Banking & Finance Newsletter : March 2008

ASSIGNMENT OF MORTGAGE - NEW LEGAL DEVELOPMENTS

Only a few weeks ago, the High Court handed down its decision in the case of Queensland Premier Mines Pty Ltd v French [2007] High Court Authority 53. The case dealt with the rights provided to a transferee where a mortgage is transferred without any transfer of a related loan agreement. The full bench of the High Court unanimously agreed with the Supreme Court of Appeal of Victoria that where a borrower signs a mortgage and a separate loan agreement, there are two covenants to pay, one under each document.

While the case dealt specifically with the wording in section 62 of the Land Title Act 1994 (Qld) (“Act”), the section appears in substantially the same form as corresponding legislation in all of the States and Territories in Australia. The judgment, therefore, has the same ramifications for all mortgage transfers around the country.

The High Court held that registration of a transfer of mortgage will not automatically provide the transferee with the right to sue on the separate agreement underlying the mortgage, if the obligations are not included in the mortgage document itself. This is because where a borrower signs a mortgage and a separate loan agreement, there are two separate covenants to pay, one under each agreement. The rights under each agreement would therefore need to be assigned separately to provide the assignee with the benefit of both agreements.

Consequently, where there is an assignment of mortgage or debt, it is imperative that, in addition to the transfer of mortgage, a collateral agreement is entered into specifically assigning all of the rights under the loan agreement. This will ensure the transferee retains the rights provided by both the loan agreement and the mortgage.

SUPERANNUATION REGULATION CHANGES POSE NEW PROBLEMS FOR THE UNWARY

Recent changes to superannuation laws covering contributions, internally-geared funds and instalment warrants are creating new challenges. Trustees must ensure they comply with the laws because substantial penalties apply to breaches.

Recent Legislation
A raft of changes to superannuation laws have been introduced in recent months with implications for both superannuation funds and self-managed super funds (SMSF). These changes may impact upon superannuation investment decisions and see new products coming on to the market.
Some of the relevant Acts passed include:

• Tax Laws Amendment (Simplified Superannuation) Act 2007
  
  
• Superannuation (Excess Concessional Contributions Tax) Act 2007
  
  
• Superannuation (Excess Non-Concessional Contributions Tax) Act 2007
  
  
• Superannuation (Excess Untaxed Roll-over Amounts Tax) Act 2007
  
  
• Superannuation (Self Managed Superannuation Funds) Supervisory Levy Amendment Act 2006
  
  
• Superannuation Legislation Amendment (Simplification) Act 2007
  
  
• Income Tax Amendment Bill 2007

With the growth, both in size and complexity of superannuation in Australia, there have also been indications that further changes are on the way.

Limits on contribution
One significant change is the imposition of limits on concessional and non-concessional contributions. From 1 July 2007, concessional contributions are capped at $50,000 per person; excess contributions will be taxed at 46.5 percent as opposed to the 15 percent tax imposed upon concessional contributions – subject to some transitional provisions.

Internally-geared funds
Previously, the Superannuation Industry (Supervision) Act 1993 prohibited superannuation funds and SMSF from borrowing money to invest to limit risk to retirement savings. However, alternative forms of gearing are available to superannuation funds where no direct borrowing is involved. The predominant means of gearing superannuation were investments in internally-geared funds and the purchase of instalment warrants.

Internally-geared funds are investment vehicles which are already geared, and thus, superannuation funds and SMSF investing in internally-geared funds obtain a level of leverage without the need to borrow. It should be noted the maximum loss which flows directly from investments in internally-geared funds is the amount invested in the fund, as opposed to borrowing to invest where the investor may be exposed to substantial levels of debt. The downside is that superannuation funds and SMSF do not have the ability to determine the level of gearing, as these decisions are made by the internally-geared fund.

Instalment warrants
Instalment warrants allow investors to purchase an asset over time. These also allowed superannuation funds and SMSF to gear their investments; particularly using equity instalment warrants – where the underlying asset is generally an Australian Stock Exchange (ASX)-listed share. This usually involved the fund making an initial part payment and paying the outstanding instalments over a period. The underlying asset is not transferred until all instalments are paid, and default before transfer will result in the forfeit of the underlying asset, and any past instalment payments. The use of instalment warrants was especially popular for SMSF, however, in 2006, the Australian Taxation Office (ATO) and Australian Prudential Regulation Authority (APRA) determined these warrants constituted a form of debt and therefore were not valid investments for super funds.

