What is a fund? This question may be simple, but it is important to alternative investments because a fund (collective investment scheme) faces a much higher level of regulation than an arrangement that it is not a fund.
Historically, the way in which many alternative investments have operated is by giving investors an identifiable share of the property of the scheme, which each investor has the ability to exercise some form of day-to-day control over. This has generally meant that those types of investments were not believed to be classed as funds for regulatory purposes.
However, a recent English case has moved the goal posts on what constitutes a fund, which may have a profound impact on the alternative investment market, including more novel financial services, such as peer-to-peer lenders.
Last year the Financial Conduct Authority in the UK (FCA) brought legal action against the promoters and managers of an African Land Scheme and three Carbon Credits Schemes because of the FCA's view that they had been deliberately structured to avoid the need to be regulated.
The African Land Scheme involved a rice farm in Sierra Leone in which an investor could purchase a sub-lease of a plot of land on the farm, so that they would receive the profit from the sale of the rice grown on their plot. The Carbon Credits Schemes involved similar arrangements in respect of forest areas in Australia, Sierra Leone and the Amazon, whereby each investor received the profits attributed to their plots from the sale of tradable carbon credits.
In short, the English Court identified that the key question of whether the schemes were funds was whether each scheme was "managed as a whole", even if investors purchased a lease over an individual plot and received income based on the value of the carbon credits or rice produced by that plot.
In answering this question the English Court explained that the test to be applied is whether "the elements of individual management, arising either from attention given by management to the interests of individual investors, or from participation by the investors themselves in the management of the property, is substantial."
If the individual management is substantial, the schemes should not be regarded to be funds because each of them is not managed "as a whole".
Ultimately, the FCA won the case. The English Court held that none of the schemes had individual management that was substantial enough to avoid being labelled as collective investment schemes. Therefore, the schemes were operating as unauthorised funds in breach of the regulatory requirements in the UK.
Many jurisdictions have a similar definition of collective investment scheme that uses the 'managed as a whole' terminology and it is possible that the regulators and Courts in those jurisdictions will look to follow the decision in this case.
Further, similar investment structures that invest in other types of alternative investments, such as classic cars, hotel rooms and wine, as well as alternative financial services providers (e.g. peer-to-peer lenders) may also be caught by the wider interpretation of 'managed as a whole'. Therefore, managers of those types of arrangements need to be aware that their regulatory authorities may now look to regulate those arrangements as funds.
However, it appears that the case has been given permission to be appealed, so watch this space to see if the goal posts are moved back again.
An original version of this article was published in Funds Europe Guide to AIFMD 2014, July 2014.
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