- Patenting financial products - a brave new world
- Holistic risk management and investing in nature-linked securities
- Regulating rating agencies - a defence of laissez-faire
- Beat the market - use geared beta strategies
- The adequacy of Australia's auditor independence regime
- Risky business - can fiduciaries invest in hedge funds?
Patenting financial products - a brave new world
At first glance, patents and financial products appear to be incompatible. After all patents have not been traditionally granted for financial products in Australia. Recent developments in Intellectual Property law suggest that a wide range of new financial products should be patentable in Australia. Methods of fund management, securities trading, financing arrangements and even security structures themselves may be potentially patentable. Many financial service organisations are now considering patent assets, and patent risks, as part of their business strategy. Andrew Christie, one of AAR's patent partners, considers the trend in the application for patent protection of financial products and the changes in Australian laws that have made this possible.
Traditional concepts of Intellectual Property favour patent protection for tangible rather than intangible inventions, particularly those that are physical rather than intellectual in their overall effect. However, modern legislation and interpretation of patent law are catching up in most countries, to match developments in technology and changes in the fundamental reasons for granting and enforcing patents.
The four main requirements for patentability of a new idea are:
- it must be an "invention" lying in an acceptable field of technology or commerce;
- it must be novel in view of existing public knowledge such as found in prior published documents or prior events;
- even if novel, it must involve a sufficient step from existing knowledge; and
- it must not have been the subject of prior commercial arrangements.
The detailed requirements vary from country to country, with many variations and exceptions. In Australia and the United States requirement (1) has been increasingly relaxed as Courts determine that new and commercially useful ideas of all kinds should be capable of patent protection. New ideas in agriculture, biotechnology, computer software, medical treatments have all become patentable over the past few decades. Most recently, decisions by the US Court of Appeals for the Federal Circuit and by the Australian Federal Court have suggested that business processes such as financial systems, and perhaps even financial instruments themselves, should also be patentable.
The number of patents sought and granted for business processes has accelerated in the United States, with several hundred having been granted in 2000, and several thousand applications filed, due for grant over the next few years. Financial organisations have begun to differentiate their products on the basis of patent rights, and litigation between banks for patent infringement has also occurred. The consequences of an action for patent infringement can be disastrous, including not only an award of costs and account of profits, but also an injunction against further operation of a system that might already have been promised to customers.
The situation in Australia
The increase of business patenting in Australia has been more modest, with most applications for patents having arrived as imports from US organisations under international conventions. The number of Australian organisations that have taken advantage of the current possibilities appears surprisingly few, although many applications are pending and not yet open to public inspection. Australian banks and other financial organisations still appear content to compete on service, reputation and price, rather than through exclusive ownership of leading ideas. Export of ideas to other countries using the international patent system is slow to take hold in current banking practice.
The move to an "innovative" step
During 2001 Australia has also changed requirement (3) for patentability in a way that is more dramatic, and is well suited for incremental improvements to business processes. The Patents Act 1990 (Cth) now distinguishes between an "inventive" step, which is necessary for a "standard" patent, and an "innovative" step, which is a lower threshold enabling grant of an "innovation" patent. In general terms, an inventive step signifies an invention of greater ingenuity for which patent rights may be granted for a period of up to 20 years in most countries. An innovative step provides a lesser standard for inventions in which the new idea makes a "substantial contribution", and are able to be protected in Australia for up to 8 years.
Conversely, under the Patents Amendment Bill 2001 (Cth), the requirements (2) and (3) are to be tightened by extending the range of existing knowledge against which novelty, inventive step and innovative step must be assessed, to include almost everything known anywhere in the world. An obligation is also imposed on the Australian Patent Office, to be satisfied that the invention is patentable before granting a patent, rather than simply giving the benefit of any doubt to an applicant. There are also stronger obligations on patent applicants to disclose information that might be relevant to the Patent Office assessment.
No prior commercial use
One of the most important requirements, that is often fatal to validity of patents, remains untouched. Namely the bar against prior commercial use. An application for patent protection must be made early on the development cycle of new and potentially valuable idea, before publication by the inventor, before competitors elsewhere in the world apply or publish first, and especially before any arrangements for commercial operation of the idea are initiated in Australia.
The effects of an expansion in the availability of patent protection for ideas in the financial services industry has yet to be seen. However the advantages for those willing to explore the possibilities seem immense.
Holistic risk management and investing in nature-linked securities
Holistic risk management is a new risk management technique that identifies and hedges against discrete risks of business and evaluates the relationship between those risks. In contrast, traditional risk management does not factor in any inter-relationship between the risks preferring instead to treat each risk as a discrete and separate. According to this article, holistic risk management has the potential to deliver more efficient risk management and substantial cost savings. Nature-linked securities are often used to manage holistic risks.
