number one are $0.001 per dollar invested while it costs $0.0002 per dollar for the second investor.
17. Mr Vincent made this point in his report at paragraph 3.7. Dr Fallon agreed. Dr Fallon is an economist called by the applicant. In summary, he said:
§The transaction costs associated with each deposit are comprised mainly of fixed costs. He said that was true of almost all deposit-taking exercises.
§Fixed costs are basically the same for each investor, regardless of the amount invested.
§While transaction costs per investor are fixed, the transaction costs per dollar invested are much lower if the investments are larger – the transaction costs can be spread over a larger amount. Big deposits are therefore preferable to small deposits from Equitiloan’s point of view, and perhaps from the point of view of other investors who might receive greater returns if the total administration costs of the Fund are lower.
§Apart from the transaction cost advantage of larger deposits, attracting more large depositors is likely to increase the size of the Fund more rapidly. The Fund (and by implication, Equitiloan and the investors) will reap the benefits of economies of scale in administration and lending – most obviously, the Fund will be able to make more of the larger and more profitable developments loans.
18. On this approach, it seems large investors in the Fund (who receive the same rate of return as small investors) may be cross-subsidising the small investors under the existing arrangements. That conclusion is different to the conclusions reached by Mr Cooper.
19. Mr Cooper criticised the proposed division of the investors in the Fund into bands. He said the choice of bandwidths is arbitrary. I accept there is necessarily a degree of imprecision in setting the bandwidths, given the difficulties Mr McIvor and Mr Vincent described in allocating all costs precisely. But I also accept the calculation of the bandwidths is substantially motivated by the applicant’s desire to sell more of its investment product to the public. It has an incentive to devise bandwidths that offer a competitive rate of return in light of the costs of administering the Fund.
20. Mr McIvor dismissed the suggestion that Equitiloan could address its concerns over the relatively greater cost of administering small investors by imposing differential administration costs or fees instead of adjusting the rate of return. The imposition of differential fees is permitted pursuant to ASIC Class Order CO 01/50. Mr McIvor said that would be confusing to investors. Marketing would be more difficult. He said it was much simpler to promise a fixed rate of return to the investor that varied depending on the size of the investment (calculated after taking into account the costs of administration) than it is to promise a standard rate of return for all investors but impose different fees.
21. It is difficult to be sure a differential fee would be relatively more difficult to market than differential returns. I accept Mr McIvor was genuine in his belief, and he appears to know Equitiloan’s market. In any event I have some difficulty in seeing the distinction made by ASIC: if differential fees are acceptable, why are differential rates of return a problem when the financial outcome – the net amount of money received by the investor from the Fund – is the same?
The Withdrawal Fees
22. Investors place their money in the Fund for twelve-month terms. The twelve-month period is convenient because many of the loans are made over a twelve-month term. To discourage investors from making an early withdrawal, Equitiloan is permitted to impose a penalty. The investor pays the penalty fee to Equitiloan, rather than to the Fund. The current prospectus sets the fee at 0.625% of the withdrawn amount, regardless of when the money is withdrawn. In other words, the same penalty must be imposed on investors who withdraw their funds regardless of whether they made the withdrawal a week after lodging the funds on deposit, or a week short of the twelve-month term. Mr McIvor says that is inappropriate, and argues it would be more appropriate to permit a higher fee to be charged if the withdrawal is made earlier. He proposed a withdrawal fee structure in paragraph 75 of his affidavit:
“When Requested Percentage Fee of Withdrawn Amount
0 - 6 months 1.00%
6 – 9 months 0.75%
10 – 11 months 0.50%”
23. Equitiloan currently has no discretion to waive that fee, regardless of the reasons for the withdrawal. Mr McIvor said in his affidavit that the rule could be harsh and inflexible. He says Equitiloan should be permitted to waive the fee in appropriate cases. The proposed criteria for the exercise of the discretion are set out in paragraph 69 of his affidavit:
“(a)the investor’s reason for early withdrawal of their funds – that is, if the investor can establish that they require an early withdrawal of their funds because of a legitimate reason or circumstance outside their control, rather than simply churning funds through the EIF to temporarily take advantage of EIF’s comparatively good rate of interest, early withdrawal would be considered;
(b)the length of time prior to the expiration of the term when the investor required the withdrawal;
(c)the amount of funds invested and the amount proposed to be withdrawn;
(d)the length of time for which the investor has been an investor in EIF (and, where relevant, its predecessors);
(e)the level of liquidity in EIF at the time of the withdrawal request;
(f)EIF being satisfied that permitting the early withdrawal would not have any adverse effect upon other investors in the fund.”
