Salient contents of the Collective Investment Schemes Control Bill
 
In this part, we look at how the Bill treats the different kinds of CISs before discussing some important cross-cutting issues. Finally we discuss certain detailed changes.
 
How the Bill deals with the different kinds of CISs
The Bill differentiates between four types of collective schemes:
- CISs in securities (this category encompasses all domestic unit trusts other than those invested in property.
- CISs in property (this category encompasses domestic unit trusts invested in property, also known as PUTs).
- CISs in participation mortgage bonds (this category was created for domestic so-called participation bond schemes).
- Foreign CISs (schemes from a foreign jurisdiction wishing to solicit funds from South African residents).
 
In addition, the Bill allows the Minister of Finance to bring other types of collective investment schemes into the regulatory net by way of declaration. Then these would become so-called ‘declared’ CISs.
 
CISs in Securities. Table 10 points to the salient elements of the Bill dealing specifically with CISs in securities, the biggest category.
 

 
Table 10. CISs in securities in the Bill
 
Clause 44 in the Bill stipulates the following with respect to how the market price of securities must be determined:
- A security must be valued at its fair market price;
- When a manager is unable to determine a market price for a security, a fair market price for such security must, at the request of such manager, be determined by a stockbroker who is a member of a licensed exchange. If such manager does not agree with the price determined by the stockbroker, it must refer the matter to the committee of the exchange concerned, which thereupon must determine the fair market price for such security.
 
This should be read in conjunction with clause 94, which deals with the valuation of participatory interests. The clause stipulates that these have to be valued on a net asset value basis.
 
Domestic CISs may of course, exchange control willing, invest in foreign securities. The Bill stipulates which foreign securities are eligible for investment.
 
CISs in securities may invest in foreign non-equity securities:
- from issuers with a long-term issuer credit rating, located in a country with an acceptable foreign currency sovereign rating, with the rating agency determined by the registrar, and
- to which the manager has applied the due diligence guidelines for issuers determined by the registrar.
 
CIS in securities may invest in foreign equity securities
- traded on an exchange which has been granted full membership by the World Federation of Exchanges, or
- listed on an exchange to which the manager has applied the due diligence guidelines determined by the registrar.
 
In principle, the Registrar has far-reaching powers with respect to the investment parameters of CISs. In terms of clause 46, the Regisrrar may determine the manner, limits, and conditions subject to which securities/ classes of securities may be included in a portfolio.
 
(In the context of CISs in securities, it should be noted that exchange traded funds (ETFs) are becoming an increasingly popular way to invest at low cost in a market. Although they are regarded as a form of mutual fund in the US and Canada, they are not considered CISs by South Africa legislators. This is due to the fact that they are contractual obligations, underwritten by a subsidiary of the JSE).
 
CISs in Property. As these are closed-end schemes, public trading is required (1) to provide an exit for investors and (2) to provide a market valuation of the participatory interests. CISs in property may invest in foreign immovable property or CIS from foreign countries, provided that the country has a registrar-approved currency sovereign rating.
 
The key points in the Bill dealing in particular with PUTs and related schemes are:
 

 
Table 11. CISs in property in the Bill
 
CISs in Participation Mortgage Bonds. Legislation relating to CIS in participation bonds used to be in a separate bill. Incorporating it into the CIS bill has a number of advantages.
- The new bill emphasises the principle of pooling. Although this has been a core tenet of CIS in securities and PUTs, it is the first time that it has been a significant influence for CIS in participation bonds. If the investors’ funds had been pooled in the Masterbond scheme, the individual losses incurred would have been substantially reduced.
- The new bill allows transferability of investments. Although, the minimum investment period for a participation bond is still five years, the investor will now be able to transfer his investment to another investor, for the remainder of the period. This will entail a cost/fee, but will be able to be done by the management company without recourse to the registrar. Under the old legislation, if an investor wanted to relinquish his investment before five years were up, the management company had to prove to the registrar that it was a case of ‘unexpected financial need’. This was a lengthy and often unsuccessful process.
 
The new transferability characteristic will make participation bonds more accessible to the small investor, and will decrease the administrative duties of the management companies.
 
This section also contains other mechanisms to protect investors in participation mortgage bond schemes, notably:
- Restrictions on the nominee company. The nominee company may not transfer, cede or in any way encumber any of its rights under a participation bond without the written consent of the registrar.
- Restrictions on collateral security. Any collateral security accepted by a manager to guarantee either the debt/mortgagor obligation under a participation bond, must be registered in the name of the nominee company.
 