Nature-linked securities, explains Paul Ali, the article's author, are debt securities used to provide companies with liquidity to cover losses that may be incurred as a result of the occurrence of a natural calamity such as an earthquake or typhoon. There are 2 types of nature-linked securities:
- contingent surplus notes; and
- catastrophe-linked bonds.
Investors in contingent surplus notes would expect to receive an enhanced coupon consisting of income generated by the investment of the subscription proceeds (often in OECD government bonds) and a premium for an option to finance. When the stipulated catastrophe occurs, the company may exercise the option and exchange the notes with preference shares in the company. This enables the company to utilise the subscription proceeds to meet any losses incurred from the catastrophe. If the stipulated catastrophe does not eventuate by the maturity date, the subscription proceeds are repaid to the investors. Catastrophe-linked bonds are similar to contingent surplus notes with a major difference being the use of a special purpose vehicle ("SPV") to indemnify the sponsoring company for losses incurred as a result of the stipulated catastrophe. The SPV is paid a periodic fee by the company for this indemnity. Indemnity payments are triggered by an actual loss, an adverse movement in an index or the general magnitude of the catastrophe. The bonds are immediately redeemed from investors when the stipulated catastrophe occurs and investors will receive an amount that is net of their subscription and the indemnity payment by the SPV.
The author examines the legal issues surrounding the investment by fund managers, trustees of superannuation funds and other fiduciaries entrusted with investment assets in these securities. He notes that the courts in the United Kingdom and United States have permitted fiduciaries when considering prospective investments, to take into account the impact of an investment on the whole of the fiduciary's investment portfolio instead of considering the investment in isolation. Although there has not been any Australian judicial pronouncement supporting such a "whole-of-portfolio" approach, the author is of the view that Australian courts might be inclined to follow the approaches taken by the courts in the United States and United Kingdom.
(Source: P Ali, "Holistic risk management, nature-linked securities and investors" (2001) 29 Australian Business Law Review 246)
Regulating rating agencies - a defence of laissez-faire
The author, Mr Steven Schwarcz, argues in this essay that rating agencies should not be regulated for a variety of reasons. Rating agencies play an important role in the issuance and trading of debt securities but they remain largely unregulated entities. They make rating determinations of the likelihood of timely payment on securities. Such determinations are made based primarily on the information provided by the issuer of the securities. The significance of a rating depends on the reputation among investors of a particular agency. Due to the role played by rating agencies, they become in effect the gatekeepers of the types of securities that investors will buy.
According to the author, one rationale for regulation should be to improve efficiency ie, by improving the performance of rating agencies or limiting the negative consequences of its actions. Rating agencies have had a very good track record of the success of their ratings without regulation and increased regulation is unlikely to improve this performance. The author further contends that as the reputation of rating agencies depend on their accuracy, the move to regulate rating agencies will not bring any significant advantages to the improvement in the performance of agencies.
The argument in favour of regulation rests on the fact that the current rating agency system is conservatively biased against innovation. The author argues that this bias is evident in the area of securitisation where rating agencies have a very limited view of what constitutes a "true sale" irrespective of the legal criteria governing a true sale. In addition, rating agencies are also reluctant to rate innovative new securitisation structures even where the innovation promises to increase efficiency and reduce transaction costs. Despite this limitation, the author is of the view that regulation will not reduce or ameliorate this problem and could reduce competition thereby giving rating agencies less motivation to be innovative.
(Source: Steven Schwarcz, to be published in 2002 University of Illinois Law Review, Issue 2.)
Beat the market - use geared beta strategies
In times of lacklustre market performance, geared beta strategies have been attracting considerable interest in the United States. Geared beta strategies are a form of enhanced index strategies which seek to combine the benefits of tracking the market/ sector index and at the same time seeking to outperform that index by relying on the use of derivatives to generate the excess returns. According to the author, Mr Paul Ali, there are 2 common methods by which derivatives are used to enhance the performance of an index fund. They are:
- derivatives arbitrage; and
- option overwriting.
The author explains that derivatives arbitrage involves continuous switching between the constituent securities of an index with the derivatives linked to the index or index securities (such as options or warrants). By comparison under the option overwriting method, there is no switching of the constituent securities of the index but out of money call or put options over the index or constituent securities are given by the fund manager. Investors in geared beta funds have a primary exposure to the performance of the underlying index.
