Section 2: First Level Regulatory Examination: FSPs (sole proprietors) and Key Individuals in Categories II and IIA

FSB REGULATORY EXAMINATION PREPARATION Section 2: First Level Regulatory Examination: FSPs (sole proprietors) and Key Individuals in Categories II and IIA

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Heading Table of contents Page number Task list 5 Glossary 6 CHAPTER 1: CATEGORY II AND IIA BUSINESS MODEL 1.1 Introduction 7 1.2 Characteristics of Category II and IIA FSP 8 1.3 Separation of Client Assets 18 1.4 Roles and responsibilities of various parties 19 1.5 Need for Relevant Contracts 27 Self-Assessment Questions 29 Self-Assessment Answers 31 CHAPTER 2: ROLE OF THE INDEPENDENT NOMINEE 33 2.1 Purpose of Independent Nominee 34 2.2 Duties of Independent Nominee 38 Self-Assessment Questions 41 Self-Assessment Answers 42 CHAPTER 3: MANAGE AND OVERSEE CLIENT MANDATES 45 3.1 Use of client mandates 46 3.2 Client mandates 46 Self-Assessment Questions 50 Self-Assessment Answers 52 CHAPTER 4: DISCLOSURES 55 4.1 Minimum disclosures 56 Self-Assessment Questions 65 Self-Assessment Answers 68 CHAPTER 5: CONFLICTS OF INTEREST 71 5.1 Conflicts of Interest 72 Self-Assessment Questions 80 Self-Assessment Answers 83 4 INSETA Section 2 10b

CHAPTER 6: MANAGE AND OVERSEE TYPICAL DAILY TRANSACTIONS 85 6.1 Different product turnaround times 86 Self-Assessment Questions 90 Self-Assessment Answers 92 CHAPTER 7: LEGAL ENVIRONMENT 95 7.1 Financial soundness 96 7.2 Fidelity cover 97 7.3 Netting of transactions 99 7.4 Conducting business with other authorised FSP s 100 7.6 Continual compliance 101 7.7 Civil remedies available to the Registrar 101 Self-Assessment Questions 104 Self-Assessment Answers 106 CHAPTER 8: RECORD-KEEPING 109 8.1 Requirements for record-keeping 110 Self-Assessment Answers 117 Self-Assessment Questions 120 CHAPTER 9: CLIENT REPORTING 123 9.1 Requirements relating to client reporting 124 Self-Assessment Questions 126 Self-Assessment Answers 128 CHAPTER 10: PROHIBITIONS IN TERMS OF DISCRETIONARY CODE OF CONDUCT 129 10.1 Personal account trading 130 10.2 Prohibitions in terms of the Discretionary Code 134 Self-Assessment Questions 125 Self-Assessment Answers 138 INSETA Section 2 10b 5

Tasks The material provided in this guide is based on the following tasks, as published in Board Notice 105 of 2008 as amended by BN60 of 2010. 1 Apply the Category II and/or IIA FSP business model. 2 Manage the role of the independent nominee. 3 Manage and oversee client mandates. 4 Manage and oversee typical daily transactions. 5 Manage and oversee disclosures. 6 Understand the legal environment of Category II and/or IIA FSP. 7 Apply the record-keeping requirements. 8 Comply with requirements when reporting to clients. 9 Institute a personal account of trading policy. 10 Apply prohibitions in terms of the Discretionary Code of Conduct. 11 Deal with Nominee Regulations. Please note that any reference to: masculine gender implies also the feminine singular indicates also the plural, and vice-versa. 6 INSETA Section 2 10b

Glossary BN: a Board Notice issued by the Registrar, each Board Notice having an issue number and year of issue. Codes of Conduct: the Codes of Conduct for Administrative and Discretionary FSP s of 2003 (Board Notice 79 of 2003) and General Codes of Conduct for Authorised Financial Services Providers and Representatives of 2003 (Board Notice 80 of 2003) as amended. CISCA: the Collective Investment Schemes Control Act of 2002 ( Act 45 of 2002). Discretionary Code: The Code of Conduct for Discretionary Financial Services Providers of 2003, (issued as Chapter II of Board Notice 79 of 2003). FAIS: the Financial Advisory and Intermediary Services Act of 2002 (Act 37 of 2002). FICA: the Financial Intelligence Centre Act of 2001 (Act 38 of 2001). Financial Product: a financial product as defined in section 1 of FAIS. FSP: an Authorised Financial Services Provider as defined in section 1 of FAIS. General Code: General Code of Conduct for Authorised Financial Services Providers and Representatives of 2003 (Board Notice 80 of 2003). Long-term Insurance Act: the Long-term Insurance Act of 1998 (Act 52 of 1998). Long-term Insurer: a registered Long-term Insurance Company as defined in section 1 of the Long-term Insurance Act. Registrar: unless otherwise indicated, means the Registrar of Financial Services Providers as defined in section 1 of FAIS. Short-term Insurance Act: the Short-term Insurance Act of 1998 (Act 53 of 1998). Short-term Insurer: a registered Short-term Insurance Company as defined in Section 1 of the Short-term Insurance Act. INSETA Section 2 10b 7

