Collective Investment Schemes Control Bill: briefing

Meeting report

FINANCE PORTFOLIO COMMITTEE

COLLECTIVE INVESTMENT SCHEMES CONTROL BILL: BRIEFING

Chairperson: Ms B Hogan (ANC)

Relevant Documents
Collective Investment Schemes Control Bill [B28-2002]
Financial Services Board Presentation
Salient Features of Bill
Draft Conditions on Capital Maintained by Schemes in Security
Draft Conditions on Repurchase of Participatory Interest
Draft Conditions on Capital Maintained by Schemes in Participation Bonds
Draft Conditions on Capital Maintained by Schemes in Property
Draft Conditions on Schemes in Foreign Countries
Draft Conditions on Securities and Classes of Securities

SUMMARY
Mr Barrow completed the FSB presentation by detailing the major changes to existing legislation with regard to collective investment schemes in securities. These include the change to its name, the introduction of ground rules for scheme managers via the duties in Clauses 2 to 4, the penalties to be imposed via Clause 18 by the registrar for non-compliance with the Bill and the introduction of single pricing under Clause 94. Clause 88 details the revision of the capital requirements, and includes the provision that the management company may now lend scrips subject to the investment objectives in the trust deed and the registrar's conditions in Clause 85.

The major changes made to collective investment schemes in property include the expansion of the categories of investible assets under Clause 47. With regard to collective investment schemes in participation bonds, Clause 52 provides that property can now be pooled to spread risk. The Bill also provides for the possibility of self-regulation by the industry itself.

The discussion focused on the checks and balances imposed on the management company with regard to lending scrips, the effect of the suspension of repurchases on the industry generally, potential investors and the trading reputation of the scheme under Clause 88(1). The decision to scrap the "buy-sell price" was considered, as well as how the new charge tables would practically be published in newspapers and the effect of this format on ordinary investors. The provision enabling self-regulation was discussed, and whether it is desirable to move away from the statutory regulatory model.

MINUTES
Briefing by Financial Services Board
Mr Rob Barrow, Deputy Executive Officer/Deputy Registrar: Investment Institutions of the FSB, continued with the presentation of the 13 August by discussing the slides entitled "Background to the Need for Revised Legislation".

The slide entitled "Major Changes to Existing Legislation: Securities and Unit Trusts" provides that unit trusts have now been renamed collective investment schemes in securities, and what were formerly known as funds are now termed portfolios.

The slide detailing Clause 4 of the Bill deals with the introduction of the duties of managers, and in this regard Clause 4(4)(f) is a newly recognised consideration. The following slide provides that Clause 114 has been included in the Bill with the express intention of adding clout to Clauses 2 to 4. Other legal structures have also been included in the Bill because, as he understands it, trusts are generally not favourably recognised internationally, especially in the United States.

With regard to the first slide dealing with Clause 88(1) it has to be noted that those capital requirements only apply to the management company of the scheme, and requires it to remain solvent at all times. The management company has to be financially sound at all times to enable it to accept funds from investors, and it has to have the necessary funds to accommodate the risks involved. This requirement has been termed capital adequacy, and it is believed that this has been achieved in the Bill via the risk-based assessment. The registrar can amend these capital requirements, should the need arise. These capital requirements do not however apply to the various portfolios because these merely house the scheme.

The three-month period was introduced so that at the end of that period the management company will not have any liabilities. It has to ensure that its investors are satisfied, and therefore has to have the necessary capital to cover the costs should the market experience an unexpected slump.

The second slide on Clause 88(1) specifies a two-week period, this is a typing error - it should be changed to a one week period. The 5% liquidity requirement has been done away with by the Bill. It was decided that it would disadvantage the underlying investors of the scheme to maintain this requirement because the management company would bear the cost, not the scheme itself.

