- OVERVIEW OF RECENT ACTIVITY
The regulatory requirements affecting the asset management industry in South Africa are continuously being refined by the applicable policymakers and regulators. For example, in the past year the Financial Markets Act (Act 19 of 2012) replaced the Securities Services Act (Act 36 of 2004), and a new regulatory framework for credit ratings agencies was introduced by the Credit Ratings Services Act (Act 24 of 2012). Specific themes emerging from recent and ongoing reforms concern the adoption of direct regulation in respect of all persons playing a role in the financial sector, the adoption of reforms to ensure that clients are treated fairly and adherence to regulatory proposals of international bodies in the aftermath of the global financial crisis. These and other changes are discussed below against the background of a high level overview of relevant regulatory requirements.
- GENERAL INTRODUCTION TO THE REGULATORY FRAMEWORK
- Main regulators
The national government department responsible for setting policy in respect of the regulation of private and public sector investment in South Africa is the National Treasury headed by the Minister of Finance. The main regulators responsible for administering applicable legislation are the Financial Services Board (the FSB) and the South African Reserve Bank (the SARB).
The FSB supervises and enforces compliance with the laws regulating financial institutions and the provision of financial services1 The FSB is organised in sector-specific departments, each headed by a registrar and deputy registrar (e.g., the Pension Funds Department is headed by the Registrar of Pension Funds). The legislation administered by the FSB is fragmented, with a specific piece of primary legislation applying to each of the different types of financial institutions and financial services providers regulated by the FSB, namely exchanges, clearing houses, securities depositories, trade repositories, credit ratings agencies, insurance companies, pension funds, collective investment schemes, friendly societies and financial services providers2 Broadly speaking, subordinate legislation is made by the Minister of Finance, while the FSB is given wide powers to regulate approved financial institutions and financial services providers through conditions, directives, rules and the like.
The SARB is responsible, inter alia, for formulating and implementing monetary policy, supervising the banking sector and administering South Africa’s system of exchange controls.3
It is the stated policy aim of the government to move toward a twin peaks model of regulation, in terms of which supervision and monitoring of the health and soundness of financial institutions will generally be exercised by the SARB, and financial market conduct will be regulated by the FSB.4 The government published a detailed policy document in this regard in February 2013.5
Another increasingly active regulator, the Financial Intelligence Centre, is responsible for administering the anti-money laundering and related requirements of the Financial Intelligence Centre Act (Act 38 of 2001).
- Intermediaries and advisers
This chapter will focus on various regulatory matters affecting financial institutions and investment vehicles. It should be noted, persons (other than providers who are specifically regulated in terms of other legislation, such as stockbrokers and managers of collective investment schemes)6 who provide intermediary services or advice to clients in respect of financial products (including insurance products, bank deposits and securities) in South Africa are subject to detailed regulation under the Financial Advisory and Intermediary Services Act (Act 37 of 2002) (the FAIS Act).
At present, the following four types of licences issued under the FAIS Act are relevant in the asset management context:
- category I (issued to financial services providers providing non-discretionary intermediary services or advice);
- category II (issued to financial services providers who provide discretionary fund management);
- category IIA (issued to financial services providers who manage hedge funds on a discretionary basis); and
- category III (issued to administrative financial services providers who aggregate client funds or securities, often through providing one-stop investment platform services).
Such licence holders (termed authorised financial services providers) are bound by principles and rules set out in applicable codes of conduct created by the FSB.
A recent requirement introduced by the FSB in relation to financial services providers is that individuals exercising oversight over the rendering of financial services by a licence holder under the FAIS Act (termed key individuals) or who represent the licence holder in rendering financial services to clients (termed representatives) must, in order to illustrate the required level of competence, successfully complete certain regulatory examinations prescribed by the FSB.7 A limited exemption applies to this requirement in respect of licence holders not domiciled in South Africa who are licensed under the FAIS Act to provide intermediary services only.8
- COMMON ASSET MANAGEMENT STRUCTURES
Investor funds are commonly pooled for investment purposes through two types of FSB-regulated financial institutions, namely collective investment schemes and long-term insurance companies who issue linked policies.