Chapter 1 Category II and IIA Business Model This chapter covers the following criteria: KNOWLEDGE CRITERIA Describe the characteristics of a Category II and/or Category IIA FSP and how that differentiates it from other FSP s in Category I or III. Discuss the separation of client assets from Category II and/or IIA FSP s assets. Explain the role of various parties. Describe the need for relevant contractual agreements to be in place with the relevant other party. SKILLS CRITERIA Take the difference between Category II and IIA FSP s into account when making business-related decisions. Perform the fiduciary duty of the Category II and/or IIA FSP. Identify which assets belong to the client and which belong to the Category II and/or IIA FSP. Interpret basic financial systems. Implement systems and processes to separate client and Category II and/or IIA FSP assets. Verify that the relevant contractual agreements are in place with the relevant other party. Business is conducted in accordance with the contractual agreements. 8 INSETA Section 2 10b

1.1 INTRODUCTION When considering the nature of a Category II or IIA Financial Services Provider ( FSP ), the starting point is to consult the source giving birth to the animal we are about to consider. Section 1 of the Financial Advisory and Intermediary Services Act 37 of 2002 ( FAIS ), defines a financial service as: any service contemplated in paragraph (a), (b) or (c) of the definition of financial services provider, including any category of such services Further references to categories of financial services can be found throughout FAIS. In Section 8(4)(a)(ii) FAIS goes further to authorise the Registrar of FSP s ( the Registrar ) to approve a license and to impose conditions and restrictions on the exercise of authority in respect of that license based on, inter alia, the category of financial services which the applicant could appropriately render or wishes to render, and the category of financial services providers in which the applicant will be classified in relation to the fit and proper requirements. It is sufficient for the purpose of our introduction to emphasise that FAIS distinguishes between various categories of financial services. Little clarity is, however, provided in FAIS as to what these categories mean. Further information and parameters are provided in several pieces of subordinate legislation, i.e. regulations, Codes of Conduct, etc. In distinguishing between Category II and IIA FSP s, one immediately experiences a complication. Category II FSP s are commonly referred to as Discretionary FSP s whereas Category IIA FSP s are commonly referred to as Hedge Fund FSP s. Whilst these names are used to distinguish these two categories of FSP s, they are, in fact, both Discretionary FSP s and are dealt with by the same Code of Conduct. The focus of this book is to concentrate on Category II and IIA FSP s with a view to providing a framework in terms of which preparation for the Regulatory Exams 2, Level 1 can be explored. In order to avoid confusion we shall refer to these FSP s jointly as Discretionary FSP s. We shall emphasise Category IIA or Hedge Fund FSP s, where appropriate. Whilst exceptions may exist, the general principle is that the provisions and obligations are applicable to both FSP s with the Hedge Fund FSP having additional INSETA Section 2 10b 9

obligations. This terminology will be used inter-changeably throughout this book, particularly where applicable legislation and or references are quoted. 1.2 CHARACTERISTICS OF CATEGORY II AND/OR IIA FSP S 1.2.1 Advice versus intermediary services As stated above, FSP s may, in terms of FAIS, render different categories of financial services. Whilst the Regulations to FAIS ( the Regulations ) promulgated on 13 June 2003 provide us with a slightly better context relating to FSP s, we are still none the wiser as to the post-fais nature of these FSP s. In order to better understand the nature of the entities we are dealing with, it is necessary to work through some definitions. These definitions collectively provide us with the characteristics of these FSP s. Section 1 of FAIS defines a financial services provider as any person who, as a regular feature of their business: 1. furnishes advice; or 2. furnishes advice and renders intermediary services; or 3. renders an intermediary service. Advice is defined in FAIS as any recommendation, guidance or proposal of a financial nature furnished, by any means or medium, to any client or group of clients- a) in respect of the purchase of any financial product; or b) in respect of the investment in any financial product; or c) on the conclusion of any other transaction, including a loan or cession, aimed at the incurring of any liability or the acquisition of any right or benefit in respect of any financial product; or d) on the variation of any term or condition applying to a financial product, on the replacement of any such product, or on the termination of any purchase of or investment in any such product, 10 INSETA Section 2 10b

and irrespective of whether or not such advice i. is furnished in the course of or incidental to financial planning in connection with the affairs of the client; or ii. results in any such purchase, investment, transaction, variation, replacement or termination, as the case may be, being effected. It is clear from the definition together with the specific exclusions that advice refers to any influence exerted by an FSP or representative over a client in relation to that client s financial situation. In contradistinction to providing advice is the rendering of intermediary services by an FSP to a client in respect of a financial product. In this instance the FSP does not render advice but performs a function without providing the client with advice. Section 1 of FAIS defines intermediary services as any act, other than the furnishing of advice, performed by an FSP for or on behalf of the client or the product supplier a) the result of which is that the client offers to enter into or enters into any transaction in respect of a financial product with a product supplier; or b) with a view to i. buying, selling or otherwise dealing in (whether on a discretionary or non-discretionary basis), managing, administering, keeping in safe custody, maintaining or servicing a financial product purchased by a client from a product supplier or in which the client has invested; ii. collecting or accounting for premiums or other moneys payable by the client to a product supplier in respect of a financial product; or iii. receiving, submitting or processing the claims of a client against a product supplier. INSETA Section 2 10b 11