The author also discusses the fact that fund managers are required by law to adhere to the prudent investor rule. Under this rule, fiduciaries have to invest the assets entrusted to them in a manner that is consistent with the return objectives and risk profile of the particular scheme. As geared beta strategies rely heavily on derivatives, consideration must be given as to what is an effective derivatives exposure in light of the overall investment strategy and objectives of the fund.
(Source: P Ali, "Using the market to beat the market: a look at "Geared Beta" strategies and implication for fiduciaries", 19 Co & SLJ 379)
The adequacy of Australia's auditor independence regime
The authors of this article examine the different approaches to ensuring auditor independence in the US, UK and Australia. The article was written before the report by Professor Ramsay on auditor independence and as such does not examine the recommendations made by Professor Ramsay. As the authors point out, the rationale for ensuring auditor independence is to reduce the risk of corporate failure. While the auditor's report is prepared for the shareholders of the company, the integrity of the auditing process affects other stakeholders such as creditors, employees and participants in financial markets.
An analysis of the situation in the US, UK and Australia indicate that there are 2 approaches to regulating auditor independence. The first is the prescriptive approach using detailed rules and prohibitions. This is the approach adopted in the US.
The other is the conceptual approach using a more general approach to ensuring auditor independence through the use of principles instead of prescriptive rules and laying the onus of ensuring independence on the individual auditors. This is the approach favoured by the UK and to some extent Australia. There is also a divergence in approach in the area of enforcement. The US favours using an external government body - the SEC. The UK has a two-tiered system called the "non-statutory independent" system of regulation whereby the rules relating to auditor independence are formulated by an independent body together with the relevant professional accounting bodies and enforced partly by an independent body (the Investigation and Discipline Board) and partly by professional accounting bodies.
Australia favours the self regulation approach with the professional accounting bodies developing and enforcing accounting rules. The authors criticise the current approach of not requiring listed companies to set up an audit committee to appoint the auditors for the company. The current Listing Rules only require listed companies to disclose in their annual report whether it has an audit committee. This falls short of the requirements in the US and UK.
(Source: G Stapledon & J Fickling, "The adequacy of Australia's auditor independence regime", 19 Co & SLJ 472)
Risky business - can fiduciaries invest in hedge funds?
The Australian hedge funds industry has experienced rapid growth in the last couple of years. Worldwide, an estimated US$550-600 billion in assets are being managed by hedge funds. This article by Paul Ali, examines the nature of hedge funds and considers whether fund managers, superannuation trustees and other fiduciaries can invest in hedge funds. Hedge funds are generally pooled investment vehicles that are subject to very little regulatory supervision. In addition, there a very limited restrictions on their investment strategies or in the classes of assets that these funds may invest in. Due to these characteristics, hedge funds have substantial flexibility in their investment strategies unavailable to conventional investment funds.
There term "hedge fund" is not defined in the Corporations Act 2001 (Cth) (the Act). However, registration under Chapter 5C of the Act may be required if the fund falls within the definition of a registrable managed investment scheme unless offers made by the fund are excluded offers. The author states that any single responsible entity (SRE), superannuation trustees and other fiduciaries wishing to invest in hedge funds should firstly ascertain whether it has the legal capacity to make such an investment. The consequences of a lack of legal capacity to invest in hedge funds will result in the fiduciary being personally liable to the unitholders and beneficiaries for the unauthorised investment including any losses suffered.
A more contentious issue relates to the "prudent investor rule" under the general law requiring a fiduciary to take "such care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide." The author states that under the "prudent investor rule", a fiduciary must assess the risk attaching to each proposed investment in isolation ie, the fiduciary is required to examine each security and instrument that forms the portfolio of investment by the hedge fund instead of viewing the entire portfolio of the fund as a whole. According to the author, modern portfolio theory has found judicial acceptance in the United States and United Kingdom. Modern portfolio theory permits the inclusion of speculative of volatile investments in a fund so long as the collective risk profile is consistent with the fiduciary's investment objectives.
The author is of the view that the courts in Australia would follow the lead of the US and UK courts and permit fiduciaries to assess prospective investments in the context of their likely impact on the risk profile and return objectives of the fund. He argues for the modernisation of the "prudent investor rule" on the grounds that unlike traditional trusts with multiple beneficiaries and each having a successive interest in the trust estate, each beneficiary in a modern commercial trust has a present interest that is contemporaneous with the interest of the other beneficiaries. In this situation, there are no future beneficiaries for whom the trustee must safeguard the trust estate from the depredations of the present beneficiaries.
(Source: P Ali, "Adding Yield to Stable Portfolios: Regulating Investments in Australian Hedge Funds", 19 Co & SLJ 414)
