Shades of grey within the “white label” CIS arrangements

Before the Collective Investment Schemes Act, 2002 (CISCA) was enacted, the practice of “white labelling” had become popular within the Unit trust industry.  Essentially, this practice entailed that certain businesses that had no capacity or intention to establish a Unit Trust could manage a Unit Trust portfolio utilizing the licence of a registered CIS manager (MANCO as it was known). These arrangements were then incorporated into CISCA. I must categorically state that the idea of third party CIS portfolios is quite noble in a developing country such as South Africa. However these arrangements don’t come without unpalatable and unintended consequences for the ultimate investor as I shall highlight below. To this end, the Financial Services Board (FSB) decided to publish Notice 778 of 2011 to further crystalize limits and conditions for the operation of third party named portfolios of CIS managers. This FSB Notice emanated from the held concerns about the potential risks that “white label” arrangements could pose to the financial system in South Africa.

The Notice created two kinds of third party CIS portfolios namely incubator portfolios and co-named portfolios. Incubator portfolios are those wherein the third party financial services providers (FSPs) intends to own a CIS licence sometime in the future. Conversely, co-named portfolios are meant for those third party FSPs that have no intention of attaining a CIS licence. The one thing in common between these third party FSPs is that they may lack the (requisite skills, investor assets, capacity, etc.) to actually run an independent CIS.

Requirements of the Notice

The FSB Notice requires the third party FSP to hold a category II licence (discretionary FSP). Prior to this Notice, many financial advisors (category I FSPs) were engaged in white labelling arrangements. Some of these brokers did not possess the necessarily requisite skills to carry out specialized activities such as asset allocation. This new requirement that: only discretionary FSPs are permitted to enter into co-named portfolio arrangements adds greater confidence into the credibility of these legal structures. The reason for this is that the Registrar of Financial Services Providers applies a much more stringent standard when approving discretionary FSPs.

According to the Notice, incubator portfolios may only exist for three years after which such FSP is expected to lodge an application as a manager of a CIS. This three year period may, with good cause be extended to five years. The Notice is silent on the kind of requirements that the FSP would have to meet after the three year period. The Notice doesn’t go into great detail about what is meant by “good cause” as far as extending the three year period is concerned. Investors are left to second guess the fate of their assets.

Disclosure Gaps

The Notice prescribes that the assets under management may not be less than R50 million after the three year period has elapsed. If this minimum size in the portfolios has not been reached, the CIS manager is empowered to apply to the CIS Registrar to wind up the portfolio or amalgamate the portfolios with one of its portfolios. It is highly questionable that investors, especially retail ones are informed of this possible eventuality when they purchase these third party co-named products. Furthermore, there may be instances in which the financial adviser is related to the CIS manager and this may result in potential or actual conflict of interest.

It is therefore critical that such disclosures are done by financial advisors. It is barely sufficient for advisors to simply disclose statistical information about these products. Material disclosures pertaining to the investment and legal implications of these structures need to be made at inception.  In certain instances, CIS managers actually have the power to wind up or amalgamate any portfolio which consistently underperforms its benchmark. The CIS manager has a far reaching discretion of electing to absorb all the assets from the third party portfolio into its own portfolios.

Treating Customers Fairly?

The issue here is that at inception, when the third party FSP markets the product to would be investors, these material disclosures are often absent. It is neither here nor there whether such winding up or amalgamation of the portfolios ultimately benefits the client. The more important question is: was the investor fully aware of the nature of portfolio they were investing in at inception? I remain unconvinced that the opaque nature of these third party co-naming arrangements comply with the FSB’s Treating Customers Fairly.   

Written by: Sibusiso Madyibi (in his personal capacity)