 
Table 12. CISs in participation mortgage bonds in the Bill
 
Foreign CISs. Foreign CISs are those that are domiciled, registered and regulated in a foreign jurisdiction. In terms of the Bill, these schemes need to be approved by the Registrar if they wish to solicit investments from members of the public in South Africa. The Registrar may at any time withdraw approval of foreign CIS if:
- it is desirable or in the interest of investors or potential investors to do so;
- the scheme has submitted inaccurate or misleading information in its application; or
- the relevant conditions stipulated in the bill are no longer being met.
 

 
Table 13. Foreign CISs in the Bill
 
The Financial Services Board have informed us that they foresee two principles guiding the conditions set for licensing:
- That the foreign CIS be subject to a level of home regulation similar to that exercised over domestic CISs in South Africa; and
- That the foreign CIS not engage in anything — higher levels of leverage, say — that is not permissible for its South African equivalents.
 
Important cross-cutting issues
In this section we deal with the following cross-cutting issues:
- The role of the trustees / custodians
- Costs and fees
- Leverage (borrowing of funds by the scheme in order to gear up performance)
- Capital and liquidity.
- Hedge funds.
 
Trustees/ Custodians. The Bill stipulates specific requirements for the qualification and registration of trustees/ custodians. It goes on to outline specific duties for trustees/ custodians:
 

 
Table 14. Trustees /custodians in the Bill
 
Costs and fees. It should be noted that CIS charges are unregulated. The only stricture is that there needs to be full disclosure at the point of sale, AND if charges are changed, three months written notice needs to be given. The new bill makes a number of specifications regarding permissible deductions from a portfolio. The only allowable deductions are
- charges payable on the buying or selling of assets for the portfolio such as brokerage, marketable securities tax, value added tax or stamp duties;
- auditor's fees, bank charges, trustee and custodian fees and other levies or taxes;
- share creation fees payable to the registrar of companies for the creation of authorised capital or, in the case of a CIS in property, the costs incurred in the creation and issue of participatory interests;
- the agreed and disclosed service charges of the manager; and
- any costs incurred as a result of a CIS in property being listed on an exchange.
 
The borrowing of money by CISs in Property. A new provision has been added that basically allows PUTs to lever. It states that managers, other than managers of CIS in securities, are allowed to borrow money on the account of the fund, subject to the limits/ conditions determined in the deed and those imposed by the Registrar. Indications from the Financial Services Board is that the maximum leverage envisaged will be borrowing of 30 % of the market value of such portfolio at the time of borrowing.
 
The chairman of the Association for PUTS, Gerald Nelson, says the ruling is a positive move for the funds, particularly in light of the recent cut in prime interest rates. "The funds now have the flexibility to take advantage of opportunities much quicker and make strategic acquisitions through gearing. In addition, the PUT sector should attract new property funds coming to market, where the property loan stock sector was previously favoured due to its ability to gear."

However, PUTs will have to alter their trust deeds before being allowed to increase their levels of debt. Property companies need to be careful to hedge their interest rate exposure. It is also a concern that various property companies may try to improve their intermediate-term returns by gearing against lower-quality assets – an action that is unsustainable over the long term.
 
Research undertaken by the Netherlands-based Global Property Research studied the gearing situation and its effects on the performance of the PUTs in a number of countries. They found that certain minimum gearing percentages allow management to capitalise on opportunities more quickly.  The gearing percentages most beneficial to growth were found to be in the region of 20-30%.
 
In principle, the Registrar will be able to set varying borrowing limits on other CISs as well.
 
Capital and liquidity. The CIS bill removes the 5% liquidity requirement for unit trusts. Many managers held that the liquidity requirement prevented them from effectively tracking indices. Furthermore the FSB was of the opinion that liquidity should be a management company liability and not a risk borne by the fund itself.
 
Although the liquidity requirement has been removed, the bill contains numerous new measures to maintain ‘capital adequacy’. Basically, management companies need to provide/maintain ‘capital’ in three areas:
i. Seed Capital. When a new fund opens, the management company needs to deposit R1 000 000 base/seed capital in the new fund. As units are purchased and money is invested in the fund however, this base capital can be reduced. After R1 000 000 worth of units are purchased, the seed capital can be entirely withdrawn.
ii. Working Capital. The management company also needs to maintain a working capital equal to three months operating expenses (maximum of R600 000). If the fund is forced to close (taking an estimated period of three months), this requirement should allow the management company meet its responsibilities.
iii. Capital to offset the risk where the management company holds its own units. When CIS management companies hold some of their own units in a fund, it is considered a liquidity risk. They are therefore required to hold a certain percentage of the value of their held units as liquid capital, notably:
- 25% of the securities based investments;
- 10% of property-based investments; and
- 15% of participation bond-based investments.
 