Intermediary services does not include i. the rendering by a bank or mutual bank of a service contemplated in paragraph (b)(ii) of the definition of "intermediary service" where the bank or mutual bank acts merely as a conduit between a client and another product supplier; ii. an intermediary service rendered by a product supplier a) who is authorised under a particular law to conduct business as a financial institution; and b) where the rendering of such service is regulated by or under such law; iii. any other service exempted from the provisions of this Act by the Registrar, after consultation with the Advisory Committee, by notice in the Gazette. In practice it is often challenging to assess whether one is providing advice or rendering intermediary services. This distinction, however, informs the category of licence an FSP has to hold and the concomitant competency, operational ability and solvency requirements. It is therefore important for the FSP to properly identify its functions to ensure that it does not render financial services for which it is not licensed thereby incurring liability. 1.2.2 Discretionary FSP Section 1 of the Codes of Conduct for Discretionary and Administrative FSP s promulgated on 8 August 2003 defines a Discretionary FSP as an FSP a) that renders intermediary services of a discretionary nature as regards the choice of a particular financial product referred to in paragraph (a), (b), (c) (excluding any short-term insurance contract or policy referred to therein), (d) and (e), read with paragraphs (h), (i) and (j) of the definition of financial product contained in section 1 of FAIS, without implementing bulking; and b) acting for that purpose specifically in accordance with the provisions of Chapter II of the Codes of Conduct for Discretionary and Administrative FSP s, read together with the General Code of Conduct (where applicable) and any other applicable law. 12 INSETA Section 2 10b

The exercise of authority by a Discretionary FSP constitutes the rendering of intermediary services. Here the FSP acts in terms of a pre-determined mandate granted by a client to the FSP to administer the client s investments, without having to seek the client s approval to implement specific investments and investment strategies, which the FSP believes to be in the best interest of the client. In comparing discretionary financial services to advice and other intermediary services, it is evident that the client is required to specifically/individually consent prior to each transaction in these instances, whilst in the case of a Discretionary FSP, the FSP exercises its authority without the client s specific/individual consent to each transaction and exercises a greater discretion over the client s investments. The financial products in respect of which a Discretionary FSP may render financial services as listed in the definition (and Section 1 of FAIS) are: a) securities and instruments, including i. shares in a company other than a "share block company" as defined in the Share Blocks Control Act, 1980 (Act No. 59 of 1980); ii. debentures and securitised debt; iii. any money-market instrument; iv. any warrant, certificate, and other instrument acknowledging, conferring or creating rights to subscribe to, acquire, dispose of, or convert securities and instruments referred to in subparagraphs (i), (ii) and (iii); v. any "securities" as defined in Section 1 of the Securities Services Act, 2002; b) a participatory interest in one or more collective investment schemes; c) a long-term or a short-term insurance contract or policy, referred to in the Long-term Insurance Act, 1998 (Act No. 52 of 1998), and the Short-term Insurance Act, 1998 (Act No. 53 of 1998), respectively; INSETA Section 2 10b 13

d) a benefit provided by i. a pension fund organisation as defined in Section 1(1) of the Pension Funds Act, 1956 (Act No. 24 of 1956), to the members of the organisation by virtue of membership; or ii. a friendly society referred to in the Friendly Societies Act, 1956 (Act No. 25 of 1956), to the members of the society by virtue of membership; e) a foreign currency denominated investment instrument, including a foreign currency deposit; f) a deposit as defined in Section 1(1) of the Banks Act, 1990 (Act No. 94 of 1990); g) a health service benefit provided by a medical scheme as defined in Section 1(1) of the Medical Schemes Act, 1998 (Act No. 131 of 1998) Read with: h) any other product similar in nature to any financial product referred to in paragraphs (a) to (g), inclusive, declared by the Registrar, after consultation with the Advisory Committee, by notice in the Gazette to be a financial product for the purposes of this Act; i) any combined product containing one or more of the financial products referred to in paragraphs (a) to (h), inclusive; j) any financial product issued by any foreign product supplier and marketed in the Republic and which in nature and character is essentially similar or corresponding to a financial product referred to in paragraphs (a) to (1), inclusive. 1.2.3 Hedge Fund FSP As stated above, on 8 August 2003 the Codes of Conduct for Discretionary and Administrative FSP s were promulgated. Of particular relevance to Category II and IIA FSP s is the Code of Conduct of Discretionary FSP s ( the Discretionary Code ). The Discretionary Code defines a Hedge Fund FSP to be an FSP 14 INSETA Section 2 10b

a) that renders intermediary services of a discretionary nature in relation to a particular hedge fund or fund of hedge funds in connection with a particular financial product listed above (applicable to Discretionary FSP s); and b) acting for that purpose specifically in accordance with the provisions of the respective codes set out in this Chapter and Chapter III of the Discretionary Code, read with FAIS, the General Code of Conduct for Authorised Financial Services Providers, 2002 (where applicable), and any other applicable law. The above definition does, in itself, not provide the necessary guidance to understand the characteristics of hedge funds. In order to better understand these characteristics, it is necessary to consider some of the other definitions contained in the Discretionary Code. These definitions relate to the hedge fund and the fund of hedge funds reference contained in the Hedge Fund FSP definition as well as the definitions of: 1. hedge 2. leverage 3. net short position and 4. short position A hedge fund means a portfolio that uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time, and in which strategies or positions include but are not limited to a) leverage; or b) net short positions; Leverage means a) any position in which the delta factor would be less than -1 or greater than 1; or INSETA Section 2 10b 15

