Is ASIC's benchmark disclosure merely regulating disclosure? If not, why not?

ASIC's recent approach to financial product disclosure has been to require issuers of specific types of financial products to prepare their disclosure documents against certain benchmarks on an "if not, why not" basis.

This approach is relatively new, but has now been adopted for a wide range of financial products. These include mortgage schemes, debentures, unlisted property schemes, agricultural schemes, over-the-counter contracts for difference, and infrastructure entities. ASIC has also released two consultation papers in relation to hedge fund disclosure.

The choice of financial products subject to benchmark disclosure appears to be driven, at least in part, by the experience of the global financial crisis (GFC). ASIC seems to believe, in hindsight, that investors who suffered losses during the GFC did not have an adequate understanding of the risks and characteristics of certain products; had the disclosure been different, investors would have had an adequate understanding (and would presumably not have acquired the financial products and therefore suffered loss). 

ASIC's approach to benchmark disclosure raises a question as to whether the benchmark requirements go beyond mere disclosure. Are they, effectively, an attempt to legislate conduct requirements through the back door?

Benchmark requirements - legislating conduct in disguise?

The provisions in the Corporations Act 2001, in particular s.1013E, allow significant flexibility to issuers to determine what information should be included in a PDS.

A PDS must include the statements and information required by s.1013D, and in addition "any other information that might reasonably be expected to have a material influence on the decision of a reasonable person, as a retail client, whether to acquire the product" (s.1013E) as well as any information required by other provisions: Pt 7.9 Div 2 Subdiv C.¹

In contrast to the general requirements of Part 7.9 of the Corporations Act, ASIC's regulatory guides on benchmark disclosure deal with product-specific disclosure requirements. For example, ASIC Regulatory Guide 231 Infrastructure Entities: Improving disclosure for retail investors (RG 231) outlines nine benchmarks and eleven disclosure principles that apply to infrastructure entities. 

The RG 231 benchmarks are intended to address the main causes that appear to have contributed to infrastructure investors suffering loss during the GFC. To give three examples of these benchmarks:

1. Benchmark 2 - Remuneration of management: Incentive-based remuneration paid to the management of the infrastructure entity is derived from performance of the infrastructure entity and not the performance of other entities within its consolidated group (except where the infrastructure entity is the parent of the consolidated group). ASIC's concern here appears to be that where the remuneration of the infrastructure entity's management is linked to performance of a group company rather than the infrastructure entity they are responsible for managing, this can lead to behaviour aimed at generating more fees for the group company, such as aggressive debt financing.
2. Benchmark 6 - Base-case financial model:Before any new transaction, and at least once every three years, an assurance practitioner performs an agreed-upon procedures check on the infrastructure entity's base-case financial model, checking the model's mathematical accuracy and including no findings that (in the infrastructure entity's opinion) would be materially relevant to the infrastructure entity's investment decision.
3. Benchmark 8 - Distributions: If the infrastructure entity is a unit trust, it will not pay distributions from scheme borrowings. ASIC's view is that to understand whether current distributions are sustainable, investors should understand whether these distributions are funded from income or from debt.

Infrastructure entities must disclose whether they meet the benchmarks, and "if not, why not". According to ASIC 'why not' means explaining how an infrastructure entity deals with the business factor or the issue underlying the benchmark.

This means that, depending on their existing practices, infrastructure entities may be required to state why they do not meet a number of the benchmarks in a PDS. There are no existing product-specific conduct requirements relating to infrastructure entities under the Corporations Act. The regulatory regime emphasises disclosure rather than prescriptive product-based conduct requirements.

ASIC states that meeting the benchmarks is not mandatory, and that the benchmarks are merely used to establish a framework for disclosure of issues regarded as important (RG 231.25). 

It must be questioned, however, whether the benchmarks will, in reality, have the effect of modifying the way in which issuers structure and operate their businesses. An issuer that does not currently comply with the benchmark would need to change its practices if it wished to avoid stating why it did not comply; if it did not comply with the benchmark, this could suggest that the issuer does not meet best practice, as prescribed by ASIC, and attract unwanted attention and further enquiries from ASIC.

A further example of the potential consequences of benchmark disclosure relates to the scope of the information required to be disclosed in a PDS.

ASIC's policy on infrastructure entities in RG 231 applies to both PDS and prospectus disclosure. So, similar infrastructure products could be offered under a PDS or a prospectus, even though there are legislative differences between the PDS and prospectus regimes. The most notable of these differences is that the provisions of the Corporations Act applicable to prospectuses require issuers to undertake a due diligence exercise to discover all material information and disclose it in the prospectus.

The provisions applicable to a PDS are different. The information to be included in a PDS under sections 1013D and 1013E of the Corporations Act is confined to information within the "actual knowledge" of the issuer and certain other persons. This is significant in the context of benchmark disclosure, because ASIC states in RG 231 that:  

We recognise that in certain circumstances it may be difficult for certain infrastructure entities to disclose the information requested because it is not available to them…We would expect infrastructure entities to use reasonable endeavours to obtain and provide such information.

Although ASIC attempts to harmonise the differences between prospectus and PDS disclosure, it is questionable whether this will be successful. It may simply be yet another instance of ASIC attempting to legislate through policy.

It is interesting to contrast ASIC's approach with the approach that the legislature took in relation to the Short Form PDS Requirements.  Whereas ASIC's approach to benchmark disclosure appears to effectively legislate conduct, the legislature's changes appear simply to prescribe what may and must be included in a PDS, emphasising concise and effective disclosure.  Although the difference is understandable, given that the Short Form PDS disclosure is intended to apply to relatively low risk products, it is interesting to note that, on one view, the regulator appears to be legislating and the legislature appears to be regulating.

Conclusion

It is arguable that ASIC's approach to benchmark disclosure,  imposes new requirements on issuer that go beyond disclosure and may affect the way in which issuers structure and operate their businesses. The original policy aim of ensuring adequate disclosure seems to have given ground to effectively legislating for issuer conduct through product-specific regulatory guides. It remains to be seen whether this will result in better disclosure outcomes. Further, the appropriateness of introducing conduct requirements in this way for certain products (but not others) without legislative change is open to question, given the significant change in approach that it entails.