London is the recognized centre in Europe for hedge fund managers
By Peter Astleford, a partner with international law firm Dechert, William Yonge and Paul Weisenfeld, senior associates at Dechert in the London and New York offices respectively.
London is the recognized centre in Europe for hedge fund managers. In addition to a fast growing number of European hedge funds which have been setting up shop in London over the past ten years, large US based hedge funds are increasingly opening operations in London. This article presents the major aspects of UK regulations applicable to hedge fund managers and fund marketing and highlights the salient differences from US regulations applicable to similar situations.
UK hedge fund managers normally require authorisation under the Financial Services Act 1986 (the "Act"). Most achieve this by membership of the Investment Management Regulatory Organisation ("IMRO"), a self-regulatory organisation. The newly enacted Financial Services and Markets Act 2000 (the "New Act") will come into force in the Summer of 2001 and the relevant regulator will then be the Financial Services Authority ("FSA").
In contrast, US hedge fund managers may avoid investment adviser registration with the Securities and Exchange Commission ("SEC") provided they have had fewer than 15 clients in the preceding year (a fund will usually count as one) and do not "hold themselves out" to the public as investment advisers. In addition, investment adviser registration with the SEC is generally unavailable to managers with less than US$25 million under management. The position from State to State can vary but is generally more relaxed than in the UK.
The IMRO application process
When authorising a new applicant, IMRO's three key concerns are:
- Is its business plan viable?
- Will its capitalisation be sufficient throughout the start-up phase?
- Will it be compliant?
The application must be made on the standard IMRO application forms accompanied by supporting documentation such as draft customer agreements, offering documents for the fund and a compliance manual. It generally takes around three months for IMRO to process a fully completed application. The IMRO application comprises an application for membership covering the applicant's corporate structure, a business plan questionnaire covering the rationale for establishing the business, a compliance arrangements questionnaire and financial resources questionnaire incorporating the financial calculations and projections for the first year.
Applications for individual registration also have to be made for each "key" individual. All "controllers" (shareholders owning 10% or more) need to be detailed to IMRO and any individuals owning 30% or more must provide a net asset value statement.
The applicant must appoint a Compliance Officer who may also have other roles such as Investment Manager or Finance Officer, provide drafts of procedures, notices and agreements issued to staff or customers from the date of authorisation and detail the intended internal staff training arrangements.
The applicant's lawyers will work with its auditors to complete the financial resources questionnaire. The financial resources requirement will depend on the proposed business of the applicant and whether it falls within the Investment Services Directive ("ISD") of the European Community. Discretionary hedge fund managers will usually fall under the ISD and if they do not propose to hold client money or assets or trade for their own account will usually have a financial resources requirement of Euro 50,000 and a liquid capital requirement based on 13 weeks' expenditure. Additional sums may be required to reflect particular risks.
In contrast, even if regulated by the SEC, US based hedge fund managers will not be subject to any such requirement, although certain SEC registered (and some State registered) hedge fund managers of investment partnerships deemed to have custody over client assets may be required to supply audited financials and be subject to annual surprise audits unless an independent client representative is retained by the fund to approve payments and disbursements by the fund to the manager and its affiliates.
On registration, individuals who perform "registrable activities" need to register individually with IMRO. Registrable activities include being directors, individuals in a senior management role (e.g. chief executive, compliance officer and finance officer), investment managers and dealers. IMRO actively verifies information produced during the registration process to ensure "fitness and properness". Non-disclosure will be looked upon gravely by IMRO.
On submission of an application to IMRO, the applicant is assigned to an IMRO officer who reviews the forms and supporting documents, conducts enquiries both directly with the applicant's lawyers and with third parties. Provided the final interview goes well, IMRO will suggest a date on which the application will be considered by IMRO's Authorisation Committee. The Committee may authorise the applicant but impose a number of special conditions such as independent quarterly compliance reviews or a limit on the number of customers.
Training and Competence
Authorised firms must identify staff engaged in investment management, advice or certain senior administration functions. These individuals must be categorised as either "threshold competent" (able to perform their role without direct supervision) or "trainees" (supervision required).
To achieve threshold competence an individual must generally have passed an appropriate IMRO approved, recognised or accredited exam and an assessment by his employer to determine that he possesses the requisite knowledge and experience. In the case of persons with substantial investment experience outside the UK, IMRO may waive the examination requirement but practice has shown that unless the individual has experience of UK regulation, he will nonetheless be required to pass the regulatory module.
The SEC has no equivalent requirements for investment managers, although a number of States do have examination requirements.
Managers must restrict their business to that which has been specifically agreed by IMRO. A newly authorised manager will be monitored by the IMRO Corporate Admissions team for the first 6-12 months. IMRO will then proactively work with the manager to help it focus on the practical realities of compliance. Thereafter it will be subject to more stringent (but less frequent) IMRO member supervision.
