CAMAC reports on the derivatives definition

In January, the Corporations and Markets Advisory Committee (CAMAC) published its report¹ on the definition of derivatives under the Corporations Act 2001 (Cth). The report was prepared at the request of the then Parliamentary Secretary to the Treasurer, the Honourable David Bradbury MP. The request followed initial consultation by Treasury in which it identified confusion among industry participants about the definition.

CAMAC has concluded that the current definition of derivatives in section 761D is suitable and adequate. It supports the principles-based approach in the section and proposes use of the regulation making power in section 761D(3)(d) to carve out arrangements falling in the periphery of the definition which should not be regulated as derivatives.

For parties dealing with arrangements that fall within the intended scope of the definition, the report will be welcome since it provides continuing certainty about how derivatives are defined in Australia. For others, the report invites two questions: Is my arrangement one which falls within the "periphery" of the definition and, if it does, what if anything is being done to exclude it from regulation as a derivative?

CAMAC's approach

In the course of its report, CAMAC provides an overview of international regulatory developments and sets out the framework for regulation of derivatives under the Corporations Act and the Corporations Regulations 2001. The report includes the history behind those provisions, in particular the approach advocated by CAMAC's predecessor, the Corporations and Securities Advisory Committee, which lead to the inclusion of the current definition in the Corporations Act.

CAMAC also reviews the issues which were raised with it during its consultations or by commentators. CAMAC considers that some concerns are misplaced or do not merit a change to the definition, while others may be resolved through use of the regulation making power.

The report then considers recent Australian case law on the derivatives definition, principally Keynes v Rural Directions Pty Ltd (No 2) [2009] FCA 567 and International Litigation Partners Pte Ltd v Chameleon Mining NL [2011] NSWCA 50, currently the subject of an appeal to the High Court.

CAMAC endorses the comments of Giles JA in International Litigation Partnersv Chameleon Mining to the effect that there is little warrant for reading down the definition even though it captures arrangements not ordinarily thought of as derivatives.

It was intended to be wide; over-width was to be controlled by the subsequent exclusions, including by regulation.²

Uncertainty identified by CAMAC

CAMAC identifies areas where the application of the definition is uncertain, or where its application results in arrangements being unnecessarily regulated as derivatives.

The first area of uncertainty is the requirement that the consideration or value vary by reference to "something else". It follows from CAMAC's approach to the definition that the term "something else" should be given a wide application and includes events. Since this could give the definition too broad an application, CAMAC proposes use of the regulation making power, for example to carve out elections and sporting events.

The second is the "derived value" element in the definition. The question is whether the value of an arrangement can vary over time due to variations in the value of the goods being sold (such as a commodity), even if the consideration under the arrangement stays the same. This was one of the arguments considered in Keynes v Rural Directions. CAMAC also observes that the derived value element may have been the source of the confusion identified by Treasury over whether physically settled forward contracts over shares are derivatives.

The report concludes that there is potential for the definition of derivatives to apply to forward contracts over intangible property that might not normally be considered to be derivatives. It gives as an example the transfer of intellectual property rights. Another example (not in the report) is intangible property created for the clean energy sector, including carbon units issued under the Clean Energy Act 2011 (Cth) and renewable energy certificates under the Renewable Energy (Electricity) Act 2000 (Cth).

CAMAC also observes that even if a forward contract were to fall outside the definition of derivative, it may still be a financial product if it is a facility for the management of financial risk. The same point does not arise for forward transactions for tangible property within the exception in section 761D(3)(a).

Next Steps

CAMAC endorses Treasury exercising the "regulation-making power" to deal with "future problematic judicial decisions" in peripheral areas or to deal with the emergence of new financial instruments.[3]

ASIC also has broad power under section 926A to, among other things, exempt a person from the financial services licensing provisions and more limited power under section 911A(2)(l) to give relief from the requirement to hold a financial services licence. CAMAC did not advocate that ASIC should use its powers to deal with future problematic judicial decisions and it appears to be somewhat reluctant to do so. To date, ASIC has issued class order relief for limited periods of time (and has extended that relief) while decisions, including the Chameleon Mining case, work their way through the courts.

Treasury has yet to indicate whether it intends to pursue CAMAC's recommendation to make regulations, and if so, the form those regulations could take. For those dealing with arrangements on the periphery of the definition, a proactive approach by either or both of ASIC and Treasury is preferable to waiting for further "problematic judicial decisions" and dealing with them after they occur.

The regulation of intangible property created for the clean energy sector is a developing area and may also be a candidate for use of the regulation making power.

Treasury has left some of these products to be regulated within the existing derivatives framework (notably, renewable energy certificates under the Renewable Energy (Electricity) Act). By contrast, carbon units under the Clean Energy Act, Australian carbon credit units under the Carbon Faming Initiative and international emissions units have been classified as particular kinds of financial products. This means that different regulation will apply to these products, such as the draft regulations recently published by Treasury that set out the exemption and disclosure framework for these new financial products.

In addition, the exclusion in section 761D(3)(a) for forward contracts over tangible property does not extend to these new environmental products. Given that they are traded as commodities, this leaves scope for further "problematic judicial decisions" in this area and it would be appropriate for Treasury to make regulations that would result in them being treated in the same way as tangible property for the purposes of the exclusion.