Paul Farrell, partner, Walkers

Regulatory changes and new opportunities

Download the special report Changing Fund Environment 2011

By Paul Farrell (pictured), Ingrid Pierce and Deborah Poole – With the impact of the global financial crisis on the performance of investment funds fading, managers’ attention is increasingly focused on the evolving regulatory framework. However, the after-effects of the crisis linger on in issues related to managers’ power to suspend redemptions and the ability of disgruntled investors to wind up solvent funds.

With final agreement on the EU’s Alternative Investment Fund Managers Directive and the impending introduction of the Dodd-Frank Act in the US, 2011 represents perhaps the best capital-raising environment for some time, with hedge fund managers poised to take advantage of significant opportunities, particularly in Europe.
 
Winding up of solvent funds
A persisting issue is whether investors can have a solvent fund wound up on the grounds of ‘loss of substratum’ – that the fund’s underlying purpose is incapable of being achieved. This stems from the adoption by various managers in 2008 of liquidity/distressed techniques that resulted in their funds being placed in informal run-off.
 
More than two years on, some investors are applying to the Cayman Islands court to wind up funds on a solvent basis. In at least one case, the Cayman court has held that this type of orderly wind-down by the board of directors and its manager does not accord with the reasonable expectations of investors in a hedge fund and has exercised its discretion in favour of investors to wind up the fund on just and equitable grounds.
 
In other cases, where the court has been satisfied with how the manager and board of directors have handled the wind-down of the fund’s business (including the regularity with which capital has been returned to investors), it has refused to make a winding-up order.
 
Having to defend applications of this type while seeking to close the fund on an orderly basis can be both time-consuming and costly for the manager, potentially resulting in lower returns to investors. Regular communication with investors and transparency regarding fees and the run-off process generally can often avert investor action of this type.
 
Redemption powers in fund articles
Some of the fund restructurings following the financial crisis have also raised important issues about the ability of funds to suspend redemptions, and relevant court decisions have been watched closely. In Culross Global SPC Limited v Strategic Turnaround Master Partnership [2010] UKPC 33, the Privy Council finally put to rest certain questions that had been hotly debated over the previous year.
 
Subject to specific provisions in a fund’s articles, the general position is that redemption occurs on the intended redemption date, not on the date of payment of redemption proceeds. Thus an investor becomes a creditor on the redemption date even if the redemption proceeds to which it was entitled have yet to be determined and the due date for payment has not yet arrived. As a result, managers should ensure that administrators remove investors from the register of members as soon as legally possible.
 
Furthermore, where offering documents purport to grant redemption powers that exceed those in a fund’s articles of association, they will be of no legal effect against investors. Managers launching new funds or undertaking updating exercises should ensure that the redemption provisions in the fund’s articles either replicate or refer to those of the offering document.
 
US regulation
The financial crisis has prompted the most significant regulatory shake-up the industry has ever witnessed. Although this primarily impacts managers, there are important implications for offshore funds. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act introduced sweeping changes affecting both US and non-US hedge fund and private equity managers and investment advisers, including those with Cayman funds.
 
Critical for managers is the elimination of the ‘private advisor exemption’ from registration with the Securities and Exchange Commission, previously available to investment advisers who satisfied certain criteria, notably having fewer than 15 clients. As a result, many investment managers currently exempt from registration with and regulation by the SEC will be required to register by July 21, 2011.
 
A change to the definition of an ‘accredited investor’ adjusts the individual net worth standard, with the threshold of USD1m henceforth excluding the value of the investor’s primary residence. Funds have therefore had to update subscription documents and in some cases constitutional documents to reflect the new definition.
 
AIFM Directive
Agreement in Europe on the future regulatory path took longer, but the final text of the directive was adopted by the European Parliament last November. Secondary rule-making is now being overseen by the new European Securities and Markets Authority, with member states required to enact domestic legislation to implement the terms of the directive by mid-2013.
 
Managers of funds that solicit investment in Europe are examining the impact on their operations and infrastructure and considering how to take advantage of the opportunities created by the AIFM Directive, as well as its associated costs. Significantly, a number of regulatory arbitrage opportunities are available during the transitional period.
 
For example, from 2013 all EU managers of funds covered by the directive will be required to comply with it in full, with certain carve-outs regarding the depositary provisions, but non EU-managers can market their funds in Europe under national private placement regimes until at least 2018, subject only to compliance with the directive’s transparency provisions. Non-EU managers of non-EU funds may be able to avoid compliance entirely even after 2018 if they only accept investments from European investors passively.
 
This evolving regulatory framework has prompted managers to engage in jurisdiction shopping for the optimal location of both their funds and management operations. Offshore and onshore solutions are proving complementary for both start-up and established managers, and many fund jurisdictions are adapting their regulatory framework to remain competitive while meeting international co-operation standards.
 
The Irish perspective
The financial regulator has introduced amendments to Ireland’s fund regime to enhance its appeal to global investment managers and fund promoters. With Ucits funds garnering significant attention in Ireland as elsewhere in Europe, some key changes affect this regime, notably the naming convention in managed account platforms and dealing day requirements.
 
Managed account platforms are currently very popular in Ireland and promoters including Merrill Lynch, Morgan Stanley and UBS have establishing these platforms as Ucits products. However, one issue they faced was restrictions on a platform sub-fund being named solely after its investment manager. In the past, the Financial Regulator permitted this only where the promoter or its parent was majority owner of the investment manager. This prevented the proper branding of a manager’s Ucits strategy within the platform and impeded the promoters’ efforts to attract suitable investment managers.
 
Following submissions on this issue, the regulator – now part of the Central Bank of Ireland – has agreed to allow the sole name of the investment manager in the title of a sub-fund where the name of the umbrella fund contains the name or brand of the promoter. Where a supplement to the prospectus is published in respect of the sub-fund, the name of the promoter must be clearly stated on the supplement cover.
 
Another issue for promoters and investment managers of more complex Ucits funds was the requirement for funds’ dealing days to occur at least fortnightly. Again following submissions from industry, the regulator moved positively to amend the requirement to twice per month at regular intervals.
 
Paul Farrell, Ingrid Pierce and Deborah Poole are partners within the global investment funds group at Walkers
 
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