A brief overview of the main rules is given below.
Conduct of business rules: Managers must comply with the conduct of business rules in areas such as:
- investment advertisements, inducements and soft commissions;
- establishing whether customers have private or non-private status (the non-private customer regime is lighter) and contents of customer documentation;
- trade allocation;
- timely and best execution; and
- disclosure of material interests.
Financial records and reporting rules: Managers must submit audited annual financial returns, auditor's reports and, usually, unaudited quarterly financial returns to IMRO.
Compliance, reporting, records and complaints rules: Managers must have written compliance procedures. This requirement is normally satisfied through the compliance manual. Managers must ensure that employees are suitable, adequately trained and properly supervised. At least annually, managers must provide IMRO with confirmations as to its business, compliance with rules and complaints statistics, etc.
Managers must take reasonable steps to ensure that staff conform with the regulatory system, the statutory restrictions on insider dealing and propriety in personal dealings. This will necessitate a personal account ("PA") dealing procedure which will be set out in the compliance manual and provision for prior clearance of most PA dealing.
Records must be kept, e.g. as to rule breaches, complaints and corrective action. These records must normally be kept for a minimum of three years and may be inspected by IMRO. There is an obligation to notify serious rule breaches immediately to IMRO.
Certain events require notification to, or pre-clearance by, IMRO. For example, clearance events include a change of controller or chief executive. IMRO will visit managers for compliance inspections and make ad hoc visits concentrating on a particular regulatory theme.
IMRO have the power to investigate managers which can lead to disciplinary proceedings. IMRO may:
- issue private written warnings;
- exercise powers of intervention, for example prohibiting a firm from carrying on investment business and, if appropriate, with publicity;
- levy summary fines; and/or
- close down the business.
Interestingly, the UK regulators do not appear to have hardened their attitude towards hedge fund managers despite publicised scandals relating to the industry in the United States.
As noted above, SEC investment adviser registration is largely voluntary for many hedge fund managers operating in the United States. Advisers that do not provide investment advisory services outside of the fund context, advise fewer than 15 funds and do not hold themselves out to the public as investment advisers are not required to register with the SEC as investment advisers. Hedge fund managers registered with the SEC must comply with certain regulatory restrictions that require the manager to obtain client consent for principal and agency trades between the manager (or its affiliates) and the fund, to comply with certain restrictions on advertising, to limit the charging of performance-based fees to certain high net worth individuals and to comply with a rule governing the manager's ability to pay cash solicitation fees for the referral of clients to the manager. Registered managers also will generally maintain written compliance procedures and are subject to periodic examinations by SEC staff. In addition, regardless of whether a hedge fund manager is registered with the SEC, the manager will be subject to the antifraud provisions under applicable law.
Following an initial examination, on-site examinations will typically occur every four years. In this regard, books and records of the manager must generally be maintained for a period of no less than five years. Aside from certain quarterly reporting requirements on securities holdings that are only applicable to larger investment advisers (regardless of the status of investment adviser registration), SEC registered investment advisers are required to complete a Uniform Application for Investment Adviser Registration - or Form ADV (the form of which is currently in the process of being amended), subject to annual amendments and interim amendments in certain circumstances. However, absent extraordinary circumstances, the SEC's regulatory involvement in the day-to-day operations of hedge fund managers tends to be more disclosure based and far less "hands-on" than its UK counterparts. SEC-registered hedge fund managers are, however, burdened with detailed requirements and an obligation to disclose (in the Form ADV) their business practices in respect of areas such as soft commissions, trade allocations and participation or interest in client transactions.
The ISD is one of a series of directives designed to implement a single market in financial services throughout the European Economic Area ("EEA"). While no European retail hedge fund product exists, UK hedge fund managers authorised by IMRO as ISD firms may conduct business throughout the EEA following certain registration formalities. A UK branch of a non-EEA business will not be eligible for the passport. Accordingly, a US business which wishes to set up a business in Europe to benefit from the passport will need to be incorporated locally. The manager's services may be structured outside the ISD requirements with consequential lower capital adequacy requirement but this will lead to inflexibility of operation and lose the benefits of the passport.
UK financial regulatory reform
The various financial services regulators have, in practice, already been rolled into one, the FSA. When the New Act comes into force, the existing regulators will finally fall away. The FSA will be solely responsible for regulating all firms that conduct investment business including management of hedge funds. In due course rules and guidance in relation to hedge fund managers will be found in a new FSA Handbook.
A code of market conduct (the "Code") will be brought into effect to support the FSA's role in policing market abuse. The Code may prove of particular relevance to certain hedge fund managers (for example, highly leveraged funds with strategic positions in a narrow market).