This requirement provides a capital provision/insurance in the event of a large redemption/withdrawal of units from the fund. This is especially when market conditions are such that the asset/unit sales would reduce the value of the fund. By maintaining a certain amount of liquid capital, the management company can meet redemptions without jeopardizing the value of the fund. (This is an improvement on the ‘liquidity requirement’ of the current Act. Now the capital required for repurchases is no longer held directly in the fund. By implication, an equity fund can now hold 100% in equities.)
 
Although the fund managers and AUT have accepted this requirement, some feel that the 25% liquid requirement for securities based investment is a little high. They feel that it may lead to an inefficient use of funds.
 
The so-called suspension provision in the Bill is a related issue to capital adequacy as it is aimed at protecting investors in the face of a mass redemption request. As mentioned earlier, the idea is that the fund may be faced with a large redemption request during a period where market conditions are unfavourable for selling shares. Selling shares at a low price in order to raise the capital for the redemption, could reduce the net asset value of the whole fund, thereby prejudicing all investors.
 
The Bill now allows for the temporary suspension of redemptions under certain circumstances. The redemption must be more than 5% of the aggregate market value of the portfolio. In order to protect the small investor, redemptions below R50 000 are exempt from this allowance. The maximum permitted suspension period is 20 business days, during which the management company must do its best to redeem the units. This allows fund managers to price the fund once the market has settled, and more realistic sales can be made.
 
In the case where insufficient liquidity exists in a portfolio or where assets cannot be realised to repurchase or cancel participatory interests, a manager may borrow the necessary funds on security of the assets and for the account of the portfolio in question, at the best commercial terms available until assets can be realised to repay such a loan. The maximum amount so borrowed may not exceed 10 % of the market value of such portfolio at the time of borrowing.
 
A major impetus for these new reforms has been the advent/proliferation of LISPs. Since LISPs invest heavily in unit trusts, the concentration of ownership in unit trusts has increased. This makes large redemptions both more likely and more lethal. Consequently, this provision was not welcomed by the LISPs. The unit trust managers on the whole are content with the provision.
 
Hedge funds. The CIS bill has opened the door to new forms of funds. In particular, hedge funds and other leveraged funds now have increased scope to operate in South Africa. This is under the condition that the FSB is satisfied that they can be responsibly marketed. In particular, the funds need to clearly convey to the investor both the risks involved and the strategies used, including the extent to which the fund makes use of leverage. Hedge funds also require a higher level of supervision and therefore a more expensive cost structure.
 
Hedging can be described as any action taken to give protection against a sudden or large adverse price change in the security or commodity in which one trades. Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market downturns, investing in any securities and/or return-enhancing tools such as leverage, derivatives, and arbitrage.
 
(In SA there are about 50 hedge funds managing about R5bn, while there are about 5000 hedge funds worldwide. Total estimated assets under management in the hedge fund industry worldwide grew rapidly from $20bn in 1990 to more than $450bn to date.)
Kevin Shames, joint president of the Hedge Fund Association, believes that hedge funds have been misconstrued as high risk, and are actually appropriate for any market, except a strong bull one. Hedge funds allow investors to target positive returns in all market environments and are not dependent on macroeconomic scenarios or positively performing equity markets. It is generally believed that hedge fund investment will take time to grow and will therefore not pose an immediate threat to unit trusts.
 
Foreign hedge funds. Foreign hedge funds also pose a problem. When exchange controls were dropped there was a real fear that suspect foreign investment schemes would begin soliciting South African customers. The FSB therefore imposed stringent requirements before foreign schemes could operate in South Africa. Firstly, the scheme’s home regulatory environment had to be on a par with the South African environment. Secondly, the foreign funds were not allowed to ‘do anything South African funds couldn’t’.
 
Under the new bill, hedge funds will be allowed to operate to a certain degree. However, if they have powers exceeding those of the South African funds, they will not be allowed to operate. For instance most foreign hedge funds function under the ‘qualified investor rule’ that allows them to target (and afford little protection to) investors above a certain income bracket. Since South Africa does not permit this, these funds will often not be able to conduct activities in South Africa.
 