Changes relating to instalment warrants
Since 24 September 2007, amendments to the Superannuation Industry (Supervision) Act 1993 reversed the position taken by the ATO and APRA, and once again permits superannuation funds to invest in instalment warrants subject to various conditions. Examples include:

• There must be no obligation to purchase the underlying asset of the instalment warrant.
  
  
• It must have limited recourse, thus limiting the loss.
  
  
• The underlying asset is a permissible asset for direct investment.

While gearing creates additional risk, it also allows super funds to magnify their returns. Properly structured, it can confer significant tax advantages. However, super funds, especially SMSF trustees with less expertise in the field, should ensure they comply with the laws in this area as substantial penalties apply for breaches.

OWNERS CORPORATIONS ACT 2006 – WHAT IT MEANS FOR YOU

The Owners Corporation Act 2006 (the Act), which came into force on 31 December 2007, changes the structure, function, rights and obligations of bodies corporate and will directly affect the one in five Victorians who own, live in, manage or develop bodies corporate. The Act replaces and enlarges upon the regulations under the Subdivision Act 1988 for bodies corporate and under the new legislation will be known as an owners corporation (OC).

Types of OCs
Under the Act, existing bodies corporate will become OCs and be subject to the new legislation. Their rules, however, will continue to the extent that they are not inconsistent with the new legislation. The legislation will affect OCs in different ways depending on whether they are:

1. OCs for two-lot subdivisions, in which case they will be exempted from compliance with a number of requirements under the new legislation,
   
   
2. OCs generally, or
   
   
3. Prescribed OCs, which are OCs that levy fees of more than $200,000 in a financial year, or an OC that consists of more than 100 lots. Prescribed OCs will have additional obligations under the Act.

Financial accountability and management
While bodies corporate are already required to keep accounts and prepare financial statements, under the Act an OC (other than a two-lot OC) must ensure the books of accounts provide a true and fair view of the financial situation of the OC. An annual financial statement must be provided at the Annual General Meeting (AGM). In addition, Prescribed OCs must have their financial statement audited after the end of the financial year. A Prescribed OC must also prepare a maintenance plan detailing certain information including anticipated major capital expenses within the next 10 years. The plan must be approved by the OC and a maintenance fund must be established.

Insurance
All OCs (except two-lot OCs) are required to obtain reinstatement and replacement insurance and public liability insurance for any common property. In addition, a Prescribed OC must obtain a valuation of all buildings it is liable to insure, not less than once every five years. The valuer’s report must be presented at the next AGM.

Committee
Any OC with 13 or more lots must elect a committee. The committee can generally do anything that an OC can do by ordinary resolution, but the OC can limit the committee’s powers. The committee must present a report of its activities to the AGM. Committee members have an obligation to act honestly and in good faith, and cannot make improper use of their position. Each OC must have a chairperson, and may have a secretary. The chairperson and secretary must be members of the OC, unless there is no committee and no secretary, in which case the manager can be the secretary.

Managers
An OC can appoint a manager, who must act to the same standard as is required of Committee members. The manager must also submit a report to the AGM, which must include details of the manager’s professional indemnity insurance. Every paid manager must have professional indemnity insurance and be registered with the Business Licensing Authority. The register will be made available to the public and include details of any orders against the manager.

Register
An OC is obliged to keep a register, which is established by the application for registration, and must keep records including copies of resolutions, financial statement and accounting records, contracts, agreements, leases and licences relating to the OC, for seven years.

Dispute Resolution
The Act provides a new three-tiered approach to dispute resolution for OCs. First, a complaint is to be lodged with the OC. The OC must have an internal resolution process or follow the process prescribed in the model rules. If the complainant is unsatisfied with the outcome of the internal process, they may contact Consumer Affairs. Consumer Affairs may act as a conciliator or mediator in the dispute. If that process fails, the matter can be referred to VCAT, which has broad powers to resolve disputes and make binding determinations. However, a matter cannot be referred to VCAT unless the process outlined in the OC rules and the Act has been exhausted.

Adverse Possession of Common Property
The Act amends the Limitation of Actions Act 1958 so the right, title and interest in common property is not affected by reason only of any adverse possession, irrespective of the period of that possession.

Summary
It is clear that the Act imposes more stringent regulation of OCs than those currently in place. While this article highlights the major changes, it does not address every topic covered in the Act. Furthermore, regulations are still to be finalised and these may impose additional or different obligations. It is important people likely to be affected become familiar with the legislation to ensure compliance.

