Opening the Market: An Update on Direct Investment into Listed Shares in Saudi Arabia

Introduction

After years of speculation that the Saudi Stock Exchange (Saudi Tadawul) may be opening up for direct investment by foreigners into listed entities in Saudi Arabia, the Capital Market Authority of Saudi Arabia (CMA) published on 21 August 2014 its proposed draft Rules for Qualified Foreign Financial Institutions’ Investment in Listed Shares (Draft Rules) to initiate this process.  The publication of the Draft Rules was followed by a public consultation period.  The CMA’s stated intention at the time was to finalise the consultation process – including internally with the government and Saudi Tadawul by the end of 2014 – in order for Saudi Tadawul to be opened up for investment in accordance with the final rules during the first half of 2015.

Although the CMA never alluded to the reasons for, or timing of, this announcement, it must be seen in the context of the UAE’s and Qatar’s reclassification by MSCI to its “Emerging Markets” reference basket in May 2014.  By any measure, Saudi Tadawul is by far the largest and most liquid exchange in the Gulf region, and its continued exclusion from this classification on account of, inter alia, direct foreign investment restrictions is likely to have played a role in the Saudi authorities changing their stance to allow some qualified ability for foreign investment into listed Saudi companies.

Since the publication of the Draft Rules, the CMA has not made any further public statements in this regard, but the latest informal indications from the CMA are that it is targeting a launch date at the end of April 2015. The CMA has not been willing to respond to informal queries as to whether the final rules will be markedly different from the Draft Rules.  However, as we have seen an increase in queries from non-Saudi clients in this regard, it is timely to revisit the content of the Draft Rules and key related issues, in anticipation of final rules that hopefully will follow shortly.

The Status Quo

Prior to 2006, any form of investment into listed securities in Saudi Arabia (directly or indirectly) was not permitted, as a consequence of longstanding restrictions mandated by the CMA and the Saudi Arabian Monetary Agency (SAMA).  Although some Saudi-based entities were willing to provide exposure to Saudi equities via nominee arrangements, these were avoided by the majority of foreign institutional investors because they were fraught with a number of risks in what was essentially an unlawful arrangement.

The introduction of the CMA’s Investment Fund Regulations (IFR) in December 2006 enabled non-resident foreign investors from countries outside the Gulf Cooperation Council (GCC) member countries to gain indirect exposure to listed Saudi equities for the first time, by investing into Saudi-based listed equity funds. Due to the variety of limitations inherent in this form of investment, a fairly widespread practice developed whereby foreign affiliates of Saudi-based authorised persons started providing more bespoke investment solutions to foreign institutional investors by way of derivative exposures, such as total return swaps and equity-linked notes.  Initially, there was also uncertainty surrounding these types of arrangements; however, the CMA ultimately confirmed the practice as permissible in 2008 – expressly regulating it by way of CMA Board of Commissioners Resolution 2-28-2008, subsequently amended by CMA Board of Commissioners Resolution 3-10-201 (CMA Swap Resolution).

At present, and despite the prominence and importance of Saudi Tadawul in the Gulf region, these are still the only means for foreigners to lawfully gain exposure to listed equities in Saudi Arabia.  As both means of indirect investment have restrictions (including the absence of voting rights in relation to corporate actions) and also add a layer of cost and risk, foreign institutional investors with an interest in the region have been hoping for quite some time that Saudi Tadawul will open up for direct investment.

The Proposed Qualified Foreign Investor and Client Registration Process

The Draft Rules have two stated primary objectives: (i) to set out the procedures, requirements and conditions for the registration of qualified foreign investors (QFIs) with the CMA; and (ii) to specify the obligations of authorised persons licensed by the CMA to conduct dealing in securities activities (Authorised Persons) with QFIs.

In order to qualify as a QFI, an applicant must meet a number of conditions (QFI Requirements) – namely, the applicant must:

• be licensed as a bank, broker/securities firm, fund manager or insurance company;
• be regulated in a jurisdiction with regulatory and monitoring standards “equivalent” to those of the CMA;
• have at least US$5 billion of assets under management (AUM), either in the form of proprietary investments or managed for the account of another person or persons (which amount can be decreased to US$3 billion on application to the CMA), held either directly or via a group related entity; and
• have been engaged in activities related to securities investment, either directly or by way of any of its affiliates, for at least five years.