Other types of investment structures (not directly regulated by the FSB) include exchange traded funds (other than those registered as collective investment schemes) and private investment vehicles housed, for example, in partnerships and trusts.
- Collective investment schemes
Collective investment schemes are managed and administered by a manager.9 The administration of each scheme is overseen by a trustee or custodian.10 Each scheme is established by way of an agreement (referred to in the legislation as a deed) between the manager and the trustee or custodian.11 In practice, the terms of such agreements follow model wording provided by the FSB. A scheme would typically have more than one portfolio or fund. Prior FSB approval is required before a person may act as a manager, or a trustee or custodian, and before the manager may establish a scheme or a portfolio. To date, collective investment schemes have been regulated on the basis that all approved schemes should be suitable for investment by members of the general public. There are no schemes that are subject to a lighter degree of regulation on the basis of limited distribution practices or the sophistication of investors.
Three types of domestic collective investment schemes are currently permitted: collective investment schemes in securities, property and participation bonds.12 Collective investment schemes in securities (which also include money-market funds, feeder funds and funds of funds) make up the overwhelming majority of the approved schemes, and collective investment schemes in property and participation bonds are relatively rare.13
Collective investment schemes are subject to detailed prudential investment requirements. Board Notice 80 of 2012 (BN80), which came into effect on 1 July 2012, sets out the portfolios that may comprise a collective investment scheme in securities, the types of investments that may be included in portfolios of a collective investment scheme in securities, as well as the conditions, limits and the manner in which the portfolios and securities may be included. It also sets out the conditions for inclusion of listed and unlisted derivative instruments in a portfolio. Collective investment schemes in securities are open-ended, and managers are typically required to provide valuations and redemptions on a daily basis.
Broadly speaking, foreign collective investment schemes may not be marketed to members of the public in South Africa unless the applicable scheme has been approved by the FSB.14 The current requirements for approval include considering whether or not the foreign jurisdiction in which the foreign collective investment scheme is domiciled has a regulatory regime for collective investment schemes of at least the same standing as that of South Africa, and whether the foreign collective investment scheme poses investment risks that are higher than would be permitted for a comparable scheme in South Africa.15 The requirements (which disqualify many foreign collective schemes from approval) are currently being reviewed and, to this end, the FSB has published draft revised requirements for public comment.16
- Linked policies
A well-known financial product used for investment purposes is a linked policy issued by a long-term insurance company. A linked policy is a long-term policy of which the amount of the policy benefits is not guaranteed by the long-term insurer, but is to be determined solely by reference to the value of particular assets or categories of assets that are specified in the policy and are actually held by or on behalf of the insurer specifically for the purposes of the policy.17 Given the circumscribed nature of the insurer’s liability under such a linked policy, assets in which a linked policy is invested need not be spread in accordance with the prescribed prudential investment requirements for insurance companies.18 The policyholder or its investment manager usually specifies the assets or types of categories of assets to be held by the insurer for the purposes of the policy. Use of an insurance policy in the above circumstances is often referred to as making use of a life wrapper.
- Other structures
One of the most significant new trends in the South African asset management sector has been the growth in passively managed funds, with exchange traded funds becoming more prevalent as an asset class. As of June 2013, more than 30 exchange traded funds were listed on the equity market of the Johannesburg Stock Exchange (the JSE).19 Exchange traded funds could in certain circumstances fall to be regulated as collective investment schemes, and would otherwise typically fall to be regulated by the Companies Act20 and the JSE.
We discuss two common vehicles used for private investment structures, namely the en commandite partnership and the bewind trust, in our discussion of hedge funds and private equity funds in Section VI, infra.
