Edition: Mar - May 2014
Editorials

SURPLUS STRIPS

Damp squib

After all the hoopla, the Somerville plea bargain has some pretty clear lessons. Amongst them, trustees should be ultra-cautious in relying on expert advice.

First, the hype flows out. Then, the reality sinks in.

There’s a world of difference between the two. It was shown with J Arthur Brown over Fidentia. Late last year, in a much lesser league and lighter shade of grey, it’s shown again with Graham Somerville over the surplus-stripping ‘Ghavalas option’. To the chagrin of the Financial Services Board, the National Prosecuting Authority appears to have inordinate difficulty in trying matters related to pension funds.

Either the Somerville charges were overblown in the first instance or the NPA, despite exhaustive assistance from FSB investigations, accepted at the courtroom door that successful prosecution of these charges was a gamble not worth taking. This has not spared Somerville the fusillades of hot air, as it turns out, directed at him over the years when jail penalties were threatened for multi-million rand fraud and theft; not to mention being hit under the Proceeds of Crime and Prevention of Organised Crime Acts, with all their mafia-like connotations.

It ends with a whimper. In a nutshell, Somerville has agreed to a R1,5m fine for negligence. The R1,5m represents probably less than three weeks of legal costs for a trial that, had he pleaded not guilty, the NPA reckons would have lasted at least three months. The negligence is for not having ensured that, as a director of the Lifecare group (a different animal from the JSE-listed Lifecare of today) and a trustee of its pension fund, certain disclosures were made to the FSB.

Ghavalas
Ghavalas . . . persuasive

Had these disclosures been made – without omitting any portion of the consolidated agreements by which the surpluses in the pension funds of six dormant companies were swished through Lifecare under the ‘Ghavalas scheme’ (TT Dec ’13-Feb ’14) – the FSB would have seen the transactions’ true purpose and disallowed them. For directors and trustees generally, there’s an implicit warning. It’s that they aren’t without risk to themselves, in their personal capacities, by relying on top experts paid top fees for professional advice and service. If that sounds pithy, consider some of the factors accepted in Somerville’s mitigation.

His big fault was that, according to the settlement statement, he’d been “persuaded by reputable persons such as (senior merchant banker) Peter Ghavalas and (leading fund administrator) Alexander Forbes” that the surplus transactions could be lawfully concluded; that the surplus in the fund of a dormant company belonged to the employer company, and that the documents relevant to the surplus transactions complied with relevant legislation while also containing proper and accurate information.

Neither Forbes nor Ghavalas had drawn Somerville’s attention to “a number of documents, such as correspondence by the Registrar and a legal opinion by a Forbes employee, which would have alerted (Somerville) that the transactions were unlawful, had they been disclosed to him”.

Forbes had processed the applications to the FSB. Reputable directors of Lifecare, including a former Accountancy firm Arthur Andersen (then one of the ‘big five’) had vetted them.

They’d even obtained a legal opinion from Basil Wunsch, one of SA’s most highly respected commercial attorneys and later a High Court judge. “He advised us that such a transaction could be done provided that all the statutory requirements were complied with,” said Somerville. On whom did the directors and trustees rely for statutory compliance? Forbes, no less.

Which begs the question of whether, as the law stood in the 1990s when these transactions were effected, there was indeed compliance with all the statutory requirements. Only in 2001 was surplus-apportionment legislation introduced, and only in 2007 was the legislation made retrospective to 1980 (see box).

It deals with the “improper use” of a surplus. There was no problem with employers, controlling defined-benefit retirement funds, from taking contribution holidays while these funds were in surplus i.e. able to pay members the promised benefits. The problem arose when these funds were wound up i.e. how the surplus was to be apportioned between the employer and members.

The ‘Ghavalas scheme’ ostensibly merged the fund (in surplus) of a dormant company with the fund of an operating company (in this case, Lifecare). Pensioners in the former were moved with their consent to a life-office annuity, where their benefits were protected and actually enhanced, while their former employer sold the dormant company (at a profit that reflected the surplus in its fund) to Lifecare.

Executives of the dormant company benefited from the profit. Lifecare benefited from the surplus in the merged fund i.e. by being able to take a contribution holiday.

  Executives of the dormant company benefited from the profit. Lifecare benefited from the surplus in the merged fund i.e. by being able to take a contribution holiday.
Not good enough. As the Somerville settlement puts it on the example of the Mitchell Cotts fund’s purported merger with the Lifecare fund: “The s14 certificate (for FSB approval of the merger) created the impression that a merger took place between two funds, whereas in fact a de facto merger did not take place as there was inter alia no transfer of members from the Mitchell Cotts fund to the Lifecare fund”.

