Fund Regulation

Unregulated Funds

Some arrangements may not be subject to domestic funds legislation because they do not fall within the definition of a fund, although they might be referred to as such.  Other entities may fall within the definition of a fund. but may enjoy an exemption.

The exemptions are commonly granted to funds with a small number of investors which are not promoted to the public anywhere, such as investments for groups which are family-linked, such as family trusts, arrangements between members of the same group, and employee share schemes.

The extent of regulation applicable to funds will depend on the jurisdiction in which they are incorporated and resident.  Greater regulation applies to open-ended funds given their maintenance of a promise of repurchase of units on an ongoing basis.

Jurisdictions distinguish between funds which are regulated which are subject to comprehensive rules and unregulated funds which may not be promoted save in limited ways.  The UK allows for the promotion of unregulated schemes on a very limited basis.

Fund Constitution

The regime will provide for how the fund is constituted.  For example, in Ireland, it must be constituted as a company, trust, partnership or contractual fund.

Provisions will be made for title to units and their transfer.  There will be provision for the powers and duties of the scheme manager, trustee custodian or directors.

Provisions relating to the reports to investors, frequency of valuations, procedures for cancellation of shares, procedures in sale and purchase of shares.

There will be provision in respect of the investment policy and restrictions imposed.  There will be provisions for investors’ meetings and winding up.

The degree of regulation may depend on the nature of the underlying investment. For example, money market funds, property funds, and securities funds. Investment restrictions may be applied to each type of scheme. Certain funds must observe rules so as to ensure liquidity so that there are sufficient monies to hand to finance redemption.

Certain types of funds may not be capable of being marketed to the public because they do not fall within the restrictions specified.  Such funds may not, in effect, promote themselves to retail customers.  They may be required to restrict themselves to a more limited class of institutional or professional investors.

Promotion Cross-Border

AIF and UCITS schemes regulated in one State may be promoted to members of the public in another State.  Other categories of funds do not enjoy the same free passporting throughout the European Union. They may be required to comply with the regulatory rules of the State of marketing.

Many categories of schemes may be promoted in their home jurisdictions but not outside.  There may be a condition requiring that sales are only permitted through investors and advisors who police this requirement.

Such schemes may be promoted to the public in other jurisdictions, provided they comply with the applicable requirements of that latter jurisdiction, if possible.  They may, for example, be capable of being marketed to non-retail investors in that jurisdiction.  The following categories of entities are likely to require licensing or regulation under most financial services legislation.

Regulators may recognize foreign regulated funds which satisfy requisite criteria.  In some cases, there may be automatic recognition by laws as in the case of AIFs and UCITS.  In other cases, there may be a fast-track appraisal in view of commonly agreed standards.

Recognition will facilitate direct sales to the public in the latter jurisdiction.  A more limited form of distribution may be allowed through intermediaries to high net-worth and sophisticated investors.

Regulation Issues

States require key entities who are involved in the fund to be regulated.  Licensing will generally be required for the manager, trustee and custodian.

Most other persons providing key functions must also be licensed or authorised under the jurisdiction’s financial services legislation.

Many States require that funds participate in compensation regimes.  They are usually funded by the industry through a levy.  There is usually a maximum cap.

Compensation schemes are usually available to retail, non-institutional investors.

Regulation of Service Providers

The fund manager will generally be required to be licensed. In some jurisdictions, if they manage small a number of unregulated funds which are not promoted, they may be exempted.  In other cases, domestic funds may be permitted to operate if a licensed third-party fund administrator manages it. For retail funds, the manager will usually be required to be licensed.

The funds administrator is usually tightly regulated. It is responsible for the administration of funds. Generally, it is provided in the public interest that they are strictly licensed.  The trustee or custodian of a publicly marketed fund may be required to be a licensed bank with significant capital.  A less tightly regulated fund may be a licensed investment business in some jurisdictions.

The investment manager or advisor may or may not be subject to regulation, depending on the jurisdiction.  Where the advisor is appointed as manager and is responsible for major fund investment decisions, licensing will almost invariably be required.  Other third-party service providers, such as share registrars and certification services providers, are likely to be licensed.

Licensing will generally require that the identity and competence of the persons managing the relevant business be fully disclosed to the regulator. A business plan showing funding and operational capacity to undertake the activity will be required.  The regulator will require sight of key contractual agreements where applicable.

