The COFI legislation to include alternative investments

The Conduct of Financial Institutions Bill (“COFI”), which is expected to be tabled in Parliament this year, is said to represent the next phase of legislation aimed at remodelling the financial sector framework toward a Twin Peaks model.

It is expected to replace and improve the conduct requirements in existing financial sector laws by addressing aspects of the current multi-pronged policy approach through building a market conduct legislative framework for all institutions performing financial activities.

The background

The Financial Sector Regulation Act, 2017 (“FSR Act”) was the first step in the implementation of the long-awaited Twin Peaks model. The model, which is based on the Australian regulatory system seeks to strengthen and address the gaps in the regulation of South African financial markets by polarising the financial market into two ‘peaks’ and regulating for them accordingly.
The emphasis will move away from a regulator being responsible for a type of entity but rather a type of activity. The two ‘peaks’ are system stability and conduct. COFI will be the legislation that enables the conduct pillar.

The FSR Act primarily deals with the regulatory architecture of the Twin Peaks model. The FSR Act is regulator-facing; providing the regulators (Prudential Authority “PA”) and the Financial Sector Conduct Authority (“FSCA”) with its powers in relation to regulated entities and dealing with the internal arrangements of the relevant regulators. COFI on the other hand is entity-facing and is the piece of legislation that financial institutions need to get to grips with. 

The enforcement and implementation of COFI falls under the jurisdiction of the FSCA, however, as it is acknowledged in COFI, there is an overlap between the role of the PA regarding regulating system stability and conduct, and in certain instances (such as with a large banking group) the PA and FSCA will need to work hand in and to achieve the outcomes of the twin peaks model. How this will look and play out is something we all eagerly waiting to see as this has the potential to create uncertainty and detract from the purpose of this entire regulatory reform.

What does COFI mean for us?

COFI seeks to regulate all market conduct dynamics, including treatment of customers. Treatment of customers had previously been codified in certain pieces of legislation, such as FAIS, the Consumer Protection Act, 2008 and the National Credit Act, 2005. However, all these acts had taken a different approach to how this objective is to be achieved and have failed to keep up with the ever-changing landscape and realities of the South African financial markets. The result of this disparate regulatory system was an uneven playing field across the various financial institutions, with some financial institutions having a much higher standard that they needed to comply with in comparison to others, yet the risk or prejudice faced by all of them was equivalent.
The Financial Sector Conduct Authority tried to address this by issuing papers and guidance notes on standards/considerations relating to treating customers fairly (TCF) and retail distribution, but as these were not codified into law, the application and acceptance of what these papers and guidance notes sought to achieve continued to be an afterthought for many financial institutions.

It is important to note that the outcomes of COFI are broader than the TCF outcomes. The TCF outcomes are aimed mainly at retail customers, whereas COFI is intended to have scope of jurisdiction across the financial sector and is not limited to the retail environment.

Aligned with the spirit of the Twin Peaks model, COFI has been drafted on the premise of four, interdependent approaches, namely, principle-based, outcomes-based, activity-based and risk-based and proportionate. A principle-based approach seeks to set principles that specify the intention of regulation, rather than set rules for financial institutions. An outcomes-based approach enables the regulator to focus on the outcomes that they require institutions to achieve, rather than setting overly prescriptive process requirements. An activity-based approach seeks to regulate an activity notwithstanding the financial institution performing such activity. Lastly, a risk-based and proportionate approach requires the regulator to assess risks (now and in the future) and apply/enforce appropriate measures.

To achieve these principles, COFI has been drafted on the basis that it will contain minimum principles and expected outcomes and, where required, conduct standards, interpretation rulings and guidance notices will be used to address the nuances in each sector. This approach is also seen as supporting sector diversification and competition by recognising that while uniformity is crucial, a one-size fits all approach would be catastrophic to the South African financial market system.

The inclusion of alternative assets

The current market dynamics have seen a shift towards alternative assets classes, which have to-date been regulated very differently to traditional financial products. Consistent with the theme of uniformity, COFI seeks to include alternative investments funds. While, this approach is applauded, the current definition in COFI has perhaps taken this a step too far by defining an alternative investment fund as including one or more investors whereas a collective investment scheme is defined as including two or more investors. It is unclear, if it was the intention of the regulator to catch bilateral contracts such as investment management agreements or if the intention was to only catch alternative investments funds used for pooling, such as a private equity fund. We don’t believe it is the intention of the regulator to catch all relationships under this definition, especially those between two financial institutions but until the next draft of COFI is circulated we can only hope that clarity will prevail.

Where to from here?

We have not gone into the detail of all the issues and concerns with the current version of COFI as it is still in its infancy stage. Notwithstanding this, one thing is certain, and that is COFI will have a big effect on how financial institutions are regulated in South Africa. This, however, should not be too much of a shock as the FSCA has required compliance with most of the principles and outcomes of COFI for many years.

COFI is currently in the form of a Bill. The public comment period ended 1 April 2019 and it is anticipated to be tabled in Parliament during 2019. This is not going to be an overnight process, and as per the FSCA’s guidance, it can be expected that COFI will only become an Act in three years from now with an additional period to allow financial institutions to comply.