The slide dealing with Clause 114 shows that the units would then be put to the underlying fund to force liquidity, even though the market might not be conducive to selling them at that point. Those investors who are leaving the scheme and causing the redemption would be driving down the value of the scheme, and this clearly adversely affects the ongoing investors. The Bill provides a solution by granting the management company the right to refuse to pay. Should it be forced to pay them out, it could then split each portfolio into two separate sections: sell those units as capital within twenty business days and pay out the departing investors as and when it is possible to do so, and the remainder of the investors who continue to invest in the scheme would remain as is. This then allows the management company to avoid being forced into a ring-fencing situation, by making best use of the twenty day period. This is the manner in which the Bill seeks to handle a run on a fund.

The slide dealing with Clause 18 states that the failure to submit a return carries a fine of up to
R1 000 per day, whereas the previous fine was only between R10 and R100. Failure to submit an annual return timeously is also a sign that the administration of the scheme is not up to scratch. The Bill now imposes a fine of R1m with regard to failures of other prudential requirements, whereas the previous amount was R400. The problem then was that the "Attorney General" would have to proceed with legal action, which is costly and time consuming, and it was decided that a fine of R1m would be a greater deterrent.

Foreign schemes are dealt with in Clause 66. It is aimed at preventing countries such as the United States from setting up a scheme in a tax haven such as Jersey and then seeking to operate within the Republic. He commented that it does not hurt to include such a provision.

Discussion
The Chair asked which clause provides for the introduction of other legal structures as investment companies.

Mr Barrow replied that this is incorporated into the Bill via the definition of the term "open-ended investment company" in Clause 1.

Mr K Moloto (ANC) referred to Clause 88(1), and requested clarity on the reason or experiences that had led to the decision to introduce the "three times" requirement.

Mr Barrow replied that the extent of the margin required for derivative instruments currently lies between five and ten percent of the underlying market exposure such as in the case of futures. It is used to cover the premium issued on these futures. It is difficult to provide a more accurate figure here because the margin depends on the volatility of the market at a specific time. In order to arrive at a figure one would have to take that margin plus twice that amount which would translate into fifteen to twenty percent, which is essentially the 25% provided.

The 18-19 October 1987 crash was the greatest JSE drop in recorded history, marked at a 19% fall. Yet the gold market has dropped on three separate occasions since then, recording a maximum of a 23% drop. Thus the "three times" requirement has been introduced based on past experience and market trends, and translates approximately into the 25%.

Mr B Mnguni (ANC) requested clarity on what is meant by 'underlying market exposure'.

Mr Barrow responded that if one is dealing with a future on an index, for example, the underlying market exposure is the value of the interest being bought in that index. The futures margin currently stands at about seven-and-a-half percent, but the market exposure afforded by that future is 100%. Arriving at the underlying value of the future is a mathematical calculation, and reflects the market exposure provided by the future.

Ms R Joemat (ANC) noted that the capital requirements in Clause 88(1) only apply to the management company. She asked for clarity for requiring the management company to then forfeit its investment in the scheme once it has generated R10m. This creates the impression that the management company would then no longer share the risk of the investors.

Mr Barrow replied that the management company will not be forfeiting its investment but would instead be selling a portion of its investment to other investors. This is done because the scheme has reached a level of financial stability and no longer needs a "kick-start" from the management company. Should the scheme fail to reach that R10m mark in a relatively short period of time, it is probably an unsuccessful product.

The Chair asked what would happen should the scheme have a "run on funds".

Mr Barrow replied that the "ring-fencing" provisions would then apply.

Ms Joemat referred to Clause 85, and requested clarity on the position should the holding company use the scrip to acquire another management company for the first R1m, and then move on to create the full R10m.

Mr Barrow replied that this is an excellent question, and this would be allowed subject to the registrar's conditions. This is typically what happens in practice, and no problems are envisaged should the management company lend to its subsidiary, as long as the necessary collateral is held by the members of that corporate grouping. Yet no consensus has been reached on this matter within the industry. The ideal situation would be that the necessary collateral would be held by an independent trustee, because the arrangement would collapse if all parties formed part of the same corporate group.

