MEMORANDUM
TO: HONOURABLE MEMBERS: PARLIAMENTARY COMMITTEE ON FINANCE

SUBJECT: BULKING AND SECRET PROFITS UPDATE

INTRODUCTION:

1.         On 24 March 2006 the Registrar of Pension Funds issued a general circular requiring all pension fund administrators to disclose voluntarily all bulking and other practices whereby secret profits were made at the expense of the pension funds whose assets they administered.

2.         Responses were received from sixty six (66) pension fund administrators, which included all the major pension fund administrators. There are approximately 200 pension fund administrators approved in terms of section 13B of the Pension Funds Act, No. 24 of 1956 (the Pension Funds Act). The majority of these administrators only administer one fund and the practice of bulking different clients' funds is therefore not available to them. Having considered the responses the Registrar was satisfied that all the major administrators co­operated and responded to the general circular.

APPLICABLE PRINCIPLES:
3.         In assessing the aforesaid responses the Financial Services Board adopted the following approach in line with applicable legal principles:

3.1 The practice of bulking client funds is not per se unlawful or objectionable. On the contrary, it is expected of administrators in fulfilling their fiduciary duties towards pension funds, to achieve the best possible return on investment for the funds.

3.2 The relationship between a pension fund and its administrator is one of agency, which encapsulates the principles of trust, confidence and good faith.

3.3 An agent is not allowed to make any profit from its agency relationship except for the agreed remuneration with its principal. Any profit derived from the relationship belongs to the principal. Accordingly, the benefit which an administrator derives from the retention of a portion of any enhanced interest earned on bulked accounts, amounts to a secret profit.

3.4 It is only permissible for the administrator to retain a portion of such profit with the prior free consent of its principal following upon a full disclosure by the agent of its practice and the benefits resulting therefrom.

3.5 An approved pension fund administrator is a financial institution as defined in section 1 of the Financial Services Board Act, No. 97 of 1990. The pension fund administrator, its directors, officials and employees have certain fiduciary duties towards the pension fund whose assets they administer, including the requirement to observe at all times the utmost good faith and to exercise the care and diligence required of trustees in the exercise of or discharge of their powers and duties. It is the FSB's view that an agent must make the necessary disclosure and obtain the informed consent of its principal before sharing or receiving any benefit or part of the profit. Retrospective agreement by the principal to a practice employed by the agent in the past will not suffice to discharge the duty of trust and confidence that is required of an administrator.

ALEXANDER FORBES:
4.         Alexander Forbes engaged the Registrar in discussions on the issues of bulking and secret profits before the issuing of the circular on 24 March 2006. Following these discussions, Alexander Forbes subsequently agreed to repay an amount of R368 million to those pension funds whose assets it administered from the inception of its bulking practice (approximately a 10 year period).

5. Alexander Forbes (AF) also instructed independent auditors, Ernst & Young, to conduct a wider review of all its business practices. AF made provision for a further R 100 million in its 2007 financial statements for any irregularities that may be uncovered as a result of this wider review. The review has been completed and the report was provided to the Registrar during September 2006. The Registrar of Pension Funds and the Registrar of Financial Services Providers are currently considering the content of the report for further supervisory and regulatory action.

6.         AF also donated an amount of R12 million to the FSB's Consumer Education Trust for the specific purpose of funding training for trustees of pension funds.

ANALYSIS OF RESPONSES:
7.         Of the sixty six (66) responses alluded to above, thirty six (36) administrators reported that they do not bulk their clients' funds; did not make secret profits and had "nothing to declare" following the invitation in the Registrar's general circular. The FSB has no reason to doubt the veracity of these reports. However, the continued surveillance of pension funds and their administrators by way of on-site visits by the Pensions Department's Compliance Division will endeavour to verify these reports.

8.         Eleven (11) administrators reported that they do bulk their clients' funds but that the full credit of the enhanced interest rate is passed on to their clients or that the prior approval of trustees were obtained for any benefit accruing to the administrator from the practice of bulking funds.