- MAIN SOURCES OF INVESTMENT
Asset managers, capital markets and investment products are utilised predominantly by a small segment of the population, consisting mainly of institutional investors and a relatively small number of high net worth individuals. Investment infrastructure is mostly inaccessible to the majority of the South African adult population, most of whom live at or below the poverty line and millions of whom do not have a bank account.21
- Capital markets
The JSE is the largest exchange in Africa with an equity market capitalisation of approximately 8.7 trillion rand at the end of July 2013.22 The JSE also operates commodity, equity and currency derivatives markets and an interest rate market.23
- Assets under management
According to the FSB,24 in December 2011 long-term insurers had assets of 1.73 trillion rand, short-term insurers had assets of 84 billion rand, and in December 2010 public and private pension funds had assets of 2.193 trillion rand.25 According to Association for Savings and Investment South Africa (ASISA),26 South Africa’s collective investment schemes industry had approximately 1.2 trillion rand under management as at 31 March 2013.
The private equity industry had an estimated 126.4 billion rand under management as at 31 December 2012.27 The hedge fund industry had an estimated 33.6 billion rand under management as at the end of June 2012.28
- KEY TRENDS
- Regulation of previously unregulated participants and investments
The FSB has taken significant steps to close what it perceives to be regulatory gaps and to exercise regulatory control over key players in the asset management industry. The recently enacted Credit Ratings Services Act (Act 24 of 2012) creates a regulatory framework administered by the FSB for the registration of credit rating agencies and the provision of credit rating services in South Africa. The newly enacted Financial Markets Act provides, inter alia, a regulatory framework pursuant to which detailed regulation of over-the-counter derivatives may be established in future (including the establishment of local and offshore trade repositories29 and independent clearinghouses30 ). The FSB also intends to publish conditions for investment in derivative instruments by pension funds, which will set clear parameters for the investment by pension funds in certain derivative instruments.31 In March 2012, the FSB published conditions32 for investment by pension funds in private equity funds. It is expected to require hedge funds to be registered under CISCA and to publish conditions for investment by pension funds in hedge funds.33
- Reforms aimed at ensuring that clients are treated fairly
The FSB is in the process of developing a Treating Customers Fairly programme for regulating the market conduct of financial services firms.34 This programme will seek to ensure that fair treatment of customers is embedded in the culture of financial firms, and it will be based on a combination of market conduct principles and explicit rules coupled with regular review of applicable reports by the FSB. Although the programme has not yet been finalised (and will only be finalised and come into effect during 2014 or possibly 2015), many firms are already evaluating their practices against the applicable outcome-based principles.
As part of the ongoing investigation of possible measures to promote household savings and reform the retirement industry, National Treasury recently published a technical discussion paper for public comment on charges in the retirement industry.35 This document will likely form part of a wider debate in respect of possible regulation of the charges financial sector firms levy against client investments.
A reform that has been completed and is in effect relates to the more detailed regulation of actual and possible conflicts of interest of financial intermediaries and advisers licensed under the FAIS Act, including the requirement that such persons must adopt and implement a conflict of interest management policy.36
- Increasingly sophisticated regulatory measures and emulating offshore developments
An example of the increased sophistication in the regulatory oversight exercised by the FSB and its emulation of offshore developments is the Solvency Assessment and Management framework (the SAM framework), which is being developed by the FSB for the purposes of establishing a risk-based supervisory regime for the prudential regulation of both long-term and short-term insurers in South Africa (including reinsurers). The SAM framework is intended to align the South African insurance industry with international standards, specifically the Solvency II regime implemented for European insurers and reinsurers. Final implementation of the SAM framework is currently envisaged to be 1 January 2016, but insurers will be expected to calculate and report on the regulatory requirements under the SAM framework from the beginning of 2015 in parallel with the existing regime.37 Certain interim measures relating to the governance, risk management and internal controls of insurers will be put in place by means of a legislative amendment, with effect from 2014.38
- SECTORAL REGULATION
The South African insurance industry is split between the long-term insurance industry (otherwise known as life insurance) and the short-term insurance industry (typically termed general insurance in other countries).