Ms Joemat asked what would then happen should the investors continue to pay the administrative fee throughout this take-over process.

Mr Barrow replied that he was not sure as to the outcome of this sort of situation, but contended that it would not happen here.

Ms R Taljaard (DP) referred to the watchdog conditions, or the investment objectives contained in the trust deed and conditions imposed by the registrar, and contended that the ability to lend scrip would surely depend on the investment objectives stipulated in the trust deed. Surely these measures seek to ensure that the investments made are regular?

Mr Barrow agreed that such investments have to be authorised in terms of the trust deed, which is essentially a contractual agreement between the parties. Furthermore, it is tax that is being invested here, because the management company is able to generate additional income via a low margin. This margin currently stands at less than one percent, half of which goes to the facilitator's fee. This arrangement could be allowed as long as the condition is included that the tax yield would first have to be used to pay the investors.

The Chair referred to the suspension of repurchases where there is a redemption demand greater than five percent of the value of the portfolio, and requested Mr Barrow to explain the effect this would have on the industry should a large volume units be redeemed. Volatility is an important factor in this regard, and how would the industry manage the type of risk associated with this situation in future?

Mr Barrow responded that the collective investment scheme industry in the United Kingdom has been faced with ring-fencing situations with only two or three schemes, because the management companies tend to bend over backwards to avoid such ring-fencing. They would then go through a huge administrative hassle to avoid this, which could be hazardous to the reputation and trading name of the scheme.

The Chair stated that this is precisely her point, as it could very well deter potential investors in the scheme.

Mr Barrow agreed, and stated that this would not apply should the departing investors give the management company a two week notice of their intention to withdraw their investment from the scheme. It is believed that two weeks is sufficient time for the management company to liquidate capital to cover this redemption/ It also serves to avoid the undesirable situations which have arisen far too frequently in the past where the departing investors declare their intention on Friday and expect a full redemption on Monday.

Mr David Stronach of Association of Unit Trusts referred to the comment made earlier by Mr Barrow regarding the moral hazard this could be to the scheme's reputation, and stated that a balance has to be struck here between maintaining a productive performance record to satisfy investors and protecting the small investors. It is believed that a successful reliance on the ring-fencing provisions would protect both the investors and the reputation of the scheme.

The Chair requested clarity on whether the capital requirements apply to the scheme itself.

Mr Barrow replied that they only apply to the management company because the scheme merely houses the investment on behalf of the investor. These requirements can be spread and there are also limits on the ability to invest in certain areas, which ensures that there is not an unduly high concentration of risk. Furthermore, the funds also have to be invested in strict accordance with the investment objectives stipulated in the trust deed.

Ms Taljaard stated that she fully appreciates the problems in this area, and is satisfied the Bill strikes a balance between the competing interests.

Mr Mnguni asked whether the FSB is prescriptive of the capital structure of the management company.

Mr Barrow answered in the affirmative, but stated that the management company must have sufficient capital to justify the risk taken when investing.

Ms Taljaard requested Mr Barrow to provide Members with examples of the types of conditions to be imposed by the registrar.

Mr Barrow replied that the Draft Conditions have been distributed to Members.

The Chair referred to Clause 18, and asked whether the penalties imposed by that clause would form part of the operational income of the scheme.

Mr Barrow replied that this money would be placed in a discretionary fund and used for consumer education or specific areas that could benefit investors, such as research into market trends.

Ms Joemat questioned whether this does not disadvantage investors because the administration costs feed into the operational costs of the management company, with the result that the investors have to bear this cost.

Mr Barrow replied that it is the management company that pays the penalty, and it is not allowed to use funds belonging to the scheme. Clause 93 is very restrictive with regards to what can be charged to the scheme, and the management company has to disclose the fees up front. It also has to give a three-month notice so that investors can decide to stay with the scheme or not.