9. One of the eleven administrators mentioned in paragraph 8 subsequently reported that it had uncovered a practice that required disclosure to the Registrar in view of the general circular. As part of its wider review of all practices the administrator discovered that during 1997 it had assisted in arranging fidelity guarantee cover for trustees of Pension Funds via a short-term insurance broker. The broker shared 50% of its fee with the administrator. Over the period 1997 to June 2006 a total amount of R859 700 had been earned. The administrator proposed to have the amounts verified by its auditors and thereafter to make full restitution. This process is closely monitored by the FSB and verification of the exact amount and repayment thereof is expected shortly.

10. Three (3) administrators declared that they derived some benefit byway of other practices such as undisclosed scrip lending fees and commission sharing arrangements with brokers or others. These administrators submitted proposals on how to deal with the benefits they derived from these practices. The Registrar of Pension Funds is monitoring the position of the administrators concerned.

11. The Registrar identified sixteen (16) administrators whose responses required further explanation and has subsequently met with these administrators. The discussions with these administrators focused not only on the issue of bulking, but also explored all other possible scenarios in terms of which the administrators might have made secret profits as a result of its agency relationship with pension funds, such as commission sharing with brokers, scrip lending fees, margin sharing arrangements etc.

11.1 Having engaged these administrators in discussions and having received further information, the FSB is satisfied with the responses from 5 of these administrators and the Registrar of Pension Funds does not intend to take any further action at this stage against these administrators.

11.2 The secret profits made by 10 of these administrators amount to an estimated R31.2 million.

11.2.1 The estimated benefit for 6 of the aforesaid 10 administrators amounts to R 10.1 million. The estimated benefit for the remaining 4 administrators amounts to R21.1 million.

11.2.2 The aforesaid 6 administrators undertook to repay the full amounts by which they benefited, with interest, to the pension funds concerned. The process of verifying the amounts concerned and the repayment thereof is being monitored by the FSB on an on going basis.

11.2.3 Of the 6 administrators, 4 offered to donate amounts totaling R3,25 million to the FSB's Educational Trust Fund over a three year period with the aim of utilising such funds for trustee training.

11.2.4 The responses of the remaining 4 administrators can be summarised as follows:
(a) One estimated that the benefit it derived from the practice of bulking amounted to R1.8 million. An investigation is still being conducted to determine whether or not proper disclosure was made of the bulking practice and the sharing of the benefit by the administrator prior to the implementation of the practice. The administrator undertook to repay all amounts with interest to those pension funds to whom there was no or inadequate disclosure. The progress on this investigation is being monitored by the FSB on an on-going basis.

(b) One (estimated benefit of R450 000 over a 4 year period) has not responded satisfactorily to the Registrar's enquiries and further information and documentation is awaited.

(c) One made special provision for an amount of R2.9 million and proposed to undertake a detailed investigation into the relationship which existed between it and each of its clients in order to determine the exact nature of that relationship and whether or not sufficient disclosure was made to those clients with regard to the practice of bulking.

(d) One indicated from the outset its unwillingness to repay any amount to any of the pension funds whose assets it administered. The total benefit derived by this administrator from the practice of bulking is estimated at R 16 million. The administrator justified its position on the basis that the pension funds derived a benefit (of a higher interest rate) from the practice of bulking than would have been the case if funds were not bulked. The administrator indicated its intention to engage the pension funds whose assets it administered in order to obtain their retrospective ratification of the past practice of making a secret profit from bulking clients' funds.

11.3 The last of the sixteen administrators identified by the FSB for further investigation received a commission from a trust in respect of death benefits paid in terms of section 37C of the Pension Funds Act by a number of retirement funds. Receipt of the commission was disclosed in some but not all instances. The administrator indicated that it would disgorge the total amount of commission received, estimated to be R20.5 million. Such amount is to be paid for the benefit of the beneficiaries, all of whom are currently experiencing hardship as a result of the Fidentia/Living Hands matter.

