“The purpose for undertaking reasonable inquiries about the client’s financial situation is to obtain an understanding of the client’s ability to meet all the repayments, fees, charges and transaction costs of complying with a possible margin call. The general position is that clients should be able to meet their contractual obligations from income and available liquid assets, rather than from long term savings or from equity in a fixed asset such as a residential home. The returns that are potentially available from the portfolio financed by the loan may be taken into account in a reasonable manner, but should not constitute the sole or main source of funds available to meet a margin call and service the margin loan.” (Note 2)
The Corporations Amendment Regulations 2010 (No.4), which will come into effect on January 1, 2011, set out the type of information a licensee and authorised representative must inquire of its clients. The reasonable inquiry must relate to:
• whether the client has taken out a loan to fund the secured property, or transferred securities contributed by the client for establishing the facility (ie, double gearing);
• if the loan has been taken out – whether the security for the loan includes the primary residential property of the client;
• whether there is a guarantor for the facility and, if so, whether the guarantor has been appropriately informed of, and warned about, the risks and possible consequences of providing the guarantee; and
• the amount of any other debt incurred by the client.
The above information must also be included in the Statement of Advice (SoA) presented to clients.
Such inquiries would encompass an examination of the client’s asset and liability position, reliability of income, investment objectives, risk tolerance, lifestyle, availability of liquid assets and other financial commitments. The legislative requirements mean that advisers will be required to delve further into a client’s financial situation when margin lending is involved.
The rationale for this requirement is clear; that is, to prevent the situation where clients risk losing their homes if they could not service their loans following a margin call.
Verification of the client’s financial situation is not required to be undertaken if a licensee that is authorised to provide financial product advice has prepared an SoA no more than 90 days before the date the facility is issued or limit of which is increased, the SoA contains specific recommendations in respect of that facility, and the limit specified in the facility is not greater than the limit detailed in the SoA. The rationale behind this is to reduce the regulatory burden on the lender where the same information has already been provided to an adviser. In practical terms, it is envisaged that margin lenders will enter into some kind of arrangement with the adviser whereby,
“…information relevant to a margin loan [is able] to be excerpted from an SoA and presented to them in a particular format. Lenders will have to obtain appropriate confirmation that any information excerpted in this way forms part of an SoA, including the date of the SOA.” (Note 3)
Facility assessed as unsuitable
Under the Act, the margin lending facility must be deemed to be unsuitable if, at the time of assessment, it is likely that the client:
i. would be unable to comply with the financial obligations under the terms of the facility; or
ii. could only comply with substantial hardship, if the facility were to go into margin call; or
iii. is, on an ongoing basis, unable to be contacted by any of the usual means of communication and has not appointed an agent to act on his/her behalf.
The first and third elements are straightforward. The question is: what constitutes “substantial hardship”? The concept is not defined in the legislation. However, in the superannuation context, one of the tests for whether a person is in “severe financial hardship” is that,
“…the person is unable to meet reasonable and immediate family living expenses”. (Note 4)
It would appear that, if this definition is adopted, then the following factors would need to be considered:
• the amount of money the client is likely to have remaining after living expenses have been deducted from his/her after-tax income;
• consistency and reliability of the income and the size of loan relative to income level;
• the client’s other debt repayment obligations and similar commitments;
• the amount of buffer between the client’s disposable income and meeting the margin loan obligations; and
• whether the client is likely to have to sell his/her assets to meet the margin loan obligations.
In paragraph 1.97 of the Explanatory Memorandum, it states,
“The assessment conducted by the lender must specifically address the ability of the client to cope with the potential consequences of a margin call, in particular the possibility of having to deal with negative equity situations. An important factor in the assessment is the time allowed to the client to meet the margin call. Where clients are allowed only a short period within which the margin call must be met, the importance of the client having sufficient liquid assets to cope with such situations is enhanced. It is not intended that the potential sell down of part or all of the portfolio to adjust the LVR to the required level should imply substantial hardship.” (Note 5)
Where it is determined that the facility would be unsuitable for the retail client, the provider must not issue, or increase the limit of, the margin lending facility. Failure to comply constitutes a criminal offence and also attracts a civil penalty of 100 penalty units, two years’ imprisonment, or both.