These fees can be changed but competition within the market itself will regulate it, and the media will expose unduly high fees. The FSB does keep a close eye on the fees charged, because these deviations and illegalities occur when the scheme is in financial stress.

Ms Joemat asked if the FSB has the necessary capacity to monitor this, as claimed by Mr Barrow.

Mr Barrow replied that if it does not, he has the responsibility to ensure the FSB does have the necessary capacity and can levy the industry to cover the cost. He can therefore not "cop out" and claim that certain functions cannot be performed due to a lack of capacity, and he has to employ properly skilled people to ensure this.

The Chair asked Mr Barrow to explain what the main source of profit is for schemes.

Mr Barrow replied that the up front charge on the unit could be up to 25%, and could even be covered by the annual service fee. All this has to be disclosed up front to the investor.

Ms Joemat asked if the management companies could then be made to encourage the investors to sell their interests if the exact amount of the fee charge is not disclosed up front, or could they even be encouraged to switch from one scheme to another, and whether this would come at an additional cost

Mr Barrow replied that this can be done at no cost, whereas certain schemes do charge a quarter percent. If this concerns a link product, the upfront cost can be negotiated.

The Chair referred to the introduction of single pricing via Clause 94, and asked if abandoning "buy-sell pricing" would not create much confusion, as it is the accepted method of pricing.

Mr Barrow responded that it would have to be done and the public can be educated with regard to the new system. It is a less complex pricing system.

Ms Diane Turpin, Executive Vice Chair of the Association of Unit Trusts, informed Members that an action plan has been devised to contract the statistics providers who compile these indices to publish them in the daily newspapers. Journalists will also be informed of this and how it enhances transparency over time. There is also a risk in making these tables of charges available on only a monthly basis, and they could be split from the value of the product to make matters easier. As mentioned by Mr Barrow, most investors do not pay the five percent charge and the charge could therefore be included in a separate table which is run monthly. The media still has to be consulted on how exactly this would be done in practice.

Ms Taljaard asked which agency would be responsible for compiling the fee structures and ensure they are made available.

Ms Turpin replied that it is already required that full reports be submitted on all charges, but the media has to be consulted about the practical implementation.

Mr Barrow added that the upfront charge is dealt with in Clause 100, but the effect that this would have on the publication in newspapers still has to be resolved. The table could also state that the price reflects the maximum upfront charge, part of which is the interest.

The Chair stated that such a separation of charges could be misleading and could create more confusion, as ordinary people do not keep track of these charges.

Ms Turpin replied that the charges are included upfront when the initial payment is made.

The Chair said that the problem arises when the investor is still trying to decide on where to invest, not once the investment has already been made.

Mr Barrow assured her that this would be clearly stated in the daily price list published in the newspapers, and he is sure that this matter can be worked out to resolve this confusion.

The Chair agreed that this is important and would increase transparency, but she shared Ms Taljaard's concern that it may not appear in the proper format in the newspapers.

Ms Samantha Anderson, Director of Financial Regulation: Treasury, stated that this is not generally done and the unit trust industry has been more honest here. Only financial information is published in the newspapers, and does not usually contain such information.

The Chair stated that one cannot compare collective investment schemes to the JSE because not many people on the street invest in the JSE.

Ms Turpin contended that it is not that the charges will not be made available, as they are available from the management company and the JSE website. She is aware that not everyone will access this information, but the media has not yet been consulted on how this would be worked out. A comparison of the charges of other companies could be provided in a separate table but making it available on a daily basis would be a problem, because the media will not use half a page on this in a daily publication. This published information would be used by those who invest via investment institutions, and would therefore not apply to the ordinary person.

The Chair asked Ms Turpin whether she is implying that the ordinary person would not use these charge tables.

Ms Turpin replied that 35% of such investors use this information.