South Africa’s long-term insurance industry is regulated by the LTIA,39 while the short-term insurance industry is governed by the Short-term Insurance Act (the STIA).40 There is no bespoke legislation in place for the reinsurance industry, which is currently regulated by the aforementioned acts, but the South African regulator is considering overhauling the legislative framework of the reinsurance industry in South Africa.41
South African insurers have an obligation to ensure that they are always able to meet their liabilities and their capital adequacy requirements, as determined by the insurer’s statutory actuary.42 To this extent, insurers have to adhere to specific prudential spread requirements, which set out the maximum permitted holdings in particular kinds of assets.43 Compliance with both the capital adequacy and prudential requirements is verified through the submission to the FSB of unaudited quarterly returns and the audited annual returns. In order to protect their assets, insurers are prohibited from encumbering their assets, borrowing any asset and giving security in relation to obligations between other persons.44 Insurers may furthermore only invest in derivatives for the purpose of reducing investment risk or for efficient portfolio management, and securities lending is subject to specific requirements, including the holding of adequate collateral in the form of cash or securities, or both. 45
We have noticed an increased interest in offshore and local investment offerings to South African high net worth individuals and institutional investors through policies (including linked policies) issued by long-term insurance companies. We have also noted that private sector pension funds are becoming increasingly interested in outsourcing their pensioner liabilities to long-term insurers.
South African pension funds that are registered under the Pension Funds Act (Act 24 of 1956) (the PFA) are regulated in terms of the PFA by the FSB.46 In March 2011 the Minister of Finance published new regulations prescribing the prudential investment limits applying to pension funds. These investment limits are commonly referred to as Regulation 28.47
Overview of Regulation 28
The board of trustees of a pension fund has a fiduciary responsibility to act in the best interest of the members of the fund, whose benefits depend on the responsible management of the pension fund’s assets. In the FSB’s view, there is a general lack of investment expertise among trustees of pension funds, and therefore the relatively new Regulation 28 remains primarily rules-based.48 Regulation 28 specifies that a pension fund may appoint specialist advisers such as asset managers, asset consultants and risk consultants to assist with investment decisions, but the board of the pension fund ultimately remains responsible for the management of the pension fund’s assets.49
A pension fund may only invest in the kinds of assets specified in Regulation 28, and within the relevant issuer and aggregate limits that are defined per asset class. By way of example, Regulation 28 limits the maximum exposure of a pension fund to equity securities to 75 per cent of the aggregate fair value of the total assets of a fund,50 and provides that (in addition to relevant sub-limits) the total exposure of a pension fund to unlisted debt instruments, unlisted shares, unlisted interests in property companies, hedge funds, private equity funds and any other asset not specifically referred to in the relevant schedule may not exceed 35 per cent of the aggregate fair value of the total assets of a pension fund.51 Should a pension fund be of the opinion that it would be prudent to exceed any of the prescribed limits, it can approach the FSB for a possible exemption.52
The look-through principle
When determining the asset class of a specific asset for the purposes of determining compliance with Regulation 28, a pension fund must apply the look-through principle. In terms of this principle, which is intended to prevent the circumvention of the prescribed limits, a pension fund must always disclose and report on the underlying assets to which it has economic exposure if the instrument directly held by the pension fund merely provides a conduit to such exposure.53 The principle does not apply to investment by pension funds in private equity and hedge funds that conform to the conditions prescribed in Regulation 28.54
A pension fund may only borrow for bridging purposes to maintain sufficient liquidity for its operational requirements.55
A pension fund may engage in securities lending, subject to certain prescribed conditions under Board Notice 2 and 4 of 2012 (the Securities Lending Notice). Any securities that are subject to a securities lending transaction remain the assets of the pension fund (and therefore subject to the Regulation 28 prudential spread limits) and must be disclosed in the annual financial statements of the pension fund as assets of the pension fund.
Pension funds may only conclude securities lending transactions in terms of a legally binding written agreement with the counterparty that complies with the definition of a master agreement as contemplated by Section 35B of the Insolvency Act,56 and such agreement must furthermore comply with certain requirements set out in the Securities Lending Notice.57 Post-insolvency set-off is, as a general rule, not permitted under South African law, but Section 35B of the Insolvency Act allows for netting and set-off provisions contained in such master agreements to be enforced post-insolvency of a party to such an agreement.
Regulation 28 allows pension funds to invest in derivative instruments subject to certain prescribed conditions. As of July 2013 these conditions have not yet been finalised.
