Despite independent reports on the financial crisis, including the EU's own De Larosiere Report, absolving hedge funds of any blame in the recent financial crisis, the European Commission has still pushed through the Alternative Investment Fund Managers (AIFM) Directive. e Directive includes measures to ensure that managers of alternative strategy funds increase disclosure to investors. It also sets out new rules on capital requirements and introduces a European 'passport' system to enable firms to market to investors across the continent.
One way in which fund managers have sought to improve demand for their products while keeping in step with the EU is by launching Undertakings for Collective Investment in Transferable Securities (Ucits), which are fast developing as a form of 'regulatory wrapper' for hedge funds as they are intended to offer greater transparency and are subject to greater regulatory scrutiny. Given the negative media and political attention that surrounded hedge funds following the financial crisis, Ucits appear to some as being able to offer a flexible alternative investment product, affording managers sufficient investment freedom to pursue alternative investment strategies while providing a variety of safeguards to protect a wide range of investors.
UCITS FOR ALTERNATIVE INVESTMENT STRATEGIES
e degree of regulation that Ucits require should, however, be very carefully considered in terms of two key issues. First, the Ucits structure is increasingly a means to circumvent established regulation by enabling retail investors into complex strategies; such investors may not have sufficient financial markets experience of the product or the wealth to withstand potential losses. One can only imagine the ways in which politicians will be able to defame and damage the industry further when vulnerable investors lose money in complex Ucits III & Ucits IV strategies that may (even in a small minority of cases) not have been appropriate in the first place. Second, Ucits structures require managers to make sacrifices, which can limit the strategy and its returns, while concurrently increasing the fund's operating costs.
Clearly there are enormous commercial advantages to the use of Ucits in the right context, but this must surely be considered as being for a separate breed of investment strategy.
As many people may be aware, the infamous Madoff used Ucits as feeders, proving that no level of regulation is 'fraud proof'. In at least one case, losses were compounded by the appearance that the intended responsibilities of the custodian were avoided by the heavily regulated bank concerned. ere are many ways in which investor protection can be achieved beyond regulation through the fund industry's existing infrastructure. Using the Cayman Islands as a case in point, the following will indicate how better governance and oversight is a realistic goal.
INVESTOR PROTECTION BEYOND REGULATION
Despite reports to the contrary, the Cayman Islands Monetary Authority (CIMA) has recently confirmed that the Cayman fund industry continues to flourish, growing by approximately 95 funds per month, with de-registrations remaining at a steady rate of around 5%, as has been typical over recent years. CIMA has also confirmed that a mere four funds have explained their fund termination in the Cayman Islands by a move to the EU.
e Cayman Islands is thriving, and is aware that the reality of achieving increased investor protection is through better oversight and better disclosure, in addition to specific built-in safeguards such as the employment of independent directors and regulated fund administrators.
THE ROLE OF INDEPENDENT DIRECTORS
Investment funds structured as companies have directors to supervise business operations and ensure that the company's corporate policies (and of course the respective legislative provisions) are respected. Properly paid, qualified and empowered independent directors who can devote appropriate time to each of the companies for which they are responsible protect investors' interests.
Directors owe a fiduciary duty to investors, and in common law jurisdictions such as the Cayman Islands, fiduciary duty is governed by the legal principle of equity. Equity prevails over other areas of law to allow fairness in place of the technical application of codes in situations where the code's creator would not have intended such an outcome. Fiduciary duty exists in equity to protect investors from the risk of the directors causing harm to either the fund or its assets through fraud or mismanagement (see also Rights in Property, below). Investors' interests would likely be better protected if a more literal and consistent application of such fiduciary rules was enforced by the courts, more in line with those of a trustee.
THE ROLE OF INDEPENDENT, PROPERLY REGULATED FUND ADMINISTRATORS
The appointment of an independent and properly regulated fund administrator further mitigates risk of fraud and mismanagement. A third-party administrator provides the independent valuation of the shares and investor reporting key to investor protection. The administrator is regarded as a fiduciary agent and must act in shareholders' best interests.
Fund administration is unregulated in much of the EU and in locations where fund administration is regulated there are often limited capitalisation requirements (only Ireland and Luxembourg within the EU have similar requirements to the Cayman Islands).
Other points of independent oversight include parties such as the deposit bank, custodian, auditor, prime broker, and other brokers. In addition, the fund will likely appoint an external law firm to provide legal services such as the drafting and review of offering documents to ensure that everything is sufficiently transparent to allow investors to make their own, informed investment decision.
RIGHTS IN PROPERTY – THE ADVANTAGES OF COMMON LAW JURISDICTIONS
As above, common law jurisdictions are governed by the legal principles of equity and offer increased protection to investors when compared to Napoleonic- or Germanicbased legal systems. Where assets are lost as a result of a breach in fiduciary duty, the principles of equity enable the courts to grant powers to continue tracing and the recovery of assets even where unmingled cash cannot be identified. Trusts outside a code that recognises equity are contract-based arrangements without such protections. Thus where assets are still held, in whole or part, there is far more chance of their recovery where the governing law is that of a common law jurisdiction.
Managers should be aware that in non-common law jurisdictions across the EU, including Luxembourg, Switzerland or the Nordics, fund cash placed with banks belongs to the bank concerned, which in turn owes a debt to the fund. Should the bank fail, other than a guaranteed amount (a fairly standard CHF100,000 ($108,400) in Switzerland, for example, and subject to certain conditions), the fund would rank below employees and alongside other creditors, including other banks and even the utility companies providing services to the building. In common law systems, the money remains the property of the investor rather than the bank and so the investors (via the fund) may often be better protected.
The knee-jerk political reaction of the EU to push the AIFM Directive through last year may be regarded by some as the EU reacting to protect investors from the opaqueness of the fund industry. However, it may also be legitimately described as misdirected. Whether the utopian ideal of investor protection that the Directive seeks will materialise in the reality of the funds industry remains to be seen, though, as this article has illustrated, the extent of its success will likely be limited in practice.
Increasing investor protection cannot be achieved through regulation alone; regulators must understand that investors need:
- effective, independent oversight;
- true accountability;
- security; and (as often seems forgotten by regulators)
- to make a profit.
Whether planned AIFMD rules and Ucits IV (as used by the hedge fund and private equity community) will help or hinder in striking the right balance for the industry will be for time to tell. It may require a level of efficiency and agreement that has been absent so far. As a result of international and industry pressure, the EU will recognise the equivalency of other, high quality jurisdictions for the purposes of the AIFM Directive. Given that protectionism will not now be a feature of the Directive, there seems little reason to domicile a fund in the EU if greater cost and ineffective regulation are a factor.
Originally published in HFM WEEK.COM.
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