b) a position in which the nominal exposures to assets in the portfolio are less than nil or more than 100% of the market value of the portfolio; Net short position, means a condition in which a portfolio has a greater nominal exposure to short positions than long positions in any asset class or in aggregate across the portfolio, meaning that more capital (including collateral) supports short positions than is invested in long positions and which may in certain cases require additional capital to be invested in the portfolio over and above the initial capital investment; Short position, means a) a position where an asset is sold by a seller for delivery at a future date or time, and the seller does not own such asset at the time of the sale; or b) in the case of a derivative instrument, a position where i. a decrease in the price of the underlying asset has a positive impact on the value of the derivative instrument; or ii. an increase in the price of the underlying asset has a negative impact on the value of the derivative instrument. The reference to a portfolio in the definition of hedge funds above indicates that a Hedge Fund FSP may elect to conduct its business in the form or a collective investment scheme portfolio. This provision is not regarded in the financial services industry as being exclusive and it is therefore possible for a Hedge Fund FSP to elect another structure in which to conduct its business. It is therefore important to understand what it means to hedge, in relation to a Hedge Fund FSP as these categories of FSP s may, in future, elect alternative structures in which to conduct their business. A fund of hedge funds is defined as a portfolio that, apart from assets in liquid form, consists of an interest, holding or investment in one or more other hedge funds. Assets in liquid form, as the name so rightly indicates, refer to those assets such as cash or near cash in nature, i.e. the latter class being capable of being liquidated in a relatively short period of time. Notice 1503 of 2005 issued in terms of the Collective Investment Schemes Control Act of 2002, (Act 45 of 2002) ( CISCA ), defines assets in liquid form as a) any amount of cash consisting of Reserve Bank notes and coins 16 INSETA Section 2 10b

b) any instrument determined in Chapters III and IV of Notice 1503, being Money Market Portfolios and Money Market Portfolios in Foreign Currencies, respectively; or c) participatory interests in money market portfolios referred to in Chapters III and IV, which are capable of being converted into cash within seven days, provided that any exposure to an entity created through the inclusion of assets in liquid form must be added to any other exposure to the same entity for purposes of calculating any limit prescribed in this notice. The similarities between the definitions of Discretionary FSP s and Hedge Fund FSP s are inescapable. In both instances the FSP exercises discretion in terms of a blanket mandate (most often with broad over-riding restrictions) provided by the client to the FSP. The difference between the Category II and IIA FSP s relate to the respective investment strategies that they employ as opposed to the nature of the discretion they exercise on behalf of their clients. The key differentiating factor between these two categories of FSP is that the Category IIA FSP is allowed to manage a portfolio on a discretionary basis via the use of a strategy which may result in leveraging or net short positions. Once again, this discretion granted by the client to the Category II and IIA FSP s is the distinguishing factor between the Discretionary and Hedge Fund FSP on the one hand, and other FSP s authorised in terms of FAIS and subordinate legislation thereto. 1.2.4 Duties of a Discretionary FSP Section 4 of the Discretionary Code prescribes that the duties of a Discretionary FSP are to provide the client, on request, in a comprehensive and timely manner, with any reasonable information regarding the financial products of a client, market practices and the risks inherent in the different market products. Prior to entering into a written or electronic mandate with the client, the Discretionary FSP must 1. obtain information with regard to the client s financial circumstances, needs and objectives and such information that is necessary to enable the FSP to render suitable intermediary services to the client; INSETA Section 2 10b 17

2. identify the financial products that best suit the client s objectives, risk profile and needs, subject to limitations and restrictions imposed on the FSP by its license issued under FAIS. 1.2.5 Duties of a Hedge Fund FSP Section 8A of the Discretionary Code stipulates that the duties applicable to a Discretionary FSP are also applicable to Hedge Fund FSP s and their clients, subject to a) the necessary changes; b) the provisions of Section 8A of the Discretionary Code and provisions of the Act or any other law which may render a particular provision applying to Discretionary FSPs clearly inapplicable to a Hedge Fund FSP and its clients, in general or in a particular case. A Hedge Fund FSP must, before rendering any intermediary services to a client, in respect of a financial product governed by FAIS, provide a written disclosure to the client: a) of the applicability to the relationship between the client and the Hedge Fund FSP of the requirements for Discretionary FSP s; and b) in the format from time to time determined by the Registrar, on the risks involved in investing through hedge funds. The Hedge Fund FSP must obtain written confirmation of receipt of these written disclosures from the client. In practice these written confirmations can be obtained from the client by either requesting the client to sign for receipt of the disclosures or through electronic confirmation sent by the client, e.g. email. The format of the risk disclosure referred to above was gazetted via Board Notice 571 of 2008. Hedge Fund FSP s must, after having made the above written disclosures to the client and before rendering any intermediary services to the client, obtain a signed mandate from the client that complies with Subsections 5.1 and subsection 5.2 (with the necessary changes) of the Discretionary Code. Other than this mandate the Hedge Fund FSP must also obtain an additional written 18 INSETA Section 2 10b