The Legislation
24. Section 601FC of the Corporations Act 2001 sets out the duties of a responsible entity of a registered scheme. In particular, s 601FC(1)(d) says the responsible entity must “treat the members who hold interests of the same class equally and members who hold interests of different classes fairly…”. The legislation echoes the requirement of impartiality imposed on trustees in their dealings with beneficiaries: see Re Lepine [1892] 1 Ch 210 at 219 per Fry LJ. That rule prevents trustees from treating beneficiaries differently on the basis of irrelevant criteria.
25. Section 601QA empowers ASIC to exempt a person from a provision of Chapter 5 (which includes s 601FC), or “declare that this Chapter applies to a person as if specified provisions were omitted, modified or varied as specified in the declaration”. ASIC has issued policy statements that set out the bases upon which it will exercise its discretion.
Does the Proposal to Offer Differential Rates of Return Contravene Section 601FC(1)(d)?
26. In order to determine whether the proposal offends s 601FC(1)(d), it is necessary to ascertain whether the proposal results in the creation of different “classes” within the meaning of s 601FC. Section 9 suggests the word “class” when used in relation to shares or interests in a managed investment scheme must be read subject to s 57. Section 57 provides:
“(1) The shares in a body corporate, if not divided into two or more classes, constitute a class.
(2)If the interests in a managed investment scheme to which an undertaking relates are not divided into two or more classes, they constitute a class.”
27. While s 57 does not offer a definitive interpretation of the word “class” in s 601FC, it does at least suggest the process of defining a class is essentially the same as it is for identifying classes of shares. ASIC acknowledges as much in its statement of facts and contentions, but goes on to say (at paragraph 56) that the interests in question should be divided into classes on the basis of some characteristic of the interest itself, rather than a different rate of return or differences in the amount invested. The applicant says that investment interests yielding different rates of return are no different to preference shares that yield a higher rate of dividend.
28. In Clements Marshall Consolidated Ltd v ENT Ltd (1988) 13 ACLR 90, Neasey J suggested (at 93) a class of shares was:
“a category of shares which differs sufficiently in respect of rights, benefits, disabilities, or other incidents, as to make it distinguishable from any other category of shares, if there are any, in the capital of the company.”
29. His Honour’s approach suggests one classifies shares according to some characteristic of the shares or perhaps of the shareholder, rather than on the basis of the company’s behaviour towards the shareholder or the identity or characteristics of the shareholder. I think that is correct, given the legislation refers to categories of share rather than categories of shareholder: cf Cumbrian Newspapers Group Ltd v Cumberland and Westmoreland Herald Newspaper and Printing Co Ltd [1987] Ch 1 at 17-22 per Scott J. But even if one accepts that caveat, the decision of the House of Lords in Welton v Saffery [1897] AC 299 suggests there are still many bases upon which one might classify shares. The basis of classification might be as simple as a declaration in the constitution that shares can be issued in two classes, even though there is no practical difference between the two types of share. That is what occurred in Lorenzi v Lorenzi Holdings Pty Ltd (1993) 12 ACSR 398. Santow J noted (at 400) one practical effect of the express classification was to permit the holders of shares that are the same in other respects to receive different rates of dividend. (His Honour went on to criticise the classification in that case because he found there was no legitimate corporate purpose for exercising the power to allot the shares. That is not the case here). Companies issuing different classes of preference shares where the shares differ only in respect of the promised rate of return are effectively doing the same thing. That is fair enough because companies should be permitted the widest possible freedom to structure their affairs to achieve an efficient and attractive capital structure. Managed investment schemes are in the same position. Provided the classification is transparent so that investors make an informed decision, it is difficult to see what objection could be taken to classification of shares on the basis of different rates of return.
