Advisers are periodically asked about how self-managed super funds can invest using derivatives. Bryce Figot provides some guidance.
There is a misconception that all self-managed super fund (SMSF) trustees that hold derivatives need a derivatives risk statement. This is incorrect, and needs to be addressed.
A derivatives risk statement is a statement that sets out:
• policies for the use of derivatives, including an analysis of the risks associated with the use of derivatives within the investment strategy of the fund;
• restrictions and controls on the use of derivatives that take into consideration the expertise of staff; and
• compliance processes to ensure that the controls are effective (for example, reporting procedures, internal and external audits and staff management procedures).
A derivatives risk statement is not needed merely because an SMSF trustee holds derivatives. Broadly, under reg 13.15A of the SIS regs, it is only needed if:
• the SMSF trustee wishes to give a charge (that is, a mortgage, lien or other encumbrance) over its assets; and
• that charge is being given in order to comply with the rules of an “approved body” (for example, the Australian Securities Exchange or the American Stock Exchange).
There are many types of derivatives that do not involve charges over SMSF assets. For example, in ATO Interpretative Decision ATO ID 2007/56, the Commissioner of Taxation discusses contracts for difference that do not involve charges. Such contracts for difference would also not necessitate a derivatives risk statement.
Also, a limited recourse borrowing arrangement for real estate would not require a derivatives risk statement (because no charge is being given to comply with the rules of an approved body).
RISK MANAGEMENT STATEMENT V DERIVATIVES RISK STATEMENT
There is some confusion about the difference between a risk management statement and a derivatives risk statement.
There is no substantive difference between the two. Merely, risk management statement was previously the term for derivatives risk statement. This name changed with effect from July 1, 2004. The change occurred to avoid any potential confusion between the term “risk management statement”, as it was previously designated, and a “risk management strategy” prepared under section 29H or ‘risk management plan’ prepared under section 29P of the SIS Act.
Accordingly, those not wishing to sound like “old fuddy-duddies” should use the term derivatives risk statement.
WHAT THE REGULATORS SAY
APRA agrees that derivatives can play a role in a properly diversified portfolio. They set out their views in Prudential Practice Guide SPG 200. Importantly, APRA states that it considers:
“… it inappropriate for trustees to use derivatives for ‘speculation’, which … refers to investment activity that results in one or more of the following:
a) the net exposure of the fund to an asset class being outside the limits set out in the fund’s investment strategy. (Net exposure is exposure taking account of both physical and derivative exposure.);
d) the risk involved for the whole portfolio being outside that which the trustee considered appropriate when it developed and approved the fund’s investment strategy;
c) the fund holding uncovered derivatives; and
d) the fund’s total portfolio being ‘geared up’ through derivatives to circumvent the limitations imposed by ss. 67, 95 and 97 of the SIS Act on borrowings.”
Naturally, APRA is not the regulator of SMSFs. The Commissioner of Taxation is the regulator of SMSFs. However, the Commissioner has not released anything as directly on point as APRA’s guide. Also, the Commissioner typically tries to be consistent with APRA. Accordingly, APRA’s comments should be borne in mind.
WHAT THE LEGISLATION SAYS
Other than derivatives risk statements (as already discussed), the legislation broadly does not expressly address derivatives.
However, the Superannuation Industry (Supervision) Act 1993 (Cth) has enshrined certain general law duties and rules in s 52(2), and these cannot be excluded by the trust deed. One such duty is: “To exercise, in relation to all matters affecting the entity, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide.”
This raises the question of the requisite degree of care, skill and diligence. The seminal case on point (King v Talbot (1869) 40 NY 76) states that:
“It … does not follow, that, because prudent men may, and often do, conduct their own affairs with the hope of growing rich, and therein take the hazard of adventures which they deem hopeful, trustees may do the same; the preservation of the fund, and the procurement of a just income therefrom, are primary objects of the creation of the trust itself, and are to be primarily regarded.”
Although this is a US case and not part of Australian law, it has been cited with approval by Australian judges and incorporated into Australian law. See, for example, ASIC v AS Nominees Limited [1995] FCA 1663 [42].
Accordingly, in a roundabout way, the legislation and the case law come to a similar conclusion to APRA. Namely, holding derivatives in an SMSF is allowable for purposes such as hedging against risks. However, they should not be used for speculative purposes – and “speculative purposes” cover a lot of purposes!
RISKS TO ADVISERS
Sometimes, when presenting to financial planners and accountants, I ask for attendees to raise their hands if an attendee has clients who invest using derivatives. A large number of hands are raised. I then ask for hands to stay up if they have clients who make money through the use of derivatives? Often almost no hands remain raised.