Regulatory Considerations

Regulation usually distinguishes between the following categories of funds: securities funds, feeder funds, funder funds, property funds, money market funds, futures and option funds.

Most schemes marketed to the public are prohibited or are restricted from borrowing.  This reflects the fact that borrowing amplifies investment risks and rewards.

The regulator must be established the persons are fit and proper persons, to carry on the relevant activity.  They must be satisfied the entity has the relevant capacity, competence and integrity.  The process of licensing may take A period from weeks to several months.

Regulators will assess the track record of the relevant business and its management and promoter.  They will consider previous track records and experience.

Regulators will consider the economic capacity of the provider to undertake the relevant service.  It will consider its capital adequacy and its liquidity.  Solvency requirements require that the business maintains appropriate capital and liquidity on an ongoing basis to withstand shocks and difficult periods.

The competence of management and controllers will be considered.  Key individuals must have the requisite qualifications and experience. The requirements will vary from jurisdiction to jurisdiction.

Ongoing Supervision

Once licensed, the relevant service providers will be subject to ongoing supervision.  The extent to which regulators are hands-on varies from jurisdiction to jurisdiction.  Supervision may be principles based on one end of the spectrum or involve more intense hands-on review and control on the other end.

The regulators will employ appropriate supervision techniques.  This may include on-site meetings in which the regulator’s staff spend time on the premises reviewing the activity in detail.  They are likely to focus on more risky businesses and aspects of the business.

Off-site supervision will involve written information and controls from auditors and other key individuals.  Periodic financial returns, statistical information and notification of certain events will be required.

There are likely to be annual meetings with ongoing reviews with the management to discuss regulatory issues and concerns that arise in the context of the business plan.  There may be ad hoc meetings to consider matters as they arise.

Regulators will generally have statutory powers, including powers to request information, enter premises, obtain books and records, and remove and copy documents.  Ultimately, regulators will have the power to revoke or suspend regulations or impose conditions.  They may make persuasive or dissuasive recommendations.

In the ultimate case, they have legal powers to impose fines.  Most regulators have the power to impose administrative sanctions without application to the court.  These will sit side-by-side with court-based sanctions and fines for criminal breaches.  There will be a power to revoke or suspend the license. There may be other sanctions.

AML

Money laundering and terrorist finance legislation have had a profound impact on the funds industry.  More rigorous customer due diligence is required.  There are ongoing obligations to monitor accounts in order to ensure that money is not being used to finance terrorist activities or is derived from unlawful purposes.

Funds have greater obligations in relation to so-called politically exposed persons.  These are persons who have opportunities or are at risk of engaging in corrupt activities due to their position.

Money-laundering, antiterrorist and associated legislation require institutions, including funds, to look beyond the registered or legal owners to determine the beneficial owners of assets.

Securities Funds

Securities funds will generally be limited to transferable equity securities. The scheme rules may provide that the fund is to be a growth fund, equity fund, smaller companies fund etc.

Investment in private companies is generally precluded on the basis of lack of transferability as well as lack of liquidity.  Although securities may require to be held to redemption, if they are transferable prior to sale, this may give sufficient liquidity.

Regulators generally require open-ended funds to invest in transferable securities only.  They have an obligation to fund the redemptions on an ongoing basis and have the requisite liquidity and transferability of underlying assets to meet this requirement.,

Regulators may allow a certain percentage of securities to be other than transferrable if this does not impair liquidity. Securities funds will typically be required to be invested in funds listed on an appropriate stock exchange or eligible market.  This ensures integrity, robustness in terms of processing and settlement, sufficient liquidity and transparency.

Regulators will usually require that security funds be either wholly or mainly invested in approved securities.  This quality will also secure their marketability.

Securities funds are generally precluded from investing in other security funds beyond a particular percentage, typically 5%.  Investment beyond this is more appropriate through a fund of funds.

Securities funds will generally be required to be diversified in order to spread investment risk.  There may be requirements that not more than 8% be invested in securities from a single issuer.  This may be tiered.  For example, it may be required that  40% of the funds be invested in issuers who issue up to 10% of the net asset value of the fund while the remainder of the fund is subject to the 5% restriction.

Regulators Flexibility

Regulators may be willing to amend the diversification requirement where this is appropriate to the type of fund.  The issue has arisen in particular in relation to tracker funds following the index of a stock market where particular issuers may be dominant.

