18 questions – FSB elaborates on Directive regarding OTC operations

From the Financial Services Board: Proposed directive on companies that provide exchange infrastructures to facilitate trade in their own securitiesimage001

Questions and Answers

1. What is the extent of the application of the draft Directive?

The draft Directive applies to all public companies that provide infrastructures conforming to the definition of an exchange where the issuer facilitates trade in its own securities.

2. What does the draft Directive intend to achieve?

The draft Directive intends to regularise the affairs of all unlicensed exchanges that facilitate trade only in their own securities, either by these exchanges ceasing the illegal unlicensed exchange activities and therefore not falling within the ambit of the Financial Markets Act, 2012 (FMA), or by them obtaining the requisite license to operate an exchange.

3. Why does the FSB want to regulate OTC trading?

The FMA makes it an offence to operate an exchange without being licensed to do so. The concept of an exchange has a specific legal definition as per the FMA, namely:

“a person who constitutes, maintains and provides an infrastructure-

(a) for bringing together buyers and sellers of securities;

(b) for matching bids and offers for securities of multiple buyers and sellers; and

(c) whereby a matched bid and offer for securities constitutes a transaction”

The FSB’s intention is not to stop the trading of OTC shares. The focus here is on the manner that trading takes place. If the manner of trading falls within the definition of an exchange as set out above, the entity must be licensed as such. If the entity trades in a manner which does not fall within the above definition of an exchange, it does not need to be licensed. One of the objects of the FMA is investor protection. The licensing requirements of the FMA are intended to ensure that certain basic safeguards for investors, who trade on an exchange, are in place. The Registrar of Securities Services (Registrar) is obliged to apply the law, the law that puts investor protection front and centre.

If the exchange is not licensed, investors are not protected in that market because the FMA doesn’t apply. Market abuse provisions such as insider trading, market manipulation and false reporting also only apply to regulated markets. Investors on these unlicensed exchanges are therefore vulnerable to market abuses, such as insider trading and price manipulation. A first time investor who feels that there is not a level playing field (as other people have inside information from which they are benefiting to his detriment) or that the share price is being manipulated, won’t continue to invest in such a market. Such investor needs protection.

Price manipulation and other market abuses are generally only identified through proper surveillance. If these exchanges are regulated, there will be market surveillance to ensure that abuses such as insider trading and price manipulation do not happen. The FSB would then also be able to act against those that are involved in insider trading or manipulate the market. If the exchange is unlicensed, the FSB cannot act against such offenders.

The other objects of the FMA licensing requirements include the reduction of systemic risks in the markets and the maintenance of a fair, efficient and transparent market.

4. Why now?

The FSB continuously evaluates its regulatory scope in line with changing market conditions. It was in the course of such an evaluation that the FSB saw it fit to issue this draft directive. In the recent past the FSB has seen a substantial increase in the activity of companies trading their own shares, especially due to the introduction of the BEE schemes. In light of this and in the course of the evaluation of its regulatory scope, the FSB approached Senior Counsel who confirmed its view that irrespective of the fact that a company only trades its own shares, this activity does fall within the definition of an “exchange” and should be regulated under the FMA.

5. Is the FSB targeting specific companies with this draft directive?

The draft Directive relates to all public companies that constitute, maintain and provide unlicensed exchange platforms for the trading of their own securities.

6. Does this mean that all current OTC trading platforms are illegal?

No. However, if an OTC trading platform falls within the definition of an exchange, and it is unlicensed, then it is operating illegally.

7. What are the requirements for an exchange license?

The main requirements that an exchange must meet are set out in Sections 7 to 17 of the FMA which deal with the licensing of an exchange, functions of licensed exchange and exchange listing requirements and rules. These requirements that must be met through the exchange licensing process have been put in the law to ensure that investors have the necessary protections.

There are also requirements set out in subordinate legislation to the FMA, i.e. Board Notices of which copies are available on the FSB’s website: www.fsb.co.za.

8. How does the draft Directive affect OTC share trading?

Trading in shares listed on a licensed exchange is subject to the provisions of the FMA and relevant subordinate legislation. OTC share trading which does not take place through an exchange is not subject to the FMA.

OTC trading infrastructures that fall within the ambit of the FMA need to be licensed, or the trading methodology needs to be changed to such an extent that it does not fall within the ambit of the FMA’s definition of an exchange.