A growing trend has been the implementation of a number of liability matching strategies by South African pension funds. These can take a number of forms, including structured bank deposits, swap and bond transactions, long-term policies, outsourcings and active mandates. Central to many of these cash-flow matching transactions is the hedging of inflation-related risks.
- Real property
Insurance companies and pension funds are significant investors in commercial property. Two other types of South African institutional investors who invest in commercial property are property unit trusts and property loan stock companies. Property unit trusts are collective investment schemes in property regulated as collective investment schemes by the FSB. Property loan stock companies are not directly regulated by the FSB. The term loan stock signifies the practice of such companies to issue linked units to investors, with each linked unit consisting of an equity share and a variable rate debenture. Due to proposed amendments to the tax legislation in respect of the deductibility of interest, property loan stock companies may be utilised less in future. Both property unit trusts and property loan stock companies are often listed on the JSE.
In terms of recent amendments to the tax legislation and the JSE listing requirements, the internationally recognised real estate investment trust (REIT) framework has been introduced in South Africa. Broadly speaking, to qualify as a REIT, an entity must be listed with the JSE and classified by the JSE as a REIT. A REIT is exempt from capital gains taxation on the disposal of its assets. In addition, distributions by a REIT are deemed to be expenditure incurred by the REIT in the production of income, and therefore fully deductible from the revenue of that REIT if, during a particular year of assessment, more than 75 per cent of the gross income of that REIT consists of amounts received by or accrued to the REIT in the form of rentals or other similar amounts derived from immoveable property, or amounts received by that REIT by way of a distribution from another REIT. Such distributions will be deemed to be rental from a source in South Africa and taxable in the hands of the investors in the REIT.
- Hedge funds
At present, provided that hedge funds are not offered to members of the public, the structures in which hedge funds are housed are not directly regulated by the FSB. For various reasons, the investment structures in which the majority of South African hedge funds are typically housed are either en commandite partnerships or debenture structures.
En commandite partnerships are regulated by the common law. The main advantage of this type of partnership is that a commanditarian, or limited partner, is not liable for the debts of the partnership in an amount greater than its investment commitment to the partnership (provided applicable common law requirements are met).58 The managing partner (also known as the general partner) has unlimited liability for the debts of the partnership.
Investors in debenture structures subscribe for debentures issued by a company. The company lends or contributes the proceeds of such subscription to a trust. The trust appoints a hedge fund manager to manage its portfolio of assets, and vests income and gains resulting from the portfolio in the holders of the debentures (in their capacity as beneficiaries of the trust).
Pension funds are significant investors in hedge funds. Under Regulation 28 pension funds are permitted to invest up to 10 per cent of their assets in hedge funds, subject to such conditions as the FSB may prescribe. The FSB published draft conditions for comment in June 2012, but the conditions have not been finalised as at August 2013.
In terms of a September 2012 policy document,59 the National Treasury and the FSB propose to regulate hedge funds directly as a new and separate category of collective investment scheme under CISCA. In terms of the proposal, hedge funds will be categorised as either restricted hedge funds or retail hedge funds. According to the policy document, restricted hedge funds will be subject to lighter regulatory requirements and must have a restricted investor base consisting only of qualified investors who invest pursuant to private arrangements. Retail hedge funds, which will be permitted to market themselves more widely, will be subject to a greater degree of regulation and will, inter alia, be required to meet investor redemption requests within 14 days and publish a key investor information document containing short-form prescribed information to assist investors to understand the investment product, and will be subject to prescribed prudential investment requirements.
- Private equity
At present, provided that private equity funds are not offered to members of the public, the structures in which private equity funds are housed are not directly regulated by the FSB. For various reasons, the investment structures in which the majority of South African private equity funds are typically housed are either en commandite partnerships or bewind trusts.
The basic features of an en commandite partnership are set out above.
A bewind trust is a type of trust vehicle registered under the Trust Property Control Act,60 in terms whereof the applicable assets that are subject to the trust arrangements are owned by the beneficiaries of the trust, but the trustees of the trust hold and manage such assets.61 In the context of a private equity vehicle structured as a bewind trust, the cash contributions of the investors to the trust form the initial assets of the trust. Each investor is a beneficiary of the trust, and the investors own the assets of the trust jointly in undivided shares in proportion to their respective contributions.