The FSA will have increased disciplinary powers, e.g.:
- unlimited civil fines in the case of market abuse;
- orders to disgorge profits and compensate victims; and
- the power to take action against individuals or companies whether regulated or not and to require anyone to answer questions and to produce documents.
The combination of the FSA's abilities to levy unlimited fines and the new Code should, according to Michael Foot, Head of Financial Supervision at the FSA, "further enhance London's reputation for clean and fair markets". Other commentators have suggested it may make London a harsh place in which to do business.
Civil fines and disgorgement of profits are remedies that are also available to the SEC to combat abuses committed by hedge fund managers. The anti-fraud provisions of the US Investment Advisers Act of 1940, as amended (the "Advisers Act"), apply to all firms and persons meeting the definition of investment adviser, whether registered with the SEC, a state securities authority, or not at all. These provisions prohibit misstatements or misleading omissions of material facts and other fraudulent acts and practices in connection with the conduct of an investment advisory business. As a fiduciary, a hedge fund manager owes its clients undivided loyalty, and may not engage in activity that conflicts with a client's interest without fully disclosing the conflict of interest to its clients. In recent years, the SEC has become more zealous in its enforcement of the anti-fraud provisions of the Advisers Act and, on occasion, has even brought enforcement proceedings against private investment advisers not registered under that Act.
Promotion of hedge funds in the UK
The promotion of hedge funds in the UK is currently regulated by Sections 56, 57 and 76 of the Act. Section 56 prohibits the making of unsolicited telephone calls or personal visits with a view to promoting investment except as permitted by regulations.
Section 57 prohibits the publication of investment advertisements in the UK unless they have been issued or approved by an authorised person in accordance with the rules of its regulator. An authorised person must ensure that advertisements are fair and not misleading and that appropriate expertise has been applied in composing the advertisement or approving it and that any relevant risk warnings are included.
There are a number of exemptions from Section 57 which, in effect, allow hedge funds to be promoted to or through:
- persons authorised under the Act, e.g. to private clients, investment managers and brokers;
- investment firms established in other EEA states carrying on passported business in the UK under the ISD;
- financial journalists;
- governments, local and public authorities;
- companies which have (or any of whose subsidiaries or parent companies have) called up share capital of not less than ?5 million (or ?500,000 provided the company or its holding company has more than 20 shareholders);
- unincorporated associations with net assets of not less than ?5 million; and
- trusts which have (or have had during the last two years) cash and investments (before deductions) with an aggregate value of not less than ?10 million or, even if they do not qualify under this size test, whose trustee itself qualifies under the above categories.
There are a number of other smaller exemptions. The Act does not regulate non-UK marketing. However, these categories do not include private customers in the UK no matter how wealthy or experienced they may be, unless they meet one of the criteria set out above. As part of the consultation process on regulatory reform, the Government suggested including an exemption for individuals who satisfy a net worth test. A decision is expected shortly.
UK authorised persons may also, where appropriate, market hedge funds to, inter alios: investors in similar funds; an "established customer" for whom the investment is suitable; and individuals sufficiently experienced and knowledgeable to waive the protections normally afforded to private customers.
Generally, the promotion of hedge funds in the US is regulated by the US Securities Exchange Act of 1934, as amended (the "Exchange Act"), the US Securities Act of 1933, as amended (the "Securities Act"), and the US Investment Company Act of 1940, as amended (the "Company Act"). Under the Exchange Act, parties promoting the sale of interests in a hedge fund are generally required to be registered as or associated with an appropriately licensed broker-dealer, unless an exemption therefrom is available. The exemption most frequently relied upon is a safe-harbour commonly referred to as the "issuer-exemption," which may be available to persons sufficiently close to the hedge fund itself (i.e., a senior executive of the general partner of a limited partnership hedge fund), whose compensation is not based upon the sale of such interests (i.e., commissions) and are not otherwise affiliated with a registered broker-dealer.
In the context of the Securities Act and the Company Act, the manner in which a hedge fund is promoted must not, inter alia, constitute any form of general solicitation or general advertising. Promotions that constitute a general solicitation or general advertising would subject the fund to registration under the US Investment Company Act , and the sale of its interests to registration under the Securities Act . SEC rules, interpretations and case law have established various factors to consider in determining whether a general solicitation or general advertising has taken place, or whether a particular offering is public or private, all of which are consistent with the notion that the sale of interests in a hedge fund must generally be conducted by means of a private placement of the securities of the hedge fund. Not surprisingly, additional regulatory concerns will be raised in the context of any promotion of a hedge fund where the promoter, sponsor or any similar party fails to state a material fact or otherwise materially misstates the facts relating to the offer of securities, or engages in any other fraudulent activity. u
Note: the contents of this article are of general application only. Readers must rely on specific advice received on their individual position.