Product suitability at the core of latest license withdrawal and debarment

The Financial Sector Conduct Authority (FSCA) announced 4 June 2020 that it had withdrawn Ecsponent Financial Services’ (EFS) license for breaches of financial sector laws, most notably its failure to conduct suitability testing before marketing or selling investments. Eight days later the authority confirmed that the key individuals on the EFS license would be debarred for a period of two years. These are the latest developments in a multi-year saga that saw investors, many among them pensioners, lend almost R2 billion to the now-struggling, Ecsponent Limited.

Is capital raising wealth generating?

Ecsponent Ltd was listed on the JSE on 2 June 2014. According to its 2014 Integrated Annual Report, the firm’s main business activities included financial services and investments in private equity opportunities. Oddly, the report identified capital raising, credit, and capital growth as its main wealth-generating activities. Ecsponent Ltd’s executive also determined that the easiest way to raise capital to fund acquisitions and grow their unsecured lending business was to issue preference shares. 

Following shareholder approval, it initially issued three classes of preference shares, saying: “The group now has the ability to raise investment capital in order to fund growth and further acquisitions which we believe will provide for improved wealth generation”. A couple of basic definitions are necessary here. First, the JSE defines a preference share as “a stock which provides a specified dividend that is paid before any dividends are paid to ordinary shareholders, which takes precedence over common stock in the event of liquidation”. And second, a redeemable preference share is one that will be ‘bought back’ or repaid by the issuer after the expiry of an agreed period. 

By June 2019 Ecsponent Ltd had raised approximately R1,9 billion under six classes of preference shares. Classes A, C, D, E, and G were “initial issue shares, redeemable after five years” and paying monthly dividends between 10% and 12,5% per annum. Class B was issued on the basis of an investor receiving a predetermined equity growth upon redemption, being offered at 70% of the initial value. “The investment product is classified as debt funding and consequently the dividends are classified as a finance cost and included in the finance cost expense in the statement of profit and loss,” explained Ecsponent Ltd. In other words, anyone investing in Ecsponent Ltd preference shares was effectively ‘loaning’ money to the company for its various acquisition and lending activities. 

Not suitable for pensioners

EFS was involved in the selling and marketing of preference shares in its parent, Ecsponent Ltd, between 2014 and 2019. In its 12 June 2020 press release the FSCA said the classes of shares that paid monthly dividends were popular amongst pensioners, as they mimicked a monthly pension payment. IFAs, approached by IOL for comment during March 2020, indicated that preference shares were potentially risky. Magnus Heystek of Brenthurst Wealth told IOL that the small micro-lenders and biotech firms that Ecsponent Ltd was investing in to repay its [preference share] loans were anything but risk free. And co-founder of Gradidge-Mahura Investments, Craig Gradidge, was equally forthright. He told IOL that “there was a definite mismatch in terms of [Ecsponent Ltd’s] funding model and the attractive interest rates [it offered, versus] investing in early stage companies”. 

The FSCA decided to investigate EFS after it received complaints from the public re the suitability of Ecsponent Ltd preference shares for risk averse investors. Subsequent investigations focused on EFS’ marketing activities and the advice and intermediary activities carried out by the entity. The FSCA felt that EFS was side-stepping the regulatory requirement to conduct suitability testing by having individual investors sign an agreement, wherein they instructed the adviser or intermediary “not to perform a comprehensive financial needs analysis” and instead “render a specific financial service”. After allowing EFS time to correct these shortcomings, the FSCA stepped in by initially suspending and finally withdrawing its license. 

Contravening section 8 of the Code

The FSCA said that it was unlawful to rely on an agreement to subvert suitability testing and that section 8 of the FAIS General Code of Conduct clearly stipulated what was required when advising clients on investments. 

The need for suitability testing becomes evident when we consider recent developments. Early 2020, Ecsponent Ltd announced it would default on R188 million worth of its redemption obligations. It also announced that the dividend dates in April, May, and June would be cancelled. And, with a weak balance sheet, it proceeded with a plan to convert preference shares into ordinary shares in the company. On 29 May 2020 it informed the market: “The relevant resolutions relating to the approval of the MOI Amendments had not been carried for Class A, B, C, and E, and these classes of preference shares would accordingly be converted to ordinary shares”. 

Commenting on the initial two week suspension of the EFS license, Ecsponent Ltd told shareholders that the regulator’s ‘investigation’ into EFS had been ongoing for several years. The firm, which is not subject to FSCA regulation, continues to trade as if nothing happened. Their final word on the matter: “We consider the FSCA’s investigation, which focused solely on the advice and intermediary activities of EFS, to be finally concluded and regard the matter as closed. EFS has, with effect from 11 February 2020, not provided financial advice on any new business and we have resolved to unwind EFS”. 

From five years to forever?

This is bad news for pensioners who expected to receive a fixed monthly dividend and have their invested capital returned after five years. “The change in the financial position of Ecsponent Ltd has diminished the chances of unsuitable clients redeeming their investments without loss,” said the FSCA. Their final warning to FSPs: “It is not permissible to encourage or expect a client to waive any of their rights or benefits conferred in terms of the FAIS General Code of Conduct. The authority encouraged FSPs and key individuals to always act in the best interests of their clients and treat them fairly. FAnews remains in awe that any FSP would attempt to dilute client rights under our comprehensive financial services regulation. 

Writer’s thoughts:
The EFS versus FSCA saga seems to follow a typical South African pattern. There is early awareness of potential financial harm, followed by a slow and unwieldly enforcement process. What are your views on preference shares to fund retirement income? And how do you believe the FSCA should have handled the EFS matter? Please comment below, interact with us on Twitter at @fanews_online or email me us your thoughts editor@fanews.co.za.