Momentum Metropolitan has reacted with surprise to the decision by the Financial Sector Conduct Authority (FSCA) to levy an administrative penalty of R100 million on Met Collective Investments (MetCI). The fine relates to its oversight of the Third Circle Met Target Return Fund, which lost 66% of its value in two days in December 2015.
This unprecedented loss was caused by extensive derivative structures that the fund was unable to unwind, in a bout of market volatility triggered by former President Jacob Zuma’s firing of then-finance minister Nhlanhla Nene.
“We are aware of the findings made by the FSCA regarding administrative issues with the Third Circle Met Target Return Fund and are considering the determination and reasons thereof,” the company noted in a statement. “We will appeal this decision given that we disagree with the content of the report. The size of the penalty is entirely disproportionate with the alleged breaches. It is also inconsistent with previous industry penalties.”
Lack of oversight
The FSCA’s findings were released on Wednesday, in a 52-page final report that details the findings of the regulator’s investigations as well as submissions made by MetCI. It records how a largely unchecked fund manager – Ian Lane at Third Circle Asset Management – was allowed to put investors’ money in jeopardy due to MetCI’s lack of effective oversight.
Moneyweb’s Patrick Cairns and FSCA Deputy CEO Jurgen Boyd discuss the decision on the SAfm Market Update with Moneyweb here:
It is worth noting that MetCI no longer operates. The business, which primarily allowed smaller asset managers to use its licence to run ‘white labelled’ or ‘co-labelled’ unit trusts, decided to exit this market in 2018. All of its funds were moved to other management companies.
It still however exists as a legal entity under Momentum Metropolitan Holdings.
Effectively this means that the parent company is on the hook to pay any fine.
While MetCI has acknowledged that there were shortcomings in its risk management leading up to this episode, it has consistently suggested that the losses in the fund were nevertheless the result of an unforeseeable ‘black swan’ type event. This argument has however been rejected by the regulator.
Board Notice 90 sets out which securities may be included in a unit trust portfolio, and states that a manager must ensure that “listed or unlisted financial instruments are not used to leverage or gear the portfolio and are covered at all times”. However, figures provided on the Third Circle portfolio show that at the close of business on December 7, 2015, the fund’s net effective exposure added to its physical underlying assets was R1.3 billion. Its market value, however, was only R346 million.
This shows that the fund was approximately 3.8 times geared at this point, which was two days before Nene was dismissed. As the FSCA notes in its determination, the fund was therefore non-compliant “by a very considerable margin” before the market event that cost its investors so dearly.
The FSCA also noted that the board notice requires a fund to hold adequate cover for derivative instruments in its portfolio. However, “when the fund’s positions are considered in aggregate as at the close of business on December 8, 2015, there were not nearly enough assets in liquid form to cover all the positions”.
The regulator also concluded that on the evidence before it “Third Circle’s aim in constructing the fund’s portfolio as it was constructed in December 2015 was not ‘to achieve the investment objective of the portfolio’”. This, according to the fund’s supplemental deed, was to provide stable positive returns in all market conditions.
However, the derivative positions that the fund had taken ensured that any significant market fall would have had “catastrophic consequences” for the portfolio. Third Circle, the FSCA held, would have known this, and therefore was not managing the fund in line with its stated objective. Evidence from Lane himself suggested that his aims were also not in line with what the fund claimed to seek to do.
Most tellingly, the FSCA found that MetCI was aware that it did not have the ability to properly monitor the derivative positions that Third Circle had been taking for more than a year before December 2015. Yet it allowed the fund to carry on investing in this fashion.
“Its own evidence is that, prior to the December event, to its knowledge it did not have reliable details in respect of currency and interest rate options,” the FSCA notes.
“Yet it took no steps, while that remained the case, to prevent the fund from continuing to hold currency and interest rate options. The consequence was that, to its knowledge, it had no way of determining whether the fund was compliant.”
This, in the regulator’s view, was reckless and therefore warranted the sizeable penalty imposed.
It is this finding in particular to which Momentum Metropolitan objects.
Theo Terblanche, executive head of retail investments, noted to Moneyweb that it was only alerted to the final report on Tuesday afternoon, and so has not had much time to consider it, but it will be appealing some of the conclusions drawn by the regulator.
“We agree that there were some shortcomings in our risk management procedure, but we disagree with the extent of some of their findings,” Terblanche said.
“The report specifically refers to recklessness on our part, which we don’t agree with. We also disagree with the extent to which we were found to be in contravention of some of the board notices.”
Terblanche could not go into further detail about the objections, as they will form part of future legal proceedings.
Off the hook?
An important question that may be raised for the regulator is why MetCI should have been singled out in this matter. If a white-labelled unit trust is in breach of the law, it would seem that there are other entities besides the management company that have come up short.
Most obvious is the entity that actually managed the portfolio – Third Circle Asset Management – although this company no longer operates. Standard Bank, which was the unit trust’s trustees, also had a fiduciary duty to protect the assets within the fund.
The FSCA however explained to Moneyweb that its determination in this instance specifically concerned MetCI.
“This order deals with the contraventions of MetCI as manager of Cisca [the Collective Investments Schemes Control Act] and its subordinate legislation,” the regulator explained. “Based on the evidence gathered during the investigation, we were not in a position to conclude whether or not the trustees failed to comply with their duties. Third Circle, as an FSP [financial service provider], is subject to the Fais [Financial Advisory and Intermediaries Services Act] legislation and may be dealt with under these laws.”
Not the end of the story?
This is therefore not necessarily the conclusion of the process, even though it has been nearly four years since the losses were recorded. The FSCA noted that the process has taken time because of the need to be thorough in a complex case.
“Given that the investments concerned were primarily in the derivatives arena, this was an intricate and highly technical matter to investigate,” the regulator told Moneyweb. “As such, the FSCA made use of external experts to assist in the investigation, and the matter therefore took some time to complete.
“The inspection commenced in May 2016 and the final inspection report was issued in September 2018, followed by an enforcement report in December 2018,” it added.
“MetCI was granted the opportunity to make submissions on both reports, and their extensive submissions had to be considered before the FSCA finalised its decision.”