BULKING BY RETIREMENT FUND ADMINISTRATORS

1. BULKING BY RETIREMENT FUND ADMINISTRATORS Presentation to Pension Lawyers Association Quarterly Sessions June 2006 By JONATHAN MORT (with acknowledgement to Adv M Wallis, SC)

2. Circular by FSB to Administrators dated 24 March 2006 “2. Administrators are financial institutions in terms of the FSB Act, and as such fall to be supervised by the FSB and are in particular subject to the provisions of the FI Act and the FAIS Act.

3. FSB Circular (cont) 3. When dealing with pension fund monies under their control, institutions like administrators are required by the law to observe the utmost good faith, to exercise proper care and diligence, to refrain from gaining directly or indirectly improper advantage for themselves for the prejudice of their principals (the pension funds concerned) and to avoid conflicts of interest. The motivation for these requirements is that administrators stand in a relationship of trust vis a viz the pension funds whose money they administer.

4. FSB Circular (cont) 4. By way of example, the following practice would be unlawful: an administrator consolidates or “bulks” credit balances of pension fund bank accounts under its control and thereby procures a higher rate of interest from the bank. All interest yielded is not passed on proportionately to the pension funds entitled thereto and the additional interest derived from the consolidated amount, goes for the benefit of the administrator. This “secret profit” is also not disclosed to the boards of management of the pension funds.” Registrar confirmed that bulking itself was unlawful.

5. Administrators’ Views View of administrators varies – • don’t do bulking – each fund receives the same interest as an individual entity; • a fund receives a higher rate of interest through bulking but the administrator benefits, either through an agreed fee or not; • bulking takes place but each fund receives the full benefit of that.

6. FAIS Act • Section 45(1)(a)(iii) – FAIS does not apply to section 13B PFA administration “to the exent that the rendering of financial services is regulated under the PFA”. • Cannot determine the extent to which FAIS applies to bulking by administrators. • Purpose of FAIS Act is to require that persons who act as FSPs are licensed to do so. • There are special provisions relating to corporates. • The conduct of FSPs is strictly regulated under prescribed codes of conduct.

7. FAIS Act (cont) • Per section 16(1) codes of conduct must prescribe that FSPs “act honestly and fairly, and with due skill, care and diligence, in the interests of clients and the integrity of the financial services industry”. • This is the same standard in the common law (Durr v ABSA 1997 (3) SA 448 SCA). • FAIS is not relevant to bulking by administrators.

8. FI Act (Financial Institutions (Protection of Funds) Act, No. 28 of 2001) • Both the administrator and a retirement fund fall within the definition of “financial institution”. • Definition of “trust property” – “Any corporeal or incorporeal, moveable or immovable asset invested, held, kept in safe custody, controlled, administered or alienated by any person, partnership, company or trust for, or on behalf of, another person, or partnership, company or trust, and such other person, partnership, company or trust is hereafter referred to as principal.”

9. FI Act (cont) “Section 2 – Duties of Persons Dealing with Funds of, and with Trust Property controlled by, Financial Institutions: A director, member, partner, official, employee or agent of a financial institution…who invests, holds, keeps in safe custody, controls, administers or alienates any funds of the financial institution or any trust property – (a) must, with regard to such funds observe the utmost good faith and exercise proper care and diligence; (b) must, with regard to the trust property and the terms of the instrument or agreement by which the trust or agency in question has been created, observe the utmost good faith and exercise the care and diligence required of a trustee in the exercise or discharge of his or her powers and duties; and (c) may not alienate, invest, pledge, hypothocate, or otherwise encumber or make use of the funds or trust property or furnish any guarantee in a manner calculated to gain directly or indirectly any improper advantage for himself or herself or for any other person to the prejudice of the financial institution or principal concerned.” • Note criminal sanction in section 10.

10. FI Act (cont) • Is it correct that the FI Act applies to the bulking issue? • Section 2 applies to individuals, not the administrator. • Sections 3, 4 and 5 also apply to individuals only. • Why should the Act distinguish between individuals on the one hand and financial institutions on the other?

11. FI Act (cont) • Administrator already owes a fiduciary duty at common law as agent to its principal (the fund). • This fiduciary duty to the fund does not extend at common law to the employees of the administrator. • FI Act appears to fill a gap by imposing a fiduciary duty on the employees and goes further by holding the employees criminally liable. • Can it be said that by implication if the employees are liable in terms of the FI Act then the administrator is also liable?

12. FI Act (cont) • An employer is only vicariously liable for the actions of its employees which are within the course and scope of their duties. • The provisions of sections 2, 3 and 4 are aimed at conduct of employees for which an employer may not be vicariously liable. • Section 2(c): an employee may make a secret profit but the employer is not liable for this. • Also criminal sanction.

13. FI Act (cont) • Reference to the FI Act in the Registrar’s circular appears to be incorrect. • The issue of whether bulking is lawful must be decided according to common law principles. • The relationship between the administrator and the fund is one of agency. • The administrator accordingly owes a fiduciary duty to the fund.

14. Fiduciary Duty of Administrator • What is the content of “fiduciary duty”? • Per Philips v Fieldstone Africa (Pty) Ltd 2004 (3) SA 465 (SCA) – “There is no magic in the term “fiduciary duty”. The existence of such a duty and its nature and extent are questions of fact to be adduced from a thorough consideration of the substance of the relationship and any relevant circumstances which affect the operation of that relationship. While agency is not a necessary element of the existence of a fiduciary relationship, that agency exists will almost always provide an indication of such a relationship.”