9. Won’t this action by the FSB stifle the freedom to trade shares over the counter (by forcing these companies to list on the JSE)?

The FSB is not outlawing OTC trading at all. The issue at hand relates unlicensed exchange platforms that are outlawed in terms of the FMA. It is therefore more about the manner that trading takes place on some platforms. If the manner of trading constitutes an exchange, it must be licensed.

These companies are not forced to list on the JSE. In terms of the FMA, any applicant can apply for an exchange licence to list itself, on condition that the applicant complies with the licence requirements.

10. What are the alternative business models that companies can adopt to facilitate transactions in their shares?

It is not appropriate for the FSB to prescribe a specific business model to any person. It is suggested that companies obtain legal advice on whether their business model would fall within the ambit of the FMA or not and what changes should be made.

11. What are the costs of licensing?

There are fixed licence application fees of R450 000 as prescribed by Board Notice under the FMA and variable costs such as legal, audit, surveillance and insurance costs. The variable costs would differ from operator to operator.

12. Who must pay the costs?

The Applicant must pay the costs. However, the applicant may raise these funds in different ways, which are not prescribed by the FSB. The FSB believes that these costs are minimal when compared with the losses that can be suffered by investors trading on an unregulated platform.

13. How many companies are currently trading on unlicensed exchange platforms?

The FSB is aware of approximately 15 companies that facilitate OTC trading in their own securities in such a manner which would likely require an exchange licence.

14. If the applicant is licensed, will the provisions of the Companies Act apply?

If there is a conflict between any provision of the Companies Act and a provision of the listing requirements of an exchange, the provisions apply concurrently to the extent that it is possible to apply and comply with one of the inconsistent provisions without contravening the second. To the extent that it is impossible to apply and comply with one of the inconsistent provisions without contravening the second, the provisions of the Companies Act prevail, except to the extent that this Act expressly provides otherwise.

The Companies Act recognises that certain investor protections are put in place through the exchange licensing process as set out in the FMA. The prospectus provisions of the Companies Act for example do not apply to securities that are listed on an exchange, or in respect of which an exchange has granted permission to deal.

Therefore, if this presumed regulation through the FMA does not factually take place, investors would be without certain investor protections which the legislature intended them to have through either the Companies Act or the FMA.

It is important to emphasise that the FSB is not outlawing the practice and the regulation of OTC trade as provided for in the Companies Act.

It is only saying that if such trading takes place through an exchange, the exchange must be licensed in terms of the law.

15. What are some of the positive effects if an exchange is licensed?

Investors will be protected through the provisions of the FMA. For example, there will be market surveillance to ensure that insider trading and price manipulation is combated. There will also be safeguards to ensure that there is pre & post trade transparency; transparent price formation and safeguards against market infrastructure failures. These safeguards provided through a well regulated could lead to increased liquidity in the shares of the issuer and an increase in confidence in the share.

16. How will this affect historically? disadvantaged people (i.e. BEE shareholders) who participate in these empowerment schemes?

Investor protection is precisely why Parliament has worded the FMA in the manner in which it did. Without these protections, investors could be vulnerable. If investors do not believe that they are protected, they will stop investing. This is why this initiative of the FSB is so important. The FSB has a duty to ensure that all exchanges operating in South Africa have sufficient investor protection mechanisms in place and that they operate in a fair, efficient, transparent manner that ensures that South Africa’s financial markets remain sound. Without investor protection there won’t be confidence in the market and investments would be at risk.

Certain investor protection mechanisms, such as the prospectus provisions of the Companies Act do not apply if a security is listed on an exchange because the legislature assumed that such investors would have the necessary protections, which are required through the exchange licensing process.

If the exchange is not licensed, these investors would not be protected through either the prospectus provisions of the Companies Act or the FMA. However, regulating unlicensed exchanges can assist in protecting these investors from becoming victims of price manipulation, insider trading, misleading statements, etc.

17. What is the status of exchanges that are operating illegally?

The Registrar’s interpretation of the law does not change the law.

All persons who believe that they may be operating unlicensed exchanges should therefore consider obtaining legal advice to ensure that their conduct is legal.

18. What is the way forward?

The Registrar will consider the submissions made in respect of the draft directive. Once these submissions have been considered, the FSB will publish a final directive.

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