An Introduction to REITS and Derivatives
Elements of Fraud in Kenya and Foreign
experiences on frauds involving REITs and
Derivatives
John Miles
Managing Director – JMiles & Co.
Real Estate Investment Trusts (REITs)
• Real Estate Investment Trusts (REITs) have been in
existence in one form or another for a while.
• More than 25 countries in the world use
internationally recognised REIT models.
• In Africa REITs are a relatively new concept. South
Africa, Nigeria, Kenya and Tanzania have
established REITs fairly recently. The earliest
country in Africa being Ghana in 1994
What are Real Estate Investment
Trusts? (1)
A REIT is defined as a regulated investment
vehicle that enables persons to collectively
contribute money as consideration for the
acquisition of rights or interests in a trust that
is divided into units with the intention of
earning profits or income from real estate as
beneficiaries of the trust.
What are Real Estate Investment
Trusts? (2)
• REITs allow anyone to invest in portfolios of largescale properties through the purchase of stock.
• Shareholders benefit by owning stocks in a REIT &
earn a share of the income without actually having
to go out and buy or finance property.
• Most REITs are traded on major stock exchanges,
but there are also public non-listed and private
REITs.
REITs and Global Markets-The US (1)
• The US has the most mature REIT market in
the world which was created in the 1960s
• REITs must comply with certain provisions
within the Internal Revenue Code and are
regulated by the SEC.
• As at 2016, there were 200 REITs with a
combined equity market capitalization of
nearly $1 trillion
REITs and Global Markets-Australia
• Australia has one of the more established
REITs markets globally with the first REIT
starting in 1971
• As of July 2012 there are 45 Australian
publicly listed real estate companies with a
market capitalisation of USD 68 billion
REITs and African Markets-South Africa
and Nigeria
South Africa
• REITs were officially established on 1 May 2013
• South Africa has Listed Company REITs and Trust REITs
which are publically traded on the JSE REIT board.
• South Africa’s 43 REITs are valued at $24bn.
Nigeria
• Nigeria’s first REIT was established in 2007. The country
currently has two listed REITs which have a total net asset
value of N3.72bn (or $2.36bn).
REITs and the Kenyan Market
• REIT’s in Kenya were established in 2013 following the Introduction of
REITs through the 2011/12 Budget Statement
• The first ever listed REIT was issued in November 2015: the Stanlib
Fahari I-REIT.
• REITs in Kenya are required to be established under a trust deed and
structured as an unincorporated common law trust divided into units.
• They should have a trustee appointed under the trust deed, a REIT
manager and a promoter. Trustee also appoints other professionals
such as a valuer, structural engineer, auditor and shariah adviser for
an Islamic REIT
Legislative Framework governing REITs
in Kenya
• Regulated by the Capital Markets Act CAP 485A and the Capital
Markets (Real Estate Investments Trusts) (Collective Investment
Schemes) Regulations, 2013 which came into force in June 2013
• Prescribes for establishment and authorization of REITs,
Management of the trusts, provisions relating to different types
of REITs among others
Types of REITs in Kenya (1)
1.
Development and Construction REITs (D-REIT): Investors pool
resources for acquiring real estate with a view to undertaking
development and construction projects
2.
Income Investment REITs (I-REIT): is a type of REIT in which the
investors pool their resources for purposes of acquiring long term
income generating real estate including housing, commercial and
other real estate
3.
Islamic REITs-based on Sharia law principles
REITs can be closed or open ended
Derivatives
What are derivatives?
Basic definition:
Financial contracts whose value
is determined by reference to
(or derived from) an underlying
asset or variable.
●Examples of derivatives:
●Swaps
●Options
●Forwards and Futures
●Can be Over the Counter
or Exchange Traded
Types of underlying asset
or Variable
equities
interest rates
debt
obligations
currency/FX
rates
fund units
property
prices
commodities inflation rates
Derivatives and the Kenyan Market
• Has come a long way from trading stock to futures
• In March 2016, the CMA enacted new Derivative Markets Guidelines, 2016
based on the International Organisation of Securities Commissions
principles
• CMA has geared up for a derivatives market through:
 Setting of Central Depository and settlement system
 Immobilization of securities
 Dematerialization of shares
 Demutualization of the Bourse
 Establishment of futures exchange
• Only the NSE has been licensed to open a derivatives and futures
exchange.