The Chair disagreed, but suggested that she and Ms Turpin might be referring to different types of investors. The problem here is that this arrangement may not be consumer-friendly, which would contradict the intention to create collective investment schemes that are a viable savings tool for the person in the street.

Mr D Hanekom (ANC) stated that this arrangement would not be a problem for an investor who is "used to the game", but it would be a problem for the ordinary person who is investing for the first time. If practical problems are being experienced in publishing these charges in the newspaper, it would perhaps be helpful to include something like "inclusive of VAT" or "exclusive of VAT". The investor could then contact the scheme to gather further information.

The Chair agreed with this approach.

Ms Mnguni suggested that this would not really help the investor who would then have to contact the scheme for clarity on the actual amount, and it would thus not be transparent. Furthermore, should the management company decide to change its fees mid-month, this would not be reflected in the newspapers, should the charges be published only monthly.

Mr Barrow informed Members that it has become a market practice to make this information available on a daily basis, but the Bill does not contain any provision that requires this information to be published daily in the newspapers. This was debated by the drafting committee, and it is working well. Furthermore, the specialist funds might not publish this information daily, whereas the hedge funds do so on a monthly basis. Yet the market forces could compel these to do otherwise and publish it daily.

The Chair referred to property unit trusts and asked what other assets could be declared as property under Clause 47(2).

Mr Barrow replied that Clause 47(2) was inserted as a catch-all provision, but it could also include a unit in a participation interest scheme. Yet these cannot be included if the assets do not fall within the investment objectives in the trust deed.

Mr Mnguni asked Mr Barrow to explain why property unit trusts do not include listed property.

Mr Barrow replied that they can only hold the property themselves, and he is not certain why this was not allowed under the previous legislation. It could be to avoid tax implications because it is cheaper to pay the half percent share than paying transfer duties on the property.

Mr Stiaan Hyman, Specialist Technical and Research: FSB, confirmed that it was done as a tax-avoidance measure.

Ms Turpin referred to the slide "Major Changes to Existing Legislation: General" and stated that the industry does not intend to apply to be a self-regulatory authority at this point, but circumstances do change and this could be done at a later stage.

The Chair stated that the inclusion of this in the Bill therefore only allows for the possibility of self-regulation.

Mr Barrow agreed and stated that it is an enabling provision subject to very strict conditions in Clauses 26 to 28.

Mr Mnguni asked Ms Turpin to explain the impact of this decision on future macro-economics.

Ms Turpin replied that this deals with market efficiency, and essentially relates to a cost issue and with regard to whom exactly would do this best and at the best price.

Ms L Mabe (ANC) asked Mr Barrow to explain the reason, besides market efficiency, for including such a provision at this stage of SA's democracy.

Mr Barrow responded that the primary reason is the representivity of the collective investment schemes industry should they believe they can do a better job of regulating the industry than the FSB. This is like a walking a tightrope though, because a balance has to be struck between ensuring the efficiency of the industry and protecting investors.

Ms Taljaard contended that the self-regulating provision has not been cast in stone and there is much fluctuation between self-regulation and statutory regulation even at international level, as with the banking industry. There is therefore merit in having an enabling provision, and it creates an intelligent balance in the absence of international consensus on the matter. It would therefore function together with the other tight regulatory provisions in the legislation.

The Chair agreed that there is confusion and uncertainty and was pleased that self-regulation is not implemented at this point because this is not the right time. The provision should therefore remain as it is and the possible debates would be dealt with when they arise.

She noted that the JSE had informed the Committee that it no longer wishes to present a submission on this Bill, and this means that the Committee has not received a single submission on this Bill. This indicates that the drafting process of the Bill has been pretty comprehensive. She suggested that a clause-by-clause analysis of the Bill would not necessary at the 15 August meeting, as the briefing had been extensive and there seemed to be general consensus on the issues. She said that Members should rather be prepared to raise specific issues.

Before the meeting adjourned, the Committee agreed that the Bill be approved on 15 August.