30. I accept that establishment of the bands would constitute the establishment of separate classes of investment. Provided members of each class receive the same treatment as their fellow class members and the fact and effect of classification is apparent to investors, s 601FC(1)(d) is satisfied.
31. I have more difficulty with the applicant’s alternative proposal that different rates be paid without classifying the investors’ interests differently. While the same logic that I have described above might justify the practice, the recognition of separate classes appears to fit more neatly within the wording of s 601FC(1)(d).
32. Are investors in the same band treated equally under this proposal? Mr Cooper suggested they would not be, because he says the bands were determined arbitrarily. He says there was an assumption that everyone falling within the band “is treated as though they have invested the average amount for the range”: see paragraph 7.3 of his report. Mr Cooper goes on to say (at paragraph 7.4ff):
“As a consequence, the use of differential rates of return will result not only in unequal treatment of investors in different ranges but, also, unequal treatment of investors within the same range.”
33. Mr Cooper then proceeds, in Appendix 4 to his report, to illustrate his view that the proposed rates of return in each class mean that some investors in each band would be subsidising other members in the same band. I have already noted that some measure of cross-subsidisation is inevitable even under the existing arrangements. The establishment of bands with returns adjusted to reflect the different value of the investors should reduce that cross-subsidisation, even if the process is inevitably a crude one. I do not accept that the bands should be criticised because they are not drawn so as to precisely reflect the different cost or value of those investors. The proposal is at least as fair and equal as the existing arrangement, whether or not investors are treated more equally.
34. In my view, there is no contravention of s 601FC(1)(d). But even if there is a technical breach, the circumstances of the breach are such that ASIC ought to exercise its discretion under s 601QA in favour of the applicant.
The Discretion to Waive the Withdrawal Fees
35. ASIC says that differential withdrawal fees are objectionable, but I do not agree. Where the fees vary according to the amount invested or the point in the investment term at which the withdrawal is made, there is a clear economic explanation for imposing differential fees.
36. ASIC also says the discretion to waive the withdrawal fees is objectionable because it will result in investors being treated differently, without the difference being explicable on an economic basis.
37. That view proceeds on the assumption there must be an equality of outcomes in every case in order to satisfy the statutory obligation to act equally. That is not necessarily so. If the criteria guiding the discretion are widely known and applied equally to all who seek the benefit of the discretion, and if ASIC can be satisfied:
§the criteria are directed towards legitimate objectives such as the relief of hardship or inequality, and
§the criteria will be administered fairly as between members and with integrity,
there is no basis for objection. (One way in which ASIC might be confident in the administration of the criteria is by ensuring that the exercise of discretion is open to review by an independent person or entity).
38. Even if I were to accept that the proposals breached s 601FC(1)(d), I am satisfied that ASIC ought to exercise its discretion under s 601QA in favour of the applicant.
Conclusion
39. The respondent’s decision is set aside and the matter is remitted to the respondent for reconsideration in accordance with the Tribunal’s reasons for decision.
I certify that the 39 preceding paragraphs are a true copy of the reasons for the decision herein of Mr BJ McCabe, Member
Signed: Sarah Oliver
AssociateDates of Hearing 6 to 8 November 2002
Date of Decision 24 April 2003Counsel for the Applicant Mr D J S Jackson QC
Mr R P S Jackson
Solicitor for the Applicant Tucker CowenCounsel for the Respondent Mr E Ford
Solicitor for the Respondent Legal and Technical Operations Section, ASIC
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