National Treasury and the Financial Services Board released a policy document earlier this month which will have a marked impact on hedge funds and collective investment schemes. The policy document, which was released on 13 September 2012 is named “The Regulation of Hedge Funds in South Africa” and sets out a framework for the direct regulation of hedge funds in South Africa. At the moment, hedge funds are not directly regulated in South Africa, but are indirectly regulated through the regulatory oversight which the Financial Services Board exercises over hedge fund managers, prime brokers and fund administrators.
outline of proposals
Broadly speaking, the framework document makes the following key proposals:
- hedge funds will be directly regulated as a new and separate category of collective investment scheme under the Collective Investment Schemes Control Act (“CISCA”);
- hedge funds will be categorised as either “restricted hedge funds” or “retail hedge funds”. 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, who will be permitted to market themselves more widely, will be subject to a greater degree of regulation and will, among other things, be required to meet investor redemption requests within 14 days, publish a key investor information document (“KIID”) containing short-form prescribed information aimed at assisting investors to understand the investment product, and will be subject to prescribed prudential investment requirements;
- each hedge fund will require a collective investment scheme manager approved under CISCA; and
- service providers to hedge funds such as prime brokers and fund administrators will be subject to specific regulatory requirements.
The framework document states that it is government’s intention that the applicable regulatory changes will be introduced in two phases. The first phase, which will be an interim measure, will commence when hedge funds are declared to be collective investment schemes under section 63 of CISCA and then regulated through subordinate legislation. The second phase will commence following legislative amendments to CISCA.
framework document to be welcomed
Whereas there are many details still to be worked out, the publication of the framework document and the changes set out therein should, in our view, be welcomed for, among others, the following reasons:
- It will promote investor choice. Having hedge funds regulated through CISCA will permit investors who have to date been wary of investing in unregulated investment structures, or who may not have known of suitable hedge funds because of restrictions on marketing, to gain exposure to alternative investment strategies through a regulated investment product which can be marketed under an established regulatory framework.
- It will likely lead to product innovation. Having hedge funds regulated through CISCA will likely encourage further product innovation in the collective investment scheme industry through the creation of more portfolios following different investment strategies.
- It will lower investor due diligence costs. It is likely that regulation under CISCA will lead to standardised legal structures and documentation, which will lower due diligence costs for prospective investors.
- It permits industry participants to plan ahead. Greater certainty in relation to the likely regulatory framework will permit industry stakeholders, including investors, hedge fund managers, prime brokers, fund administrators, collective investment scheme managers and collective investment scheme trustees to plan for the impact of the regulatory changes over the medium term.
- It will help develop regulatory capacity. Direct regulation of hedge funds will enhance regulators’ knowledge and insight into the nature and use of derivatives, which knowledge and insight will be useful in related areas of regulation given the wide-spread use of derivatives in the financial services industry.
- The role of the trustee will improve governance. Adoption of the CISCA regulatory framework will create checks and balances given the respective roles of the trustee/ custodian on the one hand and the manager of the collective investment scheme on the other. The role of the trustee/ custodian under CISCA is to verify, as an independent party, that the manager administers the relevant portfolios in compliance with CISCA and with the founding documents of the scheme. This type of oversight is not currently in place in many hedge fund structures.
various issues to consider
It is important that industry stakeholders respond to government’s call for comments on the framework document by 15 November 2012. Some of the issues which will, in our view, require further consideration include the matters set out below.
- Tax treatment: It is uncertain whether investors in the proposed hedge fund portfolios regulated under CISCA can expect the same tax treatment as investors who invest in collective investment schemes in securities. The framework document is silent on tax issues, save to say that hedge funds may be subject to separate tax treatment.
- Insolvency: Any portfolio which makes use of leverage has an inherent risk of insolvency. It is unclear how this risk should be addressed. The framework document suggests that the hedge fund manager will have to fund any shortfalls in retail hedge funds, but it seems unrealistic for managers to have unlimited liability in circumstances where the insolvency was not caused by manager wrong-doing.
- Prudential Investment Requirements: It will need to be considered whether the proposed prudential investment requirements for retail hedge funds are practical. For example, the suggestion in the framework document that over-the-counter derivatives must be capable of being “sold, liquidated or closed by an offsetting transaction” at fair value at the option of the hedge fund at any time may not be practical.
- Is the name “hedge fund” still appropriate? Lastly, it needs to be considered whether it continues to make sense to refer to the applicable portfolios as “hedge funds” given that strong existing associations with this term may be misleading if the applicable investment product will be reshaped by the new regulatory framework.