One often hears that hedge funds are unregulated in South Africa. While this is true as regards direct regulation, anyone looking at establishing a hedge fund in South Africa or investing into such a fund should be aware that a fund will need to navigate a raft of complicated South African legislation.

Indeed, a number of hedge fund structures historically used in the South African market (such as variations of the en-commandite partnership structure with undisclosed, limited liability partners and certain trust structures) may constitute illegal, unregistered collective investment schemes, and may in any event be highly inefficient investment vehicles in light of the introduction of capital gains tax. Notwithstanding the changes brought about by the Collective Investment Schemes Control Act (CISCA) in 2002, which significantly broadened the range of structures regarded as collective investment schemes, a number of the historical structures continue to operate in the South African market.

Anyone seeking to establish and operate a hedge fund needs to ensure that the structure utilised does not result in the hedge fund being regarded by the Financial Services Board (FSB) as an unregistered collective investment scheme. Most vehicles that involve the collection of funds from members of the public, and the pooling and reinvestment of those funds on the basis that the investors enjoy a proportionate right to the pooled assets and associated returns, would constitute a collective investment scheme. There is a widely held misconception that if the investment opportunity in the fund is offered to only a small group of investors, or is offered only to sophisticated, high net worth investors, that the fund will not constitute a collective investment scheme. The definition of the "public" in CISCA is surprisingly wide, and the result is that a large number of funds may inadvertently be acting in contravention of the provisions of CISCA. Parties conducting a fund in contravention of CISCA could face significant sanctions, including fines and even prison sentences.

Some hedge funds operate by offering debentures or shares to investors. In a number of instances, this sort of offering could trigger onerous compulsory disclosure requirements under the Companies Act. If the products are wrapped in insurance policies, the Insurance Acts are relevant. Any advice regarding investment in the product is highly regulated by the Financial Advisory and Intermediary Services Act.

Similarly it is easy for a hedge fund offering to breach the regulations under the Banks Act, which carefully regulates any activity that constitutes the taking of deposit (including the taking of money against the issue of a debenture or note) from the general public. There are exemptions that can be utilised, but these are highly technical and the hedge fund would generally require the assistance of experienced legal advisers to navigate the rules and regulations.

A breach of the Companies Act or the Banks Act is a serious offence and can carry significant fines or even result in imprisonment of the parties involved. Where a hedge fund has been appropriately structured, it essentially operates as an investment vehicle unregulated directly by the FSB and other regulators. Nevertheless, it must be understood that the establishment and operation of a hedge fund such that it will legitimately operate in the relatively small, unregulated area of the financial market, requires careful planning and a high degree of professional legal advice. It is easy to inadvertently breach the provisions of the various pieces of legislation that regulate the financial markets in South Africa, and a breach of these regulations would not only result in a fine and/or imprisonment for the parties operating the fund, but could also result in agreements between investors and the hedge fund being regarded as void which would give rise to complicated legal issues when the investors seek to recover funds invested.

Where a hedge fund is appropriately structured so that it operates without contravening the provisions of the current legislation it is essentially not specifically regulated by the FSB and other regulators. As a result, investors should take extra care that they understand the mandate and strategy of the hedge fund and that they are comfortable with the risk profile adopted by the hedge fund because regulators will not police these activities.

Establishing a legal hedge fund is not a simple case of someone with a nose for the market setting up an office, complete with a computer with online access to share prices. Potential hedge fund operators and investors need to understand the regulatory and common law landscape within which hedge funds operate before hard earned money changes hands.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.