mandate from the client, which deals specifically with the utilisation of a hedge fund portfolio as required. 1.3 SEPARATION OF CLIENT ASSETS Section 15 of FAIS prescribes that the Registrar must publish a Code of Conduct applicable to all categories of FSP s. In addition to this Code of Conduct Section 15 further authorises the Registrar to publish different Codes of Conduct for the various Categories of FSP s. Section 16 of FAIS requires the Registrar, when publishing these Codes of Conduct to ensure that these codes contain, inter alia, a provision relating to the proper safe-keeping, separation and protection of funds and transaction documentation of clients. Pursuant to the above sections, the Registrar published the General Code of Conduct that is applicable to all FSP s and representatives on 8 August 2003. Section 10 of the General Code prescribes that an FSP, other than a FSP who receives, holds or in any other manner deals with premiums payable under a short-term reinsurance policy or who is subject to Section 45 of the Shortterm Insurance Act (Act 53 of 1998), who holds financial products or funds on behalf of a client must account for such products and funds properly and promptly. According to this section of the General Code, the FSP must, when it receives funds from a client without the intervention of a bank, issue a receipt to the client. The FSP or its duly appointed third party agent must take all reasonable steps to ensure that the funds are adequately protected. In addition to the aforesaid, the FSP or its duly appointed agent must open a bank account with a bank designated solely to hold clients funds. The FSP or agent, as the case may be, must within one business day of receipt of the funds deposit all funds held on behalf of the client(s) into this bank account. The FSP must pay all bank charges in relation to the bank account except those associated with the deposit and withdrawal of the funds from the bank account. The FSP must also ensure that all interest is paid to the client or the owner of the funds. The FSP must ensure that: the funds are dealt with strictly according to the mandate provided by the client to the FSP; the FSP must ensure that all client funds are readily discernable or identifiable from the FSP s private assets; and INSETA Section 2 10b 19

subject to any statutory or contractual provisions that the client has ready access to the funds, less any allowable deductions, i.e. agreed to by the client and/or imposed by law. Where the client has instructed the Discretionary FSP to use the client s own bank account, the Discretionary FSP must adhere to the instruction. Where the Discretionary FSP uses its own bank account, it must ensure that it has adequate systems and processes in place to administer the client s funds. 1.4 ROLES AND RESPONSIBILITIES OF VARIOUS PARTIES It is important, when considering the context of Discretionary FSP s, to briefly consider the different parties and / or legal entities that interact or potentially interact with the Discretionary FSP s. These parties and / or legal entities include the following: 1.4.1 The Registrars Different pieces of legislation create the various Registrars that regulate FSP s, representatives and the respective product suppliers with whom a Discretionary FSP could interact. These Registrars are: i. The Registrar of Financial Services Providers. This Registrar is created by Section 2 of FAIS. Its function is to regulate the conduct of FSP s and representatives in the provision of advice and the rendering of intermediary services. ii. The Registrar of Long-term Insurers. This Registrar is created by Section 2 of the Long-term Insurance Act of 1998, (Act 52 of 1998). Its function is to regulate the conduct of Long-term Insurers in the provision of long-term insurance policies to members of the public. iii. The Registrar of Short-term Insurers. This Registrar is created by Section 2 of the Short-term Insurance Act of 1998, (Act 53 of 1998). Its function is to regulate the conduct of Short-term Insurers in the provision of short-term insurance policies to members of the public. iv. The Registrar of Pension Funds. This Registrar is created by Section 3 of the Pension Funds Act of 1956 (Act 24 of 1956). Its function is to 20 INSETA Section 2 10b

regulate the conduct of pension fund organisations in their provision of benefits to members of the public. v. The Registrar for Collective Investment Schemes. This Registrar is created by Section 7 of the CISCA. Its function is to regulate collective investment schemes in the provision of investment vehicles to members of the public. It is important to note that the above legislation appoints the executive officer and deputy executive officers of the Financial Services Board ( FSB ) to be Registrars and deputy Registrars of the respective areas detailed above. 1.4.2 The Independent Nominee The Independent nominee s function is to hold assets on behalf of clients of long-term insurers, short-term insurers or pension funds, or, Administrative and/or Discretionary FSP s who wish to hold assets on behalf of long-term insurers, short-term insurers, pension funds or hold clients securities in the strate environment, or any other independent nominee that wishes to hold securities in terms of Section 36(2) of the Securities Services Act, 2004 (Act No 36 of 2004) in order to ring-fence these assets against potential claims against these product suppliers. 1.4.3 The Management Company The term Management Company is prevalent in the CISCA environment. CISCA does not however define a management company. CISCA defines a Manager as a person authorised by the Registrar to administer a collective investment scheme. When one considers the definition of a deed (also contained in CISCA) the picture becomes a bit clearer. A deed is defined as: the agreement between a manager and a trustee or custodian, or the document of incorporation whereby a collective investment scheme is established and in terms of which it is administered, and includes the deed of a management company which immediately prior to the commencement of this Act was a management company in terms of any law repealed by this Act. It is therefore clear that reference to Management Company or Manco is historic terminology and refers to a Manager as defined in CISCA. In essence INSETA Section 2 10b 21