Derivatives traded on the NSE
• The Nairobi Securities Exchange (NSE) has
established NEXT which is a Derivatives
Market
• NEXT currently trades:
–
–
–
Currency Futures
Equity Index Futures
Single Stock Futures
• The CMA approved the NSE Derivatives Rules
on 18 December2014
Legislative Framework of Derivatives in
Kenya
• Modalities of trading in the derivatives exchange have been
established through the Capital Markets (Derivatives Markets)
Regulations, 2015 gazetted on 4 March 2016 which provides
the legal framework for trading of derivatives
• The Regulations prescribes:
–
–
–
–
licensing requirements and duties of a derivatives exchange
sets up a framework for a clearing house of the derivatives exchange
approval of derivatives transactions
conduct of derivatives business as well as specify market offences
• Follows international best practice
• An overview of the regulations will be dealt with by other
speakers
FRAUD IN ALL ITS FORMS
The legal definition of fraud
- Focus will be on civil fraud for purposes of the talk.
- Civil fraud obligations in Kenya arise from both statute law and common law.
- Some of the statutes in Kenya dealing with fraud include: Section 11(3) of the Capital
Markets Act; section 11(1A) of the Banking Act; and section 7 of the Law of Succession
Act.
• The Capital Markets Act – Section 11(3)(t) gives the Capital Markets Authority the power
to trace any assets, including bank accounts, of any person who, upon investigation by
the Authority, is found to have engaged in any fraudulent dealings in securities or insider
trading;
The legal definition of fraud (Contd..)
-
These statutes however do not delve into an analysis of fraud and its elements.
There is also no specific statute in Kenya that deals exclusively with fraud.
-
It is therefore left to English Common Law to ascertain the substantive legal
principles by virtue of section 3 of the Judicature Act.
The main types of civil fraud
 Fraudulent breach of contract
 Deceit
 Conspiracy
 Breach of fiduciary duty
The main elements of the different types of
fraud
Fraudulent breach of contract (Derry v Peek)
A fraudulent breach of contract requires all the following elements:
- The defendant makes a false representation of facts (not an opinion);
- The representation was made by the defendant himself or with the defendant’s
knowledge;
- The defendant made its representation knowingly or carelessly without ascertaining
its truth;
- When making the misrepresentation, the defendant’s main intention was to deceive
the claimant;
- Due to the misrepresentation, the claimant suffers harm, loss or damage. If the
claimant has not suffered any loss, then there is no inference of fraud.
The main elements of the different types of
fraud (Contd..)
Tort of deceit (Derry v Peek)
The tort of deceit requires all of the following elements:
- The defendant makes a representation of fact, by word or conduct;
- The defendant’s representation is made with knowledge that it is false, or may be
false (wilfully false or at least made in the absence of any genuine belief that it is
true);
- The representation is made with the intention that it would be acted on by the
claimant, or by a class of persons which include the claimant, in a manner which
resulted in damage to the claimant;
- The claimant acted on the false statement; and
- By acting on the statement, the claimant suffered damage.
The main elements of the different types of
fraud (Contd…)
Conspiracy (Lonrho Plc v Fayed [1992] )
There are two types of conspiracy, the distinctive elements of which are:
1. Unlawful means conspiracy – a conspiracy in which the participants
combine to perform acts which are themselves unlawful under either
criminal law or civil law; and
2. Lawful means conspiracy – a combination to perform acts which,
although not themselves unlawful, are done with the sole or
predominant purpose of injuring the claimant.
The main elements of the different types of
fraud (Contd..)
Conspiracy to defraud requires all the following elements:
• There must be a concerted action between two or more persons;
• The purpose of the combination is to cause loss or damage to the
claimant;
• The conspirators’ intention is to cause damage to the claimant; and
• There is an overt act, which causes damage.
• To prove lawful conspiracy, the claimant has to go a step further to
show that the defendant’s primary purpose was not to further or
protect their own interests and that their sole purpose was to injure or
cause loss to the plaintiff.
The main elements of the different types of
fraud (Contd…)
Breach of fiduciary duty
- A breach of the fiduciary duty requires all the following elements:
- A fiduciary relationship exists between the defendant (trustee) and the claimant;
- There is a trust;
- The trustee acts in bad faith (mala fides) and/or in a manner that is unconscionable
towards the claimant;
- The trustee’s actions breach its obligations under the trust;
- The breach resulted to loss and/or damage
From the foregoing, one can therefore define fraud as a wrongful act intended to
deceive the innocent party resulting in their financial loss.
Examples of recent fraud in Kenya (Contd…)
Dyer & Blair and CFC Stanbic Bank
This emanated from a 2016 court judgment whereby Dyer & Blair, an investment bank
owned by businessman Jimnah Mbaru and a South African bank, CFC Stanbic have
been ordered to pay Mr. John Kiarie Ndung’u, an investor, about Sh418 million arising
from what the High Court termed as “a complicated wave of deceit” perpetuated by the
two companies.
