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Due Diligence and the Financial Adviser

13 Apr

Author: Paul Kruger

Publications: Moonstone

Date Published: 9 April 2015

Section 2 of the General Code of Conduct requires that ‘a provider must at all times render financial services honestly, fairly, with due skill, care and diligence, and in the interests of the clients and the integrity of the financial services industry.’

To the best of my knowledge, this does not require that a FSP must conduct a due diligence to the same extent required when mergers and takeovers are concerned. This is a formal process involving lawyers and accountants, and goes far beyond what can or should be expected from a financial adviser.

In a recent determination, the FAIS Ombud again referred to this thorny issue involving an investment in the Relative Value Arbitrage Fund (RVAF) run by the late Herman Pretorius.

In the formulation of the complaint, the determination reads:

Complainant contends that he was not informed by respondent that what he was investing in what was actually a pyramid scheme as opposed to a legitimate investment. Had he so known, he would never have invested and accordingly holds respondent accountable for his losses.

From the information supplied by the respondent, it appears that she was equally unaware that the scheme was, in its last years, run as a Ponzi scheme. In fact, this only materialised after the death of Pretorius.

In the determination under discussion, the following information is supplied by the respondent:

[12] Specifically questioned as to the due diligence she conducted, respondent advised that having been introduced to Abante Capital she visited the premises where Herman Pretorius explained the strategies and how the risk was managed. Having been introduced to the trading team, respondent then proceeded to ascertain whether Abante Capital was registered with the FSB. In addition thereto respondent confirmed with Momentum and Old Mutual and spoke to their fund managers about Abante Capital and their use of the fund in their portfolios.

[13] Respondent goes on to state that, having a reasonable knowledge of Hedge Funds, respondent concluded that the strategy is sound and when mostly top 40 JSE companies are invested into, this should be a sound fund. According to respondent, Mr Pretorius explained that the way that this fund operated the risks are relatively low.

[14] Respondent contends that she was satisfied that persons investing in the fund were fully appreciative and aware of the risks involved, both in that they attended presentations by Herman Pretorius but also in that respondent further explained the process and operation of the fund as she understood it. In this regard a written explanation of Board Notice 5711 was provided and explained to each client.

[15] As to the basis upon which respondent deemed RVAF to be a suitable basis for her clients, respondent advised as follows:

15.1. Many clients need a higher return on their investment to ensure that they reached their investment goals, and as an adviser it was her duty to ensure that all products and all investment avenues are explored on behalf of clients;

15.2. Given the various market crises, hedge funds could both act as a defensive strategy and outperform traditional investments in a downturn;

15.3. Researching the different hedge funds available in the country, respondent’s research showed that Abante Capital was one of three hedge funds in South Africa;

15.4 In 2008 Abante Capital won a hedge fund award. With regards thereto respondent provided a Symmetry multi manager document showing the market neutral category winner as ‘Abante Statistical Arbitrage.’

[16] The portfolio was explained to clients as a hedge fund which invested in shares on the JSE. It was explained that as in any investment involving shares the risk is of a high nature, however historically the loss in downside markets is lessened when hedge trading strategies are used.

[17] In this regard respondent states that hedge funds may actually be a lower risk than traditional investments as the target is to protect capital, increase defensive strategies, and obtain absolute returns under all market conditions as explained by Herman Pretorius.

Concerning the client’s knowledge of investments, the determination states:

With regards to the investment in RVAF, complainant was given to understand that the underlying investment was comprised of shares on the Johannesburg Stock Exchange. To this end and having personally dabbled a bit in shares he understood that there were risks involved in the investment, chief amongst which was that the share market could go up or down;

The respondent’s version of the client’s profile states:

‘Mr VD Walt has a degree, a residential and commercial property portfolio, runs his own consulting practice and trades a share portfolio. He is investment savvy and understands how shares can be traded long and short for a profit in a bear market’.

Was the advisor negligent?

A recent Appeal Board ruling on this case contains the following interesting view:

What then constitutes negligence? The lack of skill or knowledge is not per se negligent. It is however, negligent to engage voluntarily in any potentially dangerous activity unless one has the skill and knowledge usually associated with the proper discharge of the duties connected with such an activity. Hence, in interpreting the meaning of “care and skill”, our authorities have held that a mandatory should always employ reasonable care and skill in exercising his or her mandate.

What is reasonable in the circumstances is measured against the “general level of skill and diligence possessed and exercised at the same time by members of the branch of profession to which the mandatary belongs. If a mandatary negligently falls to execute his mandate or he is negligent in exercising his mandate, he failed to act with “care and skill”. To act negligently means to act in a way that falls short of the standard of the reasonable person”. Hence the defendant is negligent if the reasonable person would have acted differently if the unlawful causing of damage was reasonably foreseeable and preventable.

It is difficult to see how the actions by the respondent, as outlined above, can be deemed to have been lacking in “… due skill, care and diligence…”, or negligent.