The conversion of CISs. Currently only trust-based CIS are allowed. This allows a CIS to convert to another structure, such as an open-ended investment company. As noted in the definitions, this refers to a company with an authorized share capital, structured in such a manner that it provides for the issuing of different classes of shares to investors, each class of share representing a separate portfolio with a distinct investment policy.
 
CIS are not allowed to be converted unless approved of by the registrar, and authorised by a resolution adopted by a majority in value of investors.
 
The New Bill: Detailed Changes
As the CIS bill supplants and combines a number of acts, the changes are numerous and substantial new legislation exists. Obviously, since the new bill covers more than just unit trusts, the phrase ‘unit trust’ has been replaced by ‘collective investment scheme’ throughout the bill. The changes in each section will now be noted. They are dealt with as they appear in the bill, preceded by the relevant section and subsection number and heading. As noted in the addendum, this bill completely repeals a number of acts. It does however include a transitional clause, which allows the Unit Trust Advisory Committee to continue to perform a number of functions.
 
Part I: Collective Investment Schemes
1. Definitions
The definition of ‘administration’, ‘collective investment scheme’ and ‘open-ended investment’ have been made clearer.
 
2. Principles for administration of collective investment scheme
This section has been clarified.
 
9. Appointment of members of advisory committee and termination of appointment
This section has been made clearer and greater details have been provided.
 
13. Remuneration and expenses of advisory committee
This has always been applied in practice but has now been formally defined in a bill.
 
Part II: Functions of the registrar
14. Special provisions concerning registrar's powers
The registrar may now conduct an investigation into a person involved in the administration of a CIS if he has reason to believe that such person is contravening or failing to comply with this act. He may direct the party to provide him with any information necessary and/or appear before him. Previously the registrar could only conduct an inspection, and had less power to request information and testimony.
 
18. Power of registrar to impose penalties for failure or inability to comply with requirements
In this section new provisions have been added and the penalty fine has been increased to R1000.
 
19. Power of registrar to request audit
New provisions have been added.
 
20. Attendance of meetings of association and furnishing of certain documents to registrar
This section has been explained in greater detail.
 
24. Board of Appeal
This area used to be regulated by the Financial Services Board Act. It has now been included in the CIS bill.
 
Part III: Association of Collective Investment Schemes
This entire ‘chapter’ is new. Associations have always been recognized by the FSB and liased with them on many industry issues. For the first time however, provision has been made for them to be legally recognized and licensed. The bill outlines a number of association functions as well as some details regarding their administration.
 
Part IV: Collective Investment Schemes in Securities
43. Change of name of manager, portfolio or collective investment scheme and change of shareholding or directors and removal of appointees
This bill stipulates that a manager may not change the name under which its fund is registered under this act or change its shareholding or directors, without the prior approval in writing of the registrar.
 
45. Foreign securities in which collective investment scheme in securities may invest
This section outlines some new specifications regarding CIS investment in foreign securities (e.g. prescriptions about rating agencies and scales.) Although these ‘rules’ were informally recognized, they have now been recorded in law.
 
Part V: Collective Investment Schemes in Property
47. Definitions
The definition has been expanded and clarified.
 
49. Foreign country in which collective investment scheme in property may invest
This section is new and allows PUTs to invest in foreign property subject to a number of provisions.
 
Part VI: Collective Investment Schemes in Participation Bonds
This industry used to be regulated by the Participation Bond Act (1981). It has now been included in the CIS bill and has been made more concise. In particular, the FSB removed some administrative issues out of the bill that it felt should not be regulated by law.
 
Part VII: Declared Collective Investment Schemes
This ‘chapter’ is new and has been included to cover CIS that do not ‘fit’ into the other categories. In order to be recognised as a declared CIS, a scheme has to be approved of by the Minister of Finance and published in the Gazette.
 
Part VIII: Foreign Collective Investment Schemes
66. Reciprocity
This section is new and gives the registrar powers to suspend, disqualify or restrict the operations of foreign CIS if similar actions have been imposed on South African CIS operating in a foreign country.
 
Part IX: Trustee or Custodian
As trustees are sometimes referred to as custodians, this ‘chapter’ adds the term ‘custodian’.
 
70. Duties of trustee or custodian
As noted earlier, these have been substantially increased.
 
71. Status of assets
This section used to be governed by the Financial Institutions (Protection of Funds)
Act, 2001.
 
72. Liability of trustee or custodian in respect of loss of assets
This section is new and requires the trustee/ custodian to indemnify the manager and investors against any loss or damage caused by a wilful or negligent act or omission by the trustee/custodian.
 