12. CONCERN
12.1 Whilst the majority of pension fund administrators tendered repatriation and repayment of all amounts to the pension funds concerned, the FSB is concerned by the approach adopted by some administrators to engage their clients in order to obtain the retrospective agreement of the trustees of those pension funds to ratify their past actions. As already indicated the FSB is of the opinion that an agent should obtain its principal's consent before receiving or sharing in any benefit or profit, or else make full restitution.

12.2 However, it may be argued administrators and the pension funds whose assets they administer enjoy contractual freedom and that there is no provision in law that prohibits the retrospective ratification of the actions of the administrator.

12.3 Such an approach would, however, be of concern to the FSB not only because current trustees may expose themselves to personal liability for failing to act in the best interests of the pension fund and its members, but also as such actions may reflect negatively on the "fit and proper" requirements of administrators. In view of these concerns, the Registrar of Pension Funds issued an information circular addressing these issues on 26 February 2007. The circular was also necessitated by a number of trustees of pension funds communicating directly with the Office of the Registrar in order to obtain guidance on how to deal with the proposals put forward by administrators on retrospective ratification of past actions.

13. EXISTING REMEDIES AND REGULATORY INADEQUACIES
13.1 The FSB's interaction with the aforesaid administrators has highlighted the need for further regulatory measures in order to address similar situations in the future. Current legislation only affords two regulatory remedies to the Financial Services Board to address secret profits.

13.2 The first is a referral of the matter to the National Prosecuting Authority for investigation and possible criminal prosecution on the basis of a contravention of the provisions of section 2 of the Financial Institutions (Protection of Funds) Act, No. 28 of 2001 (FI Act). This section requires members, directors, officials, employees and agents of financial institutions with regard to the trust property they hold, to observe the utmost good faith and to exercise the care and diligence required of a trustee in the exercise or discharge of their powers and duties.

13.3 Section 10 of the FI Act provides that a person who fails to comply with the provisions of the FI Act is guilty of an offence and on conviction is liable to a fine or imprisonment for a period not exceeding 15 years. Upon conviction a court may, in addition to any penalty it may impose, order the person to pay the institution or principal concerned any profit made and to compensate the institution or principal concerned for any damage suffered.

13.4 The second remedy at the disposal of the Financial Services Board is to withdraw the approval of an administrator in terms of section 13B of the Pension Funds Act. There is, however, a need for administrative powers for the Registrar of Pension Funds to deal with administrators who may have breached their fiduciary duties under circumstances where such breaches do not warrant the withdrawal of approval in terms of section 138. The disclosures that were made by administrators pursuant to the general circular were of a voluntary basis and those administrators who undertook to repay the amounts to their clients, did so . on a voluntary basis. The Registrar has no powers to compel an administrator to repay any amount or to impose a penalty on the administrator.

13.5 In view of the lack of regulatory measures at the disposal of the FSB, discussions are taking place between the FSB and the National Treasury with respect to potential draft legislation that will provide for the creation of an administrative enforcement committee that will be empowered to impose penalties on all financial institutions, including pension fund administrators. The Financial Services Board believes that this will provide an effective administrative remedy to address similar situations in future.

13.6 In addition a Pension Fund Amendment Bill is pending which, inter alia, seeks to strengthen and extend the Registrar's enforcement powers.

14. MATTERS REQUIRING FURTHER INVESTIGATION
The FSB's investigation has also identified an aspect that will be investigated further. Where a Life Insurance Company, who is also approved in terms of section 13B of the Pension Funds Act, provides policy contracts for underwritten funds, the Life Company finds itself in a dual capacity. Not only does it have a contractual relationship with the funds and or the members of those funds, it also acts as agent for administration purposes. The dual capacity and the manner in which Life Companies conduct themselves requires further investigation by the Registrar of Pension Funds so as to ensure that Life Companies comply with all of their fiduciary duties, especially as it pertains to the use of pension fund assets in practices such as scrip lending.

FINANCIAL SERVICES BOARD