15. Fiduciary Duty of Administrator (cont) • Also, per Philips v FieldstoneAfrica (Pty) Ltd, supra – “It is the nature of the relationship, not the specific category of act involved that gives rise to the fiduciary duty. The categories of fiduciary, like those of negligence, should not be considered closed… (the) relationship in which a fiduciary obligation has been imposed are marked by 3 characteristics – (1) scope for the exercise of some discretion or power; (2) that power or discretion can be used unilaterally so as to affect the beneficiary’s legal or practical interests; and (3) a peculiar vulnerability to the exercise of that discretion or power.”

16. Fiduciary Relationship and Secret Profits • Per Robinson v Randfontein Estates 1921 AD 168 – “Where one man stands to another in a position of confidence involving a duty to protect the interests of that other, he is not allowed to make a secret profit at the other’s expense or place himself in a position where his interests conflict with his duty. The principle underlies an extensive field of legal relationship. A guardian to his ward, solicitor to his client, an agent to his principal afford examples of persons occupying such a position…the doctrine is to be found in the civil law, and must of necessity form part of every civilized system of jurisprudence. It prevents an agent from properly entering into any transaction which would cause his interests and his duty to clash. If he is employed to buy, he cannot sell his own property; if employed to sell, he cannot buy his own property; nor can he make any profit from his agency save the agreed remuneration; all such profit belongs not to him but to his principal. There is only one way by which such transactions can be validated, and that is by the free consent of the principal following upon by a full disclosure by the agent.”

17. Fiduciary Relationship and Secret Profits (cont) • There is one rule only, that a fiduciary may not receive any benefit than the agreed remuneration, and only one exception to this: on the fully informed consent of the principal. • Per Philips v Fieldstone, it is no defence by the agent (administrator) to say that – • the fund did not suffer a loss; • the fund could not have made use of the opportunity, or probably would not have done so; • the fund, although it could have used the opportunity, has refused it; • there is no contractual relationship between the fund and the third party from whom the benefit was received, and the benefit would not have accrued to the fund anyway; • the administrator was not obliged to obtain the benefit for the fund. • the administrator acted reasonably and honestly.

18. Standard of Care Required of an Administrator • What is the standard of care required of an administrator? • This is relevant to the issue of whether bulking is lawful or not. • The standard of care is that of a reasonable competent administrator. • This is a specialized task which is regulated (by the FSB) and to which the courts would require to involve a high level of skill and care. • Van Wyk v Lewis 1924 AD 438 • Durr v ABSA Bank 1997 (3) SA 448 (SCA)

19. Lawfulness of Bulking • Bulking is not unlawful in the sense that it is prohibited by law or contrary to legal obligations. • Sackville West v Nourse 1925 AD 156 • Estate Richards v Nichol 1999 (1) SA 551 (SCA) • A competent administrator, having the requisite high level of skill and care, and operating within a financial services environment, should be aware of the benefits of bulking and should endeavour to obtain it.

20. How Does Bulking Take Place • The bank treats all the flagged fund bank accounts as one for the purpose of determining the interest rate applicable to each, and all that interest is then credited to each bank account by the bank. The administrator may then debit an additional fee from the bank account; or the bank may make payment of a rebate, which would otherwise have accrued to each fund bank account as interest, direct to the administrator so that it does not appear in the bank account of the fund. • A sweeping arrangement, whereby all the interest attributable to each account of all the funds administered by the administrator are paid into a single bank account in the name of the administrator, and then allocated from there by the administrator amongst the bank accounts of each fund after deduction of the fee by the administrator.

21. Problem Areas • Administrator adding its own funds to the pool of monies of the funds also to receive the high rate of interest that the funds receive. • The bulking arrangement requires a minimum total amount and the administrator adds its own funds to ensure that this limited is obtained; but also benefits from this. • The bank concerned is an associated entity of the administrator. • The fee is a proportion of the interest, and the amount of the benefit for the administrator may not bear any relationship to the cost of the service.

22. Problem Areas (cont) • How should a bulking arrangement be structured. • Administrator should disclose to the fund – • that the fund bank account will form part of a portfolio of accounts to be bulked for the purpose of negotiating interest rates with the bank; • some indication should be given of the extent of the enhancement in interest rates through this, and a rough indication of the extent of the potential benefit (in Rands); • if the administrator proposes to retain a proportion of the enhanced benefit for itself to compensate for the additional costs involved in putting the arrangement in place then that additional costing must be determined and made available to the fund; • the fund must be able to decide whether it would prefer to pay an enhanced administration fee to retain all the enhanced interest (a large fund may be eligible to receive in its own right a very good rate of interest without the bulking arrangement).

23. Other Problem Areas (cont) • Scrip lending; • Rebates; • Soft commissions.

24. Approach of Trustees • Trustees themselves owe a fiduciary duty and must therefore be very careful about agreeing to, or ratifying, any additional benefit which a service provider may seek. • With the current bulking issue, trustees should ask the question of their service providers whether they have received any benefit in respect of their services to the fund other than the agreed remuneration. “Any benefit” should be interpreted broadly.

25. Approach of Trustees (cont) • As with every aspect of the remuneration due to service providers, any benefit which the service provider receives should bear some relation to the services rendered to the fund; and should also be competitive. • As a general principle, every contract between a fund and its service provider should include a warranty by the service provider that it will not accept any benefit from any source in respect of its services to or administration of the fund, other than what is set out in the contract, without the agreement of the fund.

26. Approach of Service Providers • There cannot be too much transparency. • If in doubt make the disclosure in writing to the trustees and seek their agreement. If the trustees give it then you are protected. • There is a competitive advantage today in complete transparency and good governance.

27. Thank You – Jonathan Mort