Part XI: Conversion of Collective Investment Schemes
This ‘chapter’ is completely new. Currently only trust-based CIS are allowed. This allows a CIS to convert to another structure, such as an open-ended investment company.
 
Part XII: General
85. Restrictions on assets which may be included in or lent by portfolio of collective investment scheme
A new provision has been added to this section. A manager may now lend assets included in a portfolio, within the limits or on the conditions determined in the deed.
 
86. Business capacity of manager
A new provision has been added to this section. A manager may now conduct business other than administration, subject to the prior approval of the registrar.
 
87. Definition
The definition of ‘liquid form’ has been clarified as any asset capable of being liquidated within seven days.
 
88. Capital requirement which manager must maintain
Capital requirements used to be fixed by the Unit Trust Act. In the new bill, the capital asset requirements vary between the different schemes.
 
89. Obligation of manager to maintain capital requirement and failure or inability to comply
This section has been extended.
 
93. Permissible deductions from portfolio
New deductions have been allowed, notably: auditor’s fees, bank charges, share creation fees (or in the case of a PUTs, the costs incurred in the creation and issue of participatory interests) and any costs incurred as a result of a PUT being listed on an exchange.
 
95. Sale of participatory interests only on payment of full purchase price and restriction on the lending or borrowing of money
A new provision has been added that basically allows PUTs to lever. It states that managers, other than managers of CIS in securities, are allowed to borrow money on the account of the fund, subject to the limits/ conditions determined in the deed.
 
96. Power of manager to borrow money to bridge liquid asset shortfalls of portfolio
This section is new and allows CIS in securities to borrow under certain circumstances. This is mainly when a CIS is faced with a large repurchase request, and the state of the market is such that an asset liquidation would severely jeopardize the value of the portfolio. It should be noted that the fund managers have stated the reluctance about using this provision, as it would increase their weighted average cost of capital, and all borrowing costs would have to be financed by the management company. (They cannot be deducted from the portfolio.)
 
97. Matters which must be provided for in deed
A new clause has been added that allows the registrar to exempt a particular type or category of CIS from the provisions of the deed. The registrar may also suspend a provision of any deed and determine the matters to be complied with or amended.
 
98. Void provisions of deed and amendment of deed
This section has been clarified.
 
101. Principal office and public officer in Republic
This section is new and requires managers to maintain a principal office in the Republic, appoint a public officer in the Republic and notify the registrar in writing, within 30 days after the commencement of this Act, of the contact details of that officer.
 
102. Winding-up of portfolio of collective investment scheme
The circumstances relating to the winding-up of a portfolio no longer make mention of specific time periods.
104. Separation of assets of portfolio handed to or received by manager, trustee or custodian.
Although this was previously common practice, it has now been formally clarified in law.
 
105. Separation of funds of investors and other persons
This section used to be dealt with in the trust deed but has now been formally clarified in law.
 
107. Fraudulently inducing person to purchase or deal in participatory interests
This section is new and makes stipulations about making/ publishing any misleading, false or deceptive information, or concealing material information, that may induce another person to purchase or deal in a participatory interest.
 
108. Evidence
This was previously governed by Common Law.
 
109. Liability for loss
This section is new and makes stipulations regarding the liability of persons who fail to comply with the provisions of this bill, or the directives of an association.
 
110. Certain written matter to bear names of certain persons
This section is new and relates to the principle of education and full disclosure of information. It outlines restrictions regarding the publishing of any written comment that may influence the value of any participatory interest.
111. Application of Companies Act in relation to manager
This section is new and provides for CIS with company structures, which are now permitted under this bill.
 
112. Delegation of functions
This section is new and allows the Minister to delegate any power conferred upon him or her by this bill to the Director-General of Finance or any other officer in the National Treasury, the FSB, an association, or the registrar.
 
113. Exemption from Act 57 of 1988
This has been clarified.
 
114. Regulations by Minister and notices by registrar
This section has been clarified and expanded.
 
116. Penalties
Specific fines/ penalties used to be defined. This bill allows more flexibility.
 
Schedule 1: Matters which must be provided for in Deed of Collective Investment Schemes in Securities
This section has been explained in greater detail and has been separated from ‘Schedule 2: Matters which must be provided for in Deed of a Collective Investment Scheme in Securities.’
 
Schedule 4: Matters to be provided for in the Rules of Association
Since the CIS bill now provides for the licensing of associations, this section is obviously new.