QFIs that wish to make investments into equities listed on Saudi Tadawul on behalf of their clients (QFI Clients) can do so only if: (i) each QFI Client has also been individually approved by the CMA in accordance with requirements that are very similar to those applicable to QFIs themselves; and (ii) each of the following conditions (QFI Client Requirements) is met in respect of the QFI Clients:

• the QFI must be responsible for the management of the relevant QFI Clients’ assets for investment into listed shares; and
• each QFI Client is either:

(i) a fund or any type of collective investment scheme, which must be incorporated in a jurisdiction that applies regulatory and monitoring standards equivalent to those of the CMA; or

(ii) a financial institution that meets all of the QFI Requirements.

The registration process (for both QFIs and QFI Clients) is intended to be the responsibility of a so-called “assessing” Authorised Person in Saudi Arabia.  This process requires the conclusion of a QFI agreement between the QFI and the Authorised Person, as well as providing to the assessing Authorised Person an extensive set of documents and information related to the QFI and its QFI Clients.  Although the assessing Authorised Person has the discretion to make a determination as to whether the QFI or its QFI Clients have satisfied the respective QFI Requirements or QFI Client Requirements (and to make a declaration to the CMA accordingly), the final discretion as to registration ultimately lies with the CMA.

Subsequent to a successful registration process and prior to commencement of trading, QFIs must establish: (i) a trading account; and (ii) a custody account with a sub-custodian in Saudi Arabia.  Both of these may take some time to establish, as the client due diligence and documentation requirements for sub-custodians can be quite onerous in Saudi Arabia, especially when these requirements must be met for each QFI Client.

Ongoing Requirements

QFIs are subject to two key ongoing requirements under the Draft Rules, both in relation to themselves and to the QFI Clients they represent: (i) investment limits; and (ii) disclosure requirements.

Investment Limits

The Draft Rules impose the following specific investment limits for each QFI and each QFI Client:

Restriction¹: Single issuer ownership limit for each QFI and each QFI Client
Percentage: 5% of issued shares of a single issuer
Comment: Each QFI (together with its affiliates) or each QFI Client (together with its affiliates) may own up to a maximum of 5% of the issued shares of any issuer whose shares are listed on Saudi Tadawul – 5% Single Issuer Rule

Restriction: Single issuer ownership limit in the aggregate for all QFIs and QFI Clients 
Percentage: 20% of issued shares of a single issuer
Comment: QFIs and QFI Clients may in the aggregate not own more than 20% of the issued shares of any issuer listed on Saudi Tadawul (i.e., each QFI and each QFI Client can own up to 5% of the issued shares of a specific issuer, whereas all QFIs and QFI Clients registered with the CMA will not be permitted to own, in the aggregate, more than 20% of the issued shares of a single issuer listed on Saudi Tadawul – 20% Aggregate Single Issuer Rule

Restriction: Maximum foreign share ownership in the aggregate by all foreign investors in respect of any issuer listed on Saudi Tadawul
Percentage: 49% of issued shares of a single issuer
Comment: The maximum overall limit set by the CMA as to direct and indirect foreign ownership of issued shares of a single issuer listed on Saudi Tadawul, including: (i) any form of beneficial ownership by way of swaps concluded under the CMA Swap Resolution; and (ii) resident and non-resident foreign investors – 49% Foreign Ownership Rule

Restriction: Maximum foreign ownership permitted on Saudi Tadawul as a whole
Percentage: 10% of overall market value of Saudi Tadawul
Comment: This includes beneficial ownership by way of swaps concluded under the CMA Swap Resolution – 10% Overall Market Share Rule

In addition to the specific investment limits set out above, there are two general restrictions referred to in the Draft Rules that may be meaningful in the wider context of restrictions on foreign investment into Saudi Arabia: 

• “other legislative limitations on foreign ownership in joint stock companies”, which essentially brings to mind the foreign investment restrictions set out in the Foreign Investment Act of 2000 (Foreign Investment Act) and the requirements of the Saudi Arabian General Investment Authority (SAGIA) that control foreign investment into Saudi companies (thus far imposed only at the private/unlisted company level); and 
• the limitations set forth in the constitutional documents of listed companies, or any instructions issued by supervisory and regulatory authorities in Saudi Arabia to which listed companies are subject. 

Disclosure Requirements 

QFIs are proposed to have fairly extensive reporting and disclosure requirements under the Draft Rules, both in relation to themselves and to the QFI Clients they represent, including the following: 

• annual reports and consolidated audited accounts; 
• quarterly updates on any changes in the information provided at initial registration; and
• immediate disclosure to the assessing Authorised Person in respect of certain notifiable events, such as: 
  • commencement of insolvency, criminal or regulatory proceedings; 
  • breach of the 5% Single Issuer Rule; 
  • material changes to their business, activities, regulatory status or the identity of any person having control;² and 
  • QFIs, or any of their QFI Clients, ceasing to meet applicable registration conditions. 