The court found that Stanbic Bank joined the Dyer & Blair Investment Bank in a
complicated wave of deceit whose aim was to trade with the plaintiff’s money without
accounting for interest.
Defences to a claim in civil fraud
Delay
- Delay in itself is not a bar to relief.
- However, if the delay surpasses the limitation period under the Limitation of Actions Act, the
claimant will be unable to bring the claim.
- Under the Limitation of Actions Act, there is no single limitation period applicable to all
actions for civil fraud. However, actions founded on contract must be made within six years.,
actions founded on tort must be made within three years and actions for the recovery of land
must be made within twelve years.
- Noteworthy: The limitation period for an action for civil fraud does not commence until the
claimant dicovers the existence of the fraud – s.26 Limitation of Actions Act.
Lack of good faith
- An action for civil fraud cannot be brought if the claimant has filed the claim in bad faith (the
claimant has brought the action for an alternative reason) or has acted in a manner considered
an abuse of the process of the court.
Standard of proof
-
-
The standard of proof in civil cases is on the balance of probabilities – It must be
more probable than improbable that the claimant’s allegations are true.
However, in cases of fraud, where the allegation involves criminal conduct, the
standard of proof is higher.
RG Patel v Lalji Makanji [1957] EA 314 – The Court of Appeal stated that
allegations of fraud must be strictly proved . The allegation does not to be proved
beyond reasonable doubt but must be more than a mere balance of probabilities.
Must be proved to the satisfaction of court.
Fraud in REITs and Derivatives: Case
Studies
Texas REIT becomes a Ponzi Scheme
A Texas-based real estate investment trust (“REIT”), United
Development Funding (UDF) is under investigation over
allegations that the UDF IV was run for years like a Ponzi
scam. UDF was a non-traded REIT that became traded
when it listed on Nasdaq in 2014.
An anonymous author leaked allegations against UDF in
December 2015.
The UDF umbrella used new capital to pay distributions to
current investors and UDF companies and gave substantial
liquidity to earlier UDF companies to pay earlier investors.
Fraud in REITs and Derivatives: Case
Studies
UBS Scandal
In 2013, the SEC, charged UBS Securities with
violating securities laws while structuring and
marketing a collateralized debt obligation (CDO)
by failing to disclose that it retained millions of
dollars in upfront cash it received in the course
of acquiring collateral for the CDO. UBS agreed
to pay nearly $50 million to settle the SEC’s
charges.
Fraud in REITs and Derivatives: Case
Studies
Deutsche Bank
Deutsche Bank was fined a total of $55 million to settle
charges by the SEC that it filed misstated financial reports
during the financial crisis relating to its derivatives
portfolio. The bank overvalued a portfolio of derivatives
through which it purchased protection against credit
default losses. This leverage created a “gap risk”, which the
bank initially took into account in its financial statements,
but eventually changed its methodology stopped adjusting
for gap risk altogether. In other words, the bank slowly
tweaked its formula over the months so that the risk didn’t
show in its financial reports.
Challenges for the regulator and key
players (1)
• Financial derivatives have been associated with a number of
high-profile credit events over the past two decades especially
in the US: Enron 2001, Baring in 1995, AIG 2008.
• One common feature of these events was that over-thecounter (OTC) derivative tradings were thought to have played
some role: these were loosely regulated derivative contracts
such as forwards, credit swaps
• One challenge for the regulator is to monitor such transactions
and encourage movement into regulated exchanges
Challenges for the regulator and key
players (2)
In Kenya regulators face unique challenges as REITs and Derivatives are new
concepts in our developing economy. Some challenges include:
1. Lack of capacity and understanding of how REITs and derivatives workboth for the investor and regulator-low uptake of new products which the
CMA should address through investor education
2.
Deficiencies in information, monitoring and control systems, which result
in fraud, human error, system failures, management failures on the part of
the regulator.eg.
3.
Lack of strong corporate governance structures
Challenges for the regulator and key
players (3)
5. Lack of integration with other markets international financial markets-could
be changing with dual listings
6. Economic and political landscape which might deter investors-Economic and
political situations that could lead to depreciation in the value of the property.
However, gauging from the trend in the Kenyan property market in the past few
years, the values of properties have been escalating.
Lessons Learnt
•
Strengthening investor protection through:
– Dissemination of information to investors about products traded on the exchange through
more aggressive investor education-most investors are vulnerable due to lack of
information
– Create an avenue for reporting fraud-CMA has an online reporting platform, SEC has a
reporting procedure
– Reigning in investment brokers so that they do not misrepresent information about
complex products to the public
– Maintaining a listing for investment brokers where investors can check whether their
brokerage firm is legitimate-CMA maintains a list of all licensees on their website, however
this list should be more detailed and cover more information about the licensee’s
registration status, products