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Independence – the regulator takes a position

The contentious classification of when an advisor is recognised as “independent” and is allowed to use the word “independent” when describing their business or their services to the public has been clarified by the regulator.

May 26, 2021

7 minutes

Jaco van Tonder
The contentious classification of when an advisor is recognised as “independent” and is allowed to use the word “independent” when describing their business or their services to the public has been clarified by the regulator.

A. The debate surfaces again

Given the disruptions caused by COVID-19 and the ensuing lockdowns, it is understandable that regulatory initiatives like the Retail Distribution Review (RDR) have not featured in advisor conversations recently. Many of the debates on RDR have been buried in mountains of paper, reflecting almost six years of regulatory workshops and commentary on the various RDR papers.

Behind the scenes, however, the Financial Sector Conduct Authority (FSCA) was hard at work in 2020 to move ahead on some of the outstanding RDR proposals. One of these is the contentious classification of when an advisor is recognised as “independent” and is allowed to use the word “independent” when describing their business or their services to the public.

Below we explore this development, as set out in the General Code of Conduct under the Financial Advisory and Intermediary Services Act (FAIS). Advisor firms should pay close attention to these latest amendments, as:

  1. Many advisor practices include references to “independent” in either their name, or in marketing material/websites/social media posts of their business, or just in general conversations with clients.
  2. Transgressions of the FAIS General Code of Conduct can lead to fines for advisor practices.

B. FSCA position as outlined in the FAIS General Code of Conduct

Amongst a whole raft of changes to the FAIS General Code of Conduct, published in the Government Gazette on 26 June 2020, is a reference to a new set of paragraphs (3.5). This section, which is already in force, firmly sets out the FSCA’s thinking around the independence debate and confirms that the FSCA’s primary concerns are in the areas of:

  1. Ownership between product supplier and advisor
  2. Flow of a “financial interest” from a product supplier to an advisor
  3. Existence of any other material conflict of interest between a product supplier and advisor

If an advisor firm fails the tests outlined in the General Code of Conduct in any one of these three areas, the new Code precludes the advisor from referring to their own business or services as “independent”.

Compliance officers have no doubt analysed the specific wording of these latest amendments. Below we summarise our interpretation of the new paragraphs under 3.5.

1. Ownership between advisor firms and product suppliers

Paragraphs 3.5(a) and (b) of the amended FAIS General Code of Conduct deal with ownership arrangements in quite specific terms, and identifies the trigger being when either:

  1. An advisor firm is a significant owner of a product supplier, or
  2. A product supplier is a significant owner of an advisor.

The concept of a “significant owner” is then further defined in quite some detail, which boils down to having effective control of 15% or more in an entity.

In summary, if a product supplier holds 15% or more effective shareholding/control in a financial advisor practice, or the practice holds 15% or more effective shareholding/control in a product supplier, it is seen as a significant owner. And in these cases, advisor firms may no longer use the word “independent” with reference to their advice business.

The definition of “product supplier” effectively covers any institution that operates under any financial services licence in South Africa, and includes:

  1. Institutions specifically involved in the issuing of direct securities
  2. Collective Investment Scheme (CIS) companies
  3. Long-term and short-term insurance companies
  4. Companies involved in the running of pension funds
  5. Banks, providers of foreign currency investment instruments
  6. Medical schemes

To provide some context to the discussion, we have listed some real-life ownership examples in Table 1. These examples serve to illustrate the impact of these amendments on investment-focused IFA practices1 in South Africa today, and the likely implications of the “independence test” for these practices.

Table 1: Clear-cut ownership examples

Structure Qualify as independent?
Independently owned advisor business with Cat 1 and Cat 2 licences where all the shares are owned by the firm’s staff
Advisor is a tied agent of a life company, or operates as a franchise of a life insurance company
Advisor practice has own Manco2 in their group
15% of advisor practice owned by external shareholder who has either a life insurer, bank, or CIS Manco in their group
2. Flow of a "financial interest" between product supplier and advisor firm

Paragraph 3.5(c) of the Code deals with the test of whether an advisor firm receives a financial interest from a product supplier. This is the second way to potentially fail the independence test.

This paragraph states that any payment or flow of a financial interest from a product supplier to any advisor who advises on the product supplier’s products, generally fails the independence test except in the following cases:

  1. Regulated commissions from insurance companies and medical schemes;
  2. Immaterial financial interests; and
  3. Financial interests received from a product supplier for which an advisor paid fair value.

This test is not as clear cut as the ownership test. It is probably a good idea for advisor firms to carefully look at any arrangements with product suppliers to ensure these do not inadvertently fall foul of this paragraph.

Payments from a product supplier to an advisor for any services rendered by the advisor firm to the product supplier, could potentially be at risk here. The following are examples of non-standard agreements that probably trigger the restriction on using “independent”:

  1. Where an advisor receives remuneration from a CIS Manco for serving on the Manco’s investment committee
  2. Any arrangement where an advisor is paid by a product supplier (e.g. CIS Manco/life company) for any administration/service work done on behalf of the product supplier
3. Existence of any material conflict of interest between a product supplier and advisor

The final test outlined in paragraph 3.5(d) of the Code appears to be somewhat of a catch-all designed for any situations not explicitly catered for in paragraphs 3.5(a to c). It pivots on the definition of a “material conflict of interest”.

The General Code of Conduct states that where material conflicts of interest exist in advisor practices, these need to be effectively managed and disclosed. However, even a successfully managed conflict of interest will probably fail the independence test just by virtue of being a material conflict of interest.

C. Applying the independence test to some tricky examples

In Table 2 we list some real-life commercial arrangements involving advisors where the outcome of the independence test appears somewhat uncertain. We also give our interpretation of the regulations.

Structure Qualify as independent?
Advisor business also authorised as a stockbroker under the Financial Markets Act
As stockbrokers receive an exemption from FAIS for that part of their business
Advisor practice operating white-label collective investment fund/s through a third-party Manco.
If no financial interests or significant ownership in/by third-party Manco
Advisor practice with both a Cat 1 and Cat 2 licence operating a range of model portfolios on a platform
Advisor practice with a third-party DFM3 (who is not a product supplier) using model portfolios
Advisor practice where principal advisor owns another advice firm that has a franchise agreement with a large life insurance company

These examples highlight the complexity of this matter. Advisors who need more clarity are welcome to reach out to us to discuss their situations with our legal experts.

D. Conclusion

The June 2020 amendments to the FAIS General Code of Conduct signals progress on clarifying how the FSCA sees the link between advisor firm conflicts of interest and the practical implications for advisor use of the term “independent”.

The amendments are fairly clear on the tests for material ownership between advisor firms and product suppliers but are less explicit in areas of other material conflicts of interest.

Whilst the views outlined in this article are our high-level interpretations of the amended Code, we urge financial advisors to discuss the implications of these regulations with their compliance providers.

Obtaining certainty is crucial, given how widely the term “independent” is used among the different advisor firms and how unclear some of the tests around material conflicts of interest are. No advisor firm wants to run the risk of a regulatory fine because of some overlooked conflict of interest.

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1 Independent financial advisor (IFA)
2 Management company (Manco)
3 Discretionary fund manager (DFM)

Authored by

Jaco van Tonder
Director of Advisory Services

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