In addition to the above, assessing Authorised Persons have the obligation to review, on a quarterly basis, whether all QFIs and QFI Clients that have engaged them continue to meet all applicable registration requirements and to comply with all relevant obligations under the proposed Draft Rules. 

Certain Issues Need to be Clarified 

There are a number of issues emanating from the CMA’s proposed direct investment regime under the Draft Rules that require further clarification. 

“Citizens” of GCC Member Countries Excluded 

Article 1(c) of the Draft Rules specifically excludes “Citizens” of GCC member countries from the scope of the Draft Rules. The term “Citizens” is not properly defined in any of the applicable Saudi rules or legislation, or in the glossary module to the CMA’s rules; however, in its most basic sense, this means that QFIs will not be capable of registering GCC member country nationals (individuals or corporate entities) as QFI Clients with the CMA. This exclusion presumably is based on the fact that GCC nationals are exempted from the requirements of the Foreign Investment Act and the licensing requirements of SAGIA (i.e,. they can already invest directly into Saudi Tadawul without restriction). 

However, the situation in practice may be slightly more complex if one considers a similar restriction in the CMA Swap Resolution – where only “non-resident foreign investors” are permitted to enter into derivative transactions. In that context, some issuers of relevant swaps and notes excluded foreign funds purely because such funds had investors resident in GCC member countries, irrespective of the fact that the fund and its manager qualified as non-resident foreigners. It therefore remains an open question whether foreign funds having GCC member country nationals as investors (regardless of whether they hold directly or through intermediate investment structures) will be qualified by assessing Authorised Persons or the CMA as a QFI Client. 

It is also unclear whether non-Saudi financial institutions, fund managers and funds established in GCC member countries (but who are not wholly owned by GCC nationals) will be capable of registration as QFIs or QFI Clients, as the direct investment benefits of the Foreign Investment Act do not extend to them (although they do qualify as being “Citizens” of GCC member countries from a basic jurisdiction and domicile perspective). 

Acceptable Jurisdictions to Qualify as a QFI or a QFI Client 

A key requirement to qualify as a QFI is to be regulated in a manner that is “equivalent” to the regulatory and monitoring standards of the CMA. Since the CMA presently has no list of recognised jurisdictions or regulators that it considers to have such equivalent standards, it is entirely uncertain at this time: (i) who will ultimately be able to qualify as QFIs; (ii) what types of licenses or approvals from their respective regulators will qualify QFIs (especially when the Draft Rules refer to “fund manager”, which is not a consistently used term in many jurisdictions); and (iii) what types of fund clients will be able to qualify as QFI Clients. 

In this regard, it is also unclear why the CMA chose to impose a double layer of regulatory equivalency, as the Draft Rules require that both the fund manager (as QFI) and the fund (as QFI Client) must have oversight, rules, monitoring and establishment requirements equivalent to those imposed by the CMA. In the case of the fund, the equivalency test is imposed at the level where the fund was incorporated or licensed, and not where the fund manager is situated or regulated. Given the perceived lighter level of regulation of offshore funds (at the fund jurisdiction level), it seems unlikely that offshore funds will be able to qualify as QFI Clients, irrespective of the regulatory regime under which the fund manager operates. 

Other QFI Qualification Requirements 

Other QFI qualification or QFI Client classification requirements that need further clarity or consideration include the following: 

• the basis on which the US$5 billion AUM requirement to qualify as a QFI can be decreased to US$3 billion by the CMA; 
• what it means for QFIs “to be responsible for the management of the relevant clients’ assets for investment into listed shares” in order for a QFI to register the client as a QFI Client with the CMA (e.g., whether this is limited to investment management for funds and discretionary portfolio management for institutional clients, or also extends to advisory, sub-advisory and even execution-only relationships); 
• whether the requirement for QFIs to have been engaged in “activities related to securities investment” for at least five years must have been performed throughout that period on a regulated basis; 
• whether the reference to “affiliates” in the context of QFIs can include individuals involved with the QFI – as the CMA’s glossary of defined terms seems to be open to this possibility; and 
• whether an umbrella fund structure with sufficient AUM will qualify in situations where it has unrelated sub-advisers for separate sub-funds (who individually may have insufficient AUM to qualify as a QFI or a QFI Client) and, if so, who is to be registered as the QFI or the QFI Client. 