Regulators usually restrict concentration in certain types of investments.  This is not usually limited to the value of the fund but to the percentage of holding in the company concerned.

The purpose may be to protect the investee company from too much influence in the company and to remove the risk that the fund will interfere in management.

Regulators generally restrict the use of derivatives to any significant extent.  In the same way as borrowing, their systematic use could amplify risk and be inappropriate. Derivatives will usually be permitted for specific purposes on a small scale.

Some Fund Variants

Money market funds are designed to invest in money market instruments such as treasury notes, bills, commercial paper, certificates of deposit or, in some cases, bills of exchange and debentures.  Generally, they must be repayable within 12 months.

Feeder funds invest in other funds.. Funds of funds invest mainly in other funds. The regulation may seek to prevent investors from paying double commissions or layers of administration with little extra benefit.

Regulators require a minimum degree of diversification.  Funds must generally invest in at least five other funds. Funds of funds may invest generally in geared funds, property funds, warrant funds, money market funds, and security funds.

They may be permitted to invest to a limited extent in transferrable securities, cash, or gold.  Funds of funds cannot generally invest in other funds of funds, feeder funds or embedded funds which invest in the above.

Funds for the future and options must also be invested in other investments that restrict or cover the risks beyond certain levels.  These counterbalancing investments must be appropriate and of sufficient kind and value to match the risk.

Property

Property funds are inherently subject to constraints on liquidity given the length of time it takes the property to sell and its vulnerability to illiquidity in depressed.

Retail property funds may be permitted to invest a percentage of their net asset value in property.  The remainder may be invested in other property-related assets but with sufficient liquidity, such as shares and property funds. A specific proportion of cash, like investments, is required to ensure that assets are reasonably liquid.

Investment Trusts

Investment trusts are closed-end funds similar to public companies.  Investment restrictions are less as there is no requirement for the directors to repurchase the shares on demand.  The shares may be sold in an appropriate market, whether on a stock exchange or other secondary market.

In some jurisdictions, there are no investment restrictions at all. They may not be subject to authorization and regulation in other jurisdictions. They may be enforced through the tax system, so the tax benefits are disapplied if the restrictions are not maintained.

The UK requirements provide that a maximum of 15% of net assets are invested in any one company.  A maximum of 20% of the capital of any company may be held so as to avoid excessive influence.  A maximum of 25% may be held in unquoted shares, property and commodities.

Investment trusts may generally borrow to a certain extent.  The restrictions are in the constitutional documents rather than regulatory ones.

Venture Capital

In some jurisdictions, specialist regimes may be available for funds aimed at sophisticated and high-net-worth investors.  In the UK, venture capital trusts are given favourable tax treatment by way of income tax relief at a lower rate and the possibility of deferral of capital gains tax. The VCT must be listed.

In the UK, at least 70% of the value must be invested in qualified unlisted trading companies, including companies in the alternative investment market. No more than 15% may be invested in a single company.  At least 30% of investments by value must be invested in new ordinary shares in qualifying companies without preference.  The remainder of the investments may be in other types of shares.

A VCT may not invest more than one million pounds in any single qualifying trading company which has gross assets of less than ten million pounds.

Hedge Funds

Hedge funds.  So-called hedge funds operate outside of statutory regulations.  They are privately organized and administered by professional investment managers and are not widely available to the public.

Hedge funds are generally unregulated or lightly regulated and have significant freedom to invest under the law and under the terms of their mandate.  They are targeted at sophisticated or relatively sophisticated investors.

Investment Strategies

The investments that a fund may invest in will be determined by its investment policy and applicable regulations.  Investments held must be consistent with the category of fund for which it is authorized.

There may be caps on the percentage of the fund, which may be invested in particular classes of assets.  There may be restrictions in the constitutional documents in relation to particular types of investment.  Most funds have very limited borrowing powers.

Their investment strategy includes the following; Sale of stock which they do not hold by way of short selling.  They may seek to arbitrage small differences by exploiting small price differentials while the market is going back into equilibrium.

They may invest in emerging markets futures, other distressed debts, or other risky assets.  In particular, they seek arbitrage opportunities while markets are settling to equilibrium.

Strategies used by hedge funds have been used by large institutions to optimize their investments and currency positions. Hedge funds are usually structured in an offshore jurisdiction, particularly those with tax benefits.