PREPARING FOR BASEL II

INTRODUCTION

Basel II, the Basel Committee on Banking and Supervision’s (BCBS) most recent accord, came into force in Australia on 1 January 2008. Many Authorised Deposit Taking Institutions (ADIS) may need to restructure personnel and modify their system to streamline their operations to meet its requirements.

The Basel II framework seeks to improve on the existing rules by aligning capital requirements more closely to the underlying risks that banks face. It follows Basel I, the first accord issued by the BCBS with the primary purpose of securing international convergence on supervisory regulations of financial intermediaries – including banks, building societies, credit unions.

Basel I was adopted with minimal modifications in Australia, with its operation overseen by the Australian Prudential Regulation Authority (APRA). In response to criticisms such as risk insensitivity with respect to capital allocation, discussions on the creation of a new accord - Basel II began in 2001. The BCBS released the first draft of Basel II in June 2004. APRA has been releasing discussion papers and undertaking industry consultations on implementing Basel II in Australia since 2005.

On 30 November 2007, APRA announced the Basel II framework would come into force on 1 January 2008. Basel II uses a “three pillars” concept: (1) minimum capital requirements; (2) regulation and supervision; and (3) market discipline.

BASEL II FRAMEWORK

Pillar 1: Minimum Capital Requirements
Establishes how an Authorised Deposit Taking Institution (ADI) should calculate the minimum capital it should hold as a “cushion” against the credit, market, and its operational risk. Consistent with the goal of providing greater flexibility for ADIs, Pillar 1 provides the ADI with several options in calculating the capital adequacy requirement for each of the risks.

Credit Risk

• Standard Approach
  
  
• Foundation Internal Rating-Based Approach
  
  
• Advanced Internal Rating-Based Approach
  
  
  

The Standard approach is similar to the position under Basel I, with some modifications to the risk-weighting system, while the two Internal Rating Based approaches rely upon the ADI’s internal data and models to calculate the capital requirements.

Operational Risk

• Basic Indicator Approach
  
  
• Standard Approach
  
  
• Advanced Measurement Approach

The methods vary in the degree of reliance on a bank’s internal data, the level of “sophistication” required, and the flexibility it offers.

Market Risk

• Standard Approach
  
  
• Internal Model Approach
  
  
• Hybrid Standard/Internal Model Approach

Encompasses currency, commodity price, equity price and interest rate risks to which the ADI is exposed.

Pillar 2: Regulation and Supervision
Pillar 2 provides regulatory guidance in areas such as supervisory review, risk management guidance, supervisory transparency, and accountability. It also establishes a framework for dealing with other risks not addressed under Pillar 1.
Consistent with the fundamental objective of the BCBS to strengthen the soundness and stability of the banking system, Pillar 2 encourages ADIs to employ risk management techniques in managing their risks with the aim of improving internal controls and strengthening the level of provisions and reserves.

Pillar 3: Market Discipline
Pillar 3 requires ADIs to disclose certain information about a bank’s capital, risk exposures and risk assessment process. Basel II creates a more onerous disclosure regime than existed under Basel I.

PRACTICAL APPLICATION AND EFFECTS OF BASEL II

Competitive Advantages
A recent APRA media release states “The vast majority of ADIs in Australia will adopt the Basel II standardised approaches. APRA will shortly announce those ADIs it has approved to use the Basel II advanced approaches as from 1 January 2008.”
Various writers have pointed out that the Internal Models Approaches will provide significant competitive advantages. Commercial considerations dictate that ADIs will adopt the approach which will minimise their capital adequacy requirements, however, the costs of establishing and operating internal models for determining capital adequacy require extensive financial resources and know-how. This is likely to prevent many smaller ADIs adopting it.

Impact of Basel II
Even an ADI which adopts the standard approaches will need to change the way it determines its capital adequacy. One of the key changes is the inclusion of credit ratings into the risk-weighting equation. Under Basel I the risk weightings were assigned in accordance with the nature of the asset, Basel II allows for further distinctions of risk within an asset class based upon credit ratings. For example, different risk weightings can be applied to the equity or debt securities of different companies.
ADIs may require internal restructuring of personnel or modifications to their systems to streamline their operations to meet Basel II requirements.

For further information please contact:
Elpis Korosidis on +61 3 9608 2115 or e.korosidis@cornwalls.com.au or
Jessica Huberman on +61 3 9608 2277 or j.huberman@cornwalls.com.au