Monitoring and Enforcement of Various Investment Restrictions 

How the specific investment limits will be monitored and made available to all QFIs and their QFI Clients is unclear. Some cases (e.g., the 49% Foreign Ownership Rule and the 10% Overall Market Share Rule) will be completely outside the monitoring ability of individual QFIs, especially considering that these limits also include exposures to Saudi equities by way of swap transactions. Swap and equity-linked note transactions typically occur on an OTC basis (often with offshore counterparties) with no data currently being publicly available to track overall positions. It is also not clear why the CMA chose to include indirect investment exposures of foreigners under swap transactions in calculating limits relating to the 49% Foreign Ownership Rule and the 10% Overall Market Share Rule, but not investments by foreigners into listed equity Saudi funds – since both are indirect means of investment with exposure only to economic benefits rather than the underlying shares. 

Even the 5% Single Issuer Rule can potentially be problematic. The Draft Rules require “immediate” disclosure by the QFI to the assessing Authorised Person in the event of any breach. This restriction applies at a group level, including all affiliates of the QFI or the QFI Client – therefore, foreign investors operating on an international basis would be required to monitor investment levels daily on a consolidated global basis. 

The same need for daily monitoring on a global basis will potentially apply to umbrella fund structures that have a variety of sub-funds and sub-advisers with separate investment strategies, which may be seeking access to listed Saudi stocks independently from each other on a sub-fund by sub-fund basis. Consider, for example, how the 5% Single Issuer Rule will be monitored and complied with (with immediate notification required in case of breach) in situations involving third-party UCITS or AIFMD-compliant platform providers, which is becoming prevalent in a number of EU jurisdictions. These platforms typically involve an umbrella fund structure that, on its face, would qualify all sub-funds to be affiliates under the “common control” test imposed by the CMA – but which in fact are managed completely independently by sub-advisers with unrelated systems for monitoring investment exposures. 

Also, it is unclear how the CMA would deal with a breach of the 10% Overall Market Share Rule. This limit can be breached merely on account of market movements. A freeze by Saudi Tadawul on overall investment by foreigners into listed shares on Saudi Tadawul until the limit is restored is a possibility, but the real question is whether Saudi Tadawul will force foreigners at some stage to sell off shares to restore this limit and, if so, on what basis this will be done. 

Reference to Foreign Investment Act and SAGIA Requirements 

It is unclear why the CMA included a reference to “[o]ther legislative limitations on foreign ownership in joint stock companies” with respect to foreign investment into listed Saudi stocks. Thus far, other legislative limitations (e.g., those imposed by the Foreign Investment Act and SAGIA licensing requirements) have applied only to investment into private/unlisted companies established in Saudi Arabia. Whether the CMA intends to expand the scope of the above-mentioned legislation to cover public companies remains to be seen. 

It should be noted that the Foreign Investment Act has a so-called “negative list” of sensitive industries in the manufacturing and services sectors that are not open to foreign investment in Saudi Arabia. It may be that the CMA intends to expand the concept of a negative list to restrict foreign investment into listed entities operating in these sensitive industries. However, if the intention is to also bring SAGIA licensing requirements into the sphere of public company investment, the situation is likely to become unduly complicated, costly and time-consuming for institutional investors.

QFI Agreements and Commercial Arrangements 

The Draft Rules impose certain requirements as to the content of QFI Agreements to be concluded between assessing Authorised Persons and QFIs, with the overall content and format currently only subject to what is agreed by the parties. As there is no precedent in the market and the CMA has not provided a standard form agreement for use in this regard, it is expected that it will take some time for market participants to settle on a standard format. 

Also, the fees that can be charged by assessing Authorised Persons in this regard have been left open. Fee levels can expect to be driven by the fairly onerous duties imposed on assessing Authorised Persons by the Draft Rules to: (i) assess registration applications; and (ii) provide ongoing monitoring of QFIs and QFI Clients. Given that cost reduction was one of the reasons why direct foreign investment into Saudi Tadawul was so eagerly anticipated by foreign institutional investors, it is hoped that assessing Authorised Persons and CMA registration fees will not price the direct investment option out of the market. 

Conclusion 

Although widely received as an “opening up” of the Saudi market – with a fair amount of excitement building in the region and elsewhere as to the overall positive effect that this may have on inbound institutional investment into the GCC region – a closer inspection of the Draft Rules shows a very limited and cautious approach by the CMA, both in terms of who can invest and how much they can invest, with a number of open questions remaining. 

Considering the importance of Saudi Tadawul in the regional market, it is hoped that the CMA manages to strike the right balance between the historically protectionist interests of its domestic market and those of the international institutional investor community, which has an equally important role to play in this market going forward. 

Footnotes

_{1) Note the restriction is in relation to listed shares only. Listed debt securities remain as a restricted investment that is not open to non-GCC investors in Saudi Arabia.
2) In Saudi Arabia, “control” means the ability, individually (directly or indirectly) or acting in concert with relatives or affiliates, to vote 30% or more of the issued shares of a company, or having the right to appoint 30% or more of the members of its governing body.}