the Manager is responsible for the administration of the collective investment scheme as more fully detailed in Section 4 of CISCA. In essence the manager must: avoid any conflict between the interests of the manager and the interests of an investor; disclose the interests of its directors and management to the investors; maintain adequate financial resources to meet its commitments and to manage the risks to which its collective investment scheme is exposed; organise and control the collective investment scheme in a responsible manner; keep proper records; employ adequately trained staff and ensure that they are properly supervised; have well-defined compliance procedures; maintain an open and cooperative relationship with the office of the Registrar and must promptly inform that office about anything that might reasonably be expected to be disclosed to such office; and promote investor education, either directly or through initiatives undertaken by an association. 1.4.4 Trustee or Custodian Trustee or Custodian is once again a reference prevalent in the CISCA environment. Section 68 of CISCA prescribes the criteria in terms of which trustees or custodians are appointed and the termination of such appointment. A manager must appoint either a trustee or a custodian for its collective investment scheme depending on the structure of the collective investment scheme, e.g. whether it is a unit trust or a management company. 22 INSETA Section 2 10b

Section 70 of CISCA prescribes that a trustee or custodian must a) ensure that the basis on which the sale, issue, repurchase or cancellation, as the case may be, of participatory interests effected by or on behalf of a collective investment scheme is carried out is in accordance with this Act and the deed b) ensure that the selling or repurchase price of participatory interests is calculated in accordance with this Act and the deed c) carry out the instructions of the manager unless they are inconsistent with this Act or the deed d) verify that in transactions involving the assets of a collective investment scheme any consideration is remitted to it within time limits which are acceptable market practice in the context of a particular transaction e) verify that the income accruals of a portfolio are applied in accordance with this Act and the deed f) enquire into and prepare a report on the administration of the collective investment scheme by the manager during each annual accounting period, in which it must be stated whether the collective investment scheme has been administered in accordance with: i. the limitations imposed on the investment and borrowing powers of the manager by this Act; and ii. the provisions of this Act and the deed g) if the manager does not comply with the limitations and provisions referred to in paragraph (f)(i) or (ii), state the reason for the noncompliance and outline the steps taken by the manager to rectify the situation h) send the report referred to in paragraph (f) to the Registrar and to the manager in good time to enable the manager to include a copy of the report in its annual report INSETA Section 2 10b 23

i) ensure that i. there is a legal separation of assets held under custody and that the legal entitlement of investors to such assets is assured ii. appropriate internal control systems are maintained and that records clearly identify the nature and value of all assets under custody, the ownership of each asset and the place where documents of title pertaining to each asset are kept A trustee or custodian must report to the manager any irregularity or undesirable practice of which it is aware, whether declared in terms of Section 21 or not, concerning the collective investment scheme and if steps to rectify the irregularity or practice in question are not taken to the satisfaction of the trustee or custodian, it must report such irregularity or undesirable practice to the Registrar as soon as possible. The trustee or custodian must satisfy itself that every income statement, balance sheet or other return prepared by the manager in terms of Section 90 fairly represents the assets and liabilities, as well as the income and distribution of income, of every portfolio of the collective investment scheme administered by the manager. At the request of the trustee or custodian, every director or employee of the manager must submit to the trustee or custodian any book or document or information relating to the administration by the manager of its collective investment scheme which is in his or her possession or at his or her disposal, and which the trustee or custodian may consider necessary to perform its functions. A person may not interfere with the performance by a trustee or custodian of its functions. (6) A trustee or custodian of a collective investment scheme, which fails to perform any of its duties referred to in this section, is guilty of an offence. Finally, section 72 of CISCA prescribes that the trustee or custodian must indemnify the manager and investors against any loss or damage suffered in respect of money or other assets in the custody of the trustee or custodian and of which loss or damage is caused by a wilful or negligent act or omission by the trustee or custodian. 24 INSETA Section 2 10b

1.4.5 The Asset Manager In searching the relevant legislation such as CISCA and the Security Services Act, one does not detect a formal definition of the Asset Manager or Asset Managing. Wikipedia defines an investment management as follows: Investment management is the professional management of various securities (shares, bonds and other securities) and assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations, etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes, e.g. mutual funds or exchangetraded funds). The term asset management is often used to refer to the investment management of collective investments, (not necessarily) whilst the more generic fund management may refer to all forms of institutional investment as well as investment management for private investors. Investment managers who specialise in advisory or discretionary management on behalf of (normally wealthy) private investors may often refer to their services as wealth management or portfolio management often within the context of socalled private banking ". The provision of 'investment management services' includes elements of financial statement analysis, asset selection, stock selection, plan implementation and ongoing monitoring of investments. Investment management is a large and important global industry in its own right responsible for care-taking of trillions of dollars, euros, pounds and yen. Coming under the remit of financial services many of the world's largest companies are at least in part investment managers and employ millions of staff and create billions in revenue. (http://en.wikipedia.org/wiki/investment_manager) In essence the manager may elect to outsource the investment or asset management function to an external asset or investment manager. The trustee or custodian would still be responsible for ensuring that the manager and asset manager remains within the parameters of the Investment Policy contained supplemental deed INSETA Section 2 10b 25