Pension funds are significant investors in private equity funds. Under Regulation 28 pension funds are permitted to invest up to 10 per cent of their assets in private equity funds, subject to such conditions as the FSB may adopt. The FSB has issued binding conditions for investment by a pension fund in a private equity fund.62
- Other sectors – the Public Investment Corporation (the PIC)
The PIC is the principal asset manager for South Africa’s public sector (including the Government Employees Pension Fund) and has, as an additional mandate, the obligation to contribute to economic development. The PIC is wholly-owned by the South African government. It is regulated by its own statute, the Public Investment Corporation Act,63 and as a public entity is bound to comply with the financial management and governance provisions of the South African Public Finance Management Act.64 As at 31 March 2012 it reported assets of 1.17 trillion rand under management.65
The PIC has allocated 5 per cent of its funds under management for investment in Africa other than in South Africa, and 5 per cent of its funds in offshore investments other than in Africa as at 31 March 2011.66 Furthermore, it is active in promoting environmental, social and governance issues in the South African marketplace, and is one of the key supporters of the recently drafted Code for Responsible Investing in South Africa.67
- TAX LAW
South African tax legislation has been, and continues to be, subject to numerous changes that affect the asset management industry. A number of the pertinent changes (and proposed changes) that have occurred in the past year are set out below.
- Interest withholding tax
An interest withholding tax has been introduced, which is proposed to take effect from 1 January 201568 at an expected rate of 15 per cent on any interest paid to a non-resident to the extent that the interest is regarded to be from a source within South Africa (in this regard, certain deeming source rules have been introduced). Final details of the interest withholding tax provisions are not currently known.
- Hybrid debt and hybrid interest
New rules have been proposed in respect of the deductibility of interest, limiting the amount of interest that is deductible in respect of certain restructure transactions or in respect of debt where there is a controlling relationship between the debtor and the creditor, and delaying the deduction until such time as the interest is included in the income of the debtor where certain controlling relationships are present. Furthermore, in terms of the proposed amendments, debt that contains equity-like characteristics will be treated as equity for South African income tax purposes.69
- Changes to the tax treatment of collective investment schemes
The changes in the regulatory treatment of hedge funds as collective investment schemes have prompted a number of proposed amendments to the tax treatment of collective investment schemes. In terms of existing law, collective investment schemes are exempt from capital gains tax. Amounts other than amounts of a capital nature that are distributed by the collective investment scheme to the holders of participatory interests by no later than 12 months after receipt or accrual of the amount, is deemed to have accrued directly to the holders for tax purposes. Redemptions or disposals of participatory interests in collective investment schemes are treated in accordance with ordinary principles (i.e., capital gains tax if the participatory interests are held as capital assets (or deemed to be capital assets if they were held for more than three years) or income tax if the participatory interests are held as revenue assets). The proposed amendments that are currently being considered include an income tax exemption (in addition to the existing capital gains tax exemption) for collective investment schemes and the deemed revenue treatment of disposals or redemptions of participatory interests in restricted funds (which issue participatory interests to the general public, but only to qualifying investors). The proposed amendments are currently being considered and debated, and certainty regarding the proposed amendments will only be obtained when the final Taxation Laws Amendment Bill, 2013 is released.
Significant new developments on the horizon are the introduction of the FSB’s Treating Customers Fairly programme, the introduction of the SAM framework for insurers, the introduction of regulation under CISCA for hedge funds, ongoing tax changes in relation to the treatment of interest and the introduction of the twin peaks regulatory model. While the precise nature of these reforms is not yet finalised, they are likely to have a marked impact on the South African asset management industry.
With respect to specific regulatory measures, in the next 12 months the industry expects to see the finalisation of the respective conditions under Regulation 28, subject to which a pension fund may have exposure to derivative instruments and to hedge funds and the finalisation of a number of changes to the present regulatory framework, as contemplated in the Financial Services Laws General Amendment Bill 2012.