If the s14 certificate had disclosed the true nature of the acquisition – the purchase of a surplus in the Mitchell Cotts fund under circumstances where the pensioners belonging to the Mitchell Cotts fund would have no claim or right to the surplus – the plea-bargain statement adds that “the Registrar would not have approved the transaction which was made under the guise of a merger contemplated in terms of s14 of the Pension Funds Act”.

But the Act as it stood at what date? Also, the part of the agreement not disclosed to the FSB concerned the disbursement of payments between Ghavalas (the intermediary), the sellers (of six dormant companies) and Lifecare (the buyer). It contained a confidentiality clause. “At the time I regarded Ghavalas’ strong desire to maintain the confidentiality of the so-called second agreement as a legitimate concern on his part to keep the structure of the transaction confidential,” said Somerville. “Ghavalas represented to me that it was normal practice with merchant banking transactions.”


Stripping's greasy pole

Indeed, it has long been the normal practice for dealmakers to try as best they can to prevent competitors from emulating their fee-earning intellectual property. However, the confidentiality clause did allow for disclosure of the second agreement when the parties were “bound in law” to make it.

Clearly, at the time neither Forbes in submitting the s14 certificate – nor the other Lifecare advisers, trustees and directors – considered it necessary to make the disclosure to the FSB under the law as it then stood. Many years and legislative amendments later, Somerville is convicted for having “negligently failed to ensure that the s14 certificate disclosed the true nature of the transaction” and for not having observed “the utmost good faith and exercised proper care and diligence”.

Now to ask what difference it might have made, had the second agreement been disclosed to the FSB’s office of the Registrar in the mid-1990s, is academic. Unfortunately. To be safe in future, tell the Registrar everything and trust that confidences will be respected.

THE LAW AS IT WAS

All transactions under the so-called ‘Ghavalas scheme’ took place during the 1990s. Surplus-apportionment legislation was gazetted only in 2001. Until then, ownership of surpluses was uncertain. Retirement-fund stakeholders had to negotiate surplus apportionments and no party had a right to them.

The 2001 legislation introduced the concept of “improper utilisations” (such as an employer taking a surplus to the detriment of fund members) as well as the right of employers and employees to share fairly in a surplus (the actuarial excess over the amount required by a defined-benefit fund to honour its pension promises to members).

In a 2006 test case, Justice Mynhardt held in the North Gauteng High Court that only “improper utilisations” subsequent to 7 December 2001 (when the legislation was gazetted) should be taken into account for surplus-apportionment schemes.

The FSB lodged an appeal, later abandoned. Instead, in 2007 it brought about an amendment that made the 2001 legislation retrospective to 1980. So far, the retrospective nature of the amendment has not been challenged for constitutional validity.

In 2008, Justice Joffe declared in the South Gauteng High Court: “Prior to some substantial amendments brought about to the Pension Funds Act on 7 December 2001, it was not believed by anyone that pensioners had a right to any actuarial surplus....That amendment declared for the first time in our law that all actuarial surplus in the fund belongs to the fund.”

During the 1990s, there were several rulings by the Supreme Court of Appeal on the matter of surplus apportionment. They were summarised in a 1999 decision by the FSB Appeal Board sitting under Gerald Friedman, retired judge president of the Cape:

“The SCA upheld the employer’s contention that, for as long as a surplus in a pension fund existed, it was under no obligation to contribute to the pension fund, irrespective of the source of the surplus. The court declined, however, to uphold the contention that while the surplus existed, members and erstwhile members of the pension fund had the right to demand that the surplus or part of it be used to increase the benefits payable to them upon retirement or upon transfer to another fund.”

account would have to be taken of s14 in the Pension Funds Act which deprives a transfer of any force unless the Registrar is satisfied that the scheme “accords full recognition to the rights and reasonable benefit expectations of the persons concerned”, he added:

“What is meant by ‘reasonable benefit expectations’ is not easy to say. Plainly, it must mean something over and above defined benefits to which the persons mentioned are entitled. Periodic inflation-related increases may be an example”

But it is a huge step from there to the bold proposition that, whatever the size of the surplus may be and however it may have come about, members and erstwhile members of a fund are essentially entitled to expect that it or most of it will be applied in such a way as to give them benefits substantially greater than those to which they are entitled as of right.” This appeal, by the Paarl Municipality, was against a refusal by the Registrar to approve a fund’s rule amendment. The Board directed the Registrar to register the rule amendment on grounds that “there is nothing in the Pension Funds Act which prohibits the payment of a surplus in the fund, or a portion thereof, to the Municipality (the employer) in the event of the voluntary winding-up of the fund”.