1.4.6 Long and Short-term Insurance Companies These entities perform a same function to a collective investment scheme in that they supply the financial product so that the FSP or representatives (on behalf of the FSP), as the case may be, may make it available to members of the public or other investors. Long-term insurance Companies are governed by the Long-term Insurance Act 52 of 1998 and the short-term insurance companies are governed by the Short-term Insurance Act 53 of 1998, together with various subordinate legislation. These entities may themselves appoint a Discretionary FSP to manage their assets in terms of a mandate. 1.4.7 Retirement funds Contrary to popular opinion, pension funds, provident funds and retirement annuity funds are established in terms of the Income Tax Act of 1962, (Act 58 of 1962), instead of the Pension Funds Act. These entities also play a similar role to long and short-term insurers in that they supply retirement financial products so that FSP s and representatives may (subject to the rules of the fund) make them available to members of the public. 1.4.8 Third party FSP s The identification of third party FSP s have become more important since the addition of subsection (3) to Section 7 of FAIS. Subsection 7(3) reads as follows: (3) An authorised financial services provider or representative may only conduct financial services related business with a person rendering financial services if that person has, where lawfully required, been issued with a license for the rendering of such financial services and the conditions and restrictions of that license authorises the rendering of those financial services, or is a representative as contemplated in this Act. As a Category II and IIA FSP s will conduct business with other persons who render financial services, it is important to ensure that those third Party FSP s possess the necessary licenses, failing which the Category II and IIA FSP s will attract liability. The key issue in 7(3) is to understand what it means to render financial services. 26 INSETA Section 2 10b

Section 1 of FAIS states that: financial service means any service contemplated in paragraph (a), (b) or (c) of the definition of financial services provider, including any category of such services The definition of financial services provider is also defined in Section 1 of FAIS as follows: financial services provider means any person, other than a representative, who as a regular feature of the business of such person a) furnishes advice; or b) furnishes advice and renders any intermediary service; or c) renders an intermediary service; The enquiry into whether the person is rendering financial services as a regular feature of that person s business is a factual one, and all FSP s should be wary of conducting business with any person who renders financial services without the relevant licenses. 1.4.9 Financial Advisers vs. Brokers FAIS does not contain formal definitions of financial advisors or brokers. In essence, a broker performs an integral role in bringing the product from to the supplier to the market. In essence, a broker is a distribution agent or channel. The same theory holds true in the financial services industry. With the advent of FAIS, the industry experienced a fundamental reconstruction. FAIS requires that appropriate advice be provided by a representative or independent intermediary when providing a financial product to client(s). This requirement has resulted in many brokers (who were primarily focussed on selling a financial product to a client) shifting their roles to that of financial planners. These financial planners are now required to hold the minimum fit and proper requirements (honesty, integrity, competency and operational ability). Once again Section 7(3) plays an important role when FSP s deal with independent intermediaries as the FSP s now have to ensure that these independent intermediaries possess their own FSP licenses for the category of financial products that they seek to provide to the market. INSETA Section 2 10b 27

1.4.10 Clients Clients can be broadly categorised into institutional and retail clients. Whilst many layers may exist in an investment context, these persons are typically the end-user(s) of the financial product or service. Section 1 of FAIS defines client as follows: Client means a specific person or group of persons, excluding the general public, who is or may become the subject to whom a financial service is rendered intentionally, or is the successor in title of such person or the beneficiary of such service; 1.5 RELEVANT CONTRACTS Part III of the General Code requires an FSP, other than a direct marketer, to at the earliest reasonable opportunity, and only where appropriate, furnish the client with full particulars of the following information about the relevant product supplier; a) Name, physical location, and postal and telephone contact details of the product supplier; b) the contractual relationship with the product supplier (if any), and whether the provider has contractual relationships with other product suppliers;... c) the existence of any conditions or restrictions imposed by the product supplier with regard to the types of financial products or services that may be provided or rendered by the provider;... Where such information is provided verbally, the FSP must confirm the information in writing within 30 days. It is therefore clear that the FSP is required to contract with relevant product suppliers when distributing that product supplier s financial product. In addition to the aforesaid, Section 13(1)(b)(ii) stipulates that the FSP who appoints a representative must appoint such representative in terms of an employment contract or other mandatory agreement. In terms of Section 5 of the Discretionary Code the Discretionary FSP is also required to have a signed mandate with each client prior to providing the financial services. This mandate is a contract. 28 INSETA Section 2 10b

Other contracts with third party services provider such as IT Services are required to be in place to ensure that these systems are adequately supported, thereby managing the risk for the Discretionary FSP. Summary In this chapter you should have gained a better understanding of the nature of a Discretionary FSP and Hedge Fund FSP. In so doing we considered the following: 1. The distinction between advice and intermediary services; 2. Clarification that the Discretionary FSP and Hedge Fund FSP renders intermediary services and not advice; 3. The duties of a Discretionary FSP and how it exercises the discretion granted to it by the client; 4. The duties of a Hedge Fund FSP and how it exercises the discretion granted to it by the client. In particular how the Hedge Fund FSP uses a combination of transactions resulting in leveraging or net short positions; 5. The different role-players in the context of the Discretionary FSP and Hedge Fund FSP; 6. The need for relevant contracts. INSETA Section 2 10b 29

Self-Assessment Questions 1. Section 1 of FAIS defines financial services as: a) rendering intermediary services b) providing advice c) rendering intermediary services and providing advice d) rendering intermediary services or providing advice OR rendering intermediary services and providing advice 2. A discretionary FSP renders: a) intermediary services b) advice c) advice and intermediary services d) advice or intermediary services 3. Intermediary services include: a) an act, the result of which is that the client may enter into any transaction in respect of a financial product b) an act, the result of which is that the client offers to enter into any transaction in respect of a financial product c) an act, the result of which is that the client enters into any transaction in respect of a financial product d) all of the above 4. A Discretionary FSP is defined as: a) an FSP that renders intermediary services b) an FSP that renders intermediary services of a discretionary nature c) an FSP that renders intermediary services of a discretionary nature in respect of financial products referred to in paragraphs a, b, c (excluding any short-term insurance contract or policy), d and e of the definition of financial product d) an FSP that renders intermediary services of a discretionary nature in respect of financial products referred to in paragraphs a, b, c (excluding any short-term insurance contract or policy), h and i of the definition of financial product 30 INSETA Section 2 10b

5. A hedge fund means: a) a portfolio that uses a strategy to hedge against potential losses b) a portfolio that uses a strategy to take any position that could result in losses greater than its aggregate market value c) a portfolio that uses leverage to hedge against market losses d) a portfolio that uses a short position to hedge against market losses 6. Prior to rendering intermediary services the Hedge Fund FSP must: a) make relevant disclosures b) obtain a written receipt from the client of the disclosure(s) made by the Hedge Fund FSP c) obtain a signed mandate from the client d) all of the above 7. Relevant contracts required by a Discretionary FSP include, but are not limited to: a) mandates from clients b) contracts with other FSPs c) contracts with third party service providers d) all of the above 8. A short position means: a) selling an asset that one does not own b) buying an asset with the intention of re-selling it c) selling an asset that has been held for a short period of time d) buying an asset directly off the JSE as opposed to buying an asset through a third party provider such as a Collective Investment Scheme Portfolio 9. A manager must have: a) well defined compliance procedures b) disclose all conflicts of interest c) maintain adequate financial resources to meet commitments d) all of the above 10. A CISCA deed means: a) an agreement between two parties b) an agreement in terms whereof a collective investment scheme is established c) an agreement to transfer immovable property INSETA Section 2 10b 31

d) an agreement in terms whereof a trust is established Self-Assessment Answers 1. Section 1 of FAIS defines financial services as: a) rendering intermediary services b) providing advice c) rendering intermediary services and providing advice d) rendering intermediary services or providing advice OR rendering intermediary services and providing advice 2. A discretionary FSP renders: a) intermediary services b) advice c) advice and intermediary services d) advice or intermediary services 3. Intermediary services include: a) an act, the result of which is that the client may enter into any transaction in respect of a financial product b) an act, the result of which is that the client offers to enter into any transaction in respect of a financial product c) an act, the result of which is that the client enters into any transaction in respect of a financial product d) all of the above 4. A Discretionary FSP is defined as: a) an FSP that renders intermediary services b) an FSP that renders intermediary services of a discretionary nature c) an FSP that renders intermediary services of a discretionary nature in respect of financial products referred to in paragraphs a, b, c (excluding any short-term insurance contract or policy), d and e of the definition of financial product d) an FSP that renders intermediary services of a discretionary nature in respect of financial products referred to in paragraphs a, b, c (excluding any short-term insurance contract or policy), h and i of the definition of financial product 32 INSETA Section 2 10b

5. A hedge fund means: a) a portfolio that uses a strategy to hedge against potential losses b) a portfolio that uses a strategy to take any position that could result in losses greater than its aggregate market value c) a portfolio that uses leverage to hedge against market losses d) a portfolio that uses a short position to hedge against market losses 6. Prior to rendering intermediary services the Hedge Fund FSP must: a) make relevant disclosures b) obtain a written receipt from the client of the disclosure(s) made by the Hedge Fund FSP c) obtain a signed mandate from the client d) all of the above 7. Relevant contracts required by a Discretionary FSP include, but are not limited to: a) mandates from clients b) contracts with other FSPs c) contracts with third party service providers d) all of the above 8. A short position means: a) selling an asset that one does not own b) buying an asset with the intention of re-selling it c) selling an asset that has been held for a short period of time d) buying an asset directly off the JSE as opposed to buying an asset through a third party provider such as a Collective Investment Scheme Portfolio 9. A manager must have: a) well defined compliance procedures b) disclose all conflicts of interest c) maintain adequate financial resources to meet commitments d) all of the above 10. A CISCA deed means: a) an agreement between two parties b) an agreement in terms whereof a collective investment scheme is established c) an agreement to transfer immovable property INSETA Section 2 10b 33