Styperson POPE

Strategy & Compliance for Investment Firms


Leave a comment

The UCIS / AIF Boundary in UK Fund Structures

I know, it sounds fun, right? OK, this one’s a bit technical but I seem to have had this conversation a few times recently…

Since the introduction of AIFMD back in 2013, the EU-derived definition of a fund (or “AIF”) have had to map onto our similar but subtly different UK-derived definition of a collective investment scheme (“CIS”). So when is an AIFM required rather than (or, in one case, as well as) an Operator?

For this purpose, we’ll only consider Unregulated CIS (“UCIS”) so we’re excluding the bigger funds which are sold to the public and focusing instead on private fund structures.

AIFs
‘Alternative Investment Funds’ are defined in the Alternative Investment Fund Managers Directive and there are a few limbs to that definition:

  • They are “undertakings”—while some have argued that this excludes certain, unincorporated arrangements, the consensus seems to be it is a broad enough concept to capture pretty much any arrangements, incorporated or otherwise, and in writing or otherwise.
  • They are “collective”—this means that the risk and reward are pooled among the participants.
  • They are “managed”—meaning arrangements where all of the participants have ‘daily’ control are not AIFs but if that control is passed to a manager, which may be one of the other participants, it will be.
  • They “raise capital”—this means that arrangements between a small number of individuals which don’t then raise capital from others are unlikely to be an AIF.

UCIS
‘Unregulated Collective Investment Schemes’ are defined in the Financial Services & Markets Act 2000 and again, there are a few limbs to that definition (some of which will look a little familiar):

  • They are “arrangements” for income or profit—so, pretty much the same as ‘undertakings’ from the AIF definition.
  • They are “pooled”—so, pretty much the same as ‘collective’ in the AIF definition.
  • They are “managed”—there’s a very subtle distinction between the UK concept of ‘day-to-day’ control as defined by case law and the EU’s definition of ‘daily’ control as defined by ESMA guidance but that’s too fine grained to worry about here!

So what’s the problem? Other than AIFs needing to “raise capital” they sound the same as UCIS? Ah, but then there are all the exemptions!

AIF Exemptions
There are few exemptions to the definition of AIFs and they’re all pretty practical, these ensure that holding companies, companies with a general commercial purpose, central banks, securitisation SPVs and employee share schemes don’t get caught up in the definition, generally because there is other EU legislation covering these areas.

UCIS Exemptions
Thee exemptions to the definition of UCIS are much more numerous and have evolved over the years to address particular circumstances and market effects the Treasury wanted to influence. This means that some arrangements and structures which would otherwise be a UCIS are subject to an exemption. In the fund context, this includes:

  • All bodies corporate—i.e. any limited company (meaning that unregulated UCIS are generally LPs, LLPs or Trusts); and
  • EIS or SITR funds.

AIFs but not CIS
So, the main categories of investment structure which are AIFs but not UCIS are:

  • Investment Companies;
  • EIS funds; and
  • SITR funds.

These all require an authorised (or, in some cases, registered) AIFM with the regulatory permission of Managing an AIF to run them, even though they didn’t need the services of an Operator prior to AIFMD.

UCIS but not AIFs
And the main categories of investment structure which are CIS but not AIFs are:

  • UCIS which don’t raise capital; and
  • “Grandfathered” AIFs (being fully invested prior to AIFMD coming in).

These all require the appointment of an authorised Operator with the regulatory permission of Operating, Establishing & Winding Up an Unregulated Collective Investment Scheme.

Both UCIS and AIFs
To keep it simple, the Treasury introduced a regulation to say that if a fund’s manager has the permission to Manage an AIF (i.e. they’re an AIFM) this covers all regulated activity relating to their management of an AIF. This means that where a fund is both an AIF and a UCIS, the AIFM doesn’t require a separate permission to act as an Operator.

Small UK Property Funds
There is also one structure which requires both an operator and an AIFM.

When the UK implemented AIFMD in 2013, the Treasury took the opportunity to make some consequential changes to the UK’s local regime for smaller managers to whom AIFMD doesn’t apply. This resulted in them creating the concept of a Small UK Registered AIFM. The ‘registration’ required is a lot less onerous than the full ‘authorisation’ process and so this is a lighter-touch regime designed to reduce barriers to entry for some smaller fund managers.

These funds include property funds structured as a UCIS, i.e. a UCIS which holds the majority of its assets (save for their first and last six months) as land and does not hold any shares derivatives, bonds, fund units (save for shares in a company owning the property). The definition of small is derived from AIFMD and is applied to the manager, not the fund; small means less than €500m or less than €100m where any fund under management uses debt.

The trade off for this lighter-touch regime is that the registered AIFM for such a fund must also appoint an authorised Operator. This is the only scenario which requires both an AIFM and an Operator.

UCIS AIF Boundary


The Role of a Depositary under AIFMD

The Alternative Investment Fund Managers Directive (AIFMD) is due to be transposed into law on 22 July 2013 and while some Alternative Investment Fund Managers (AIFMs) will want to make use of the transitional year to avoid implementing changes straight away, others (for instance those marketing outside the UK) will want to comply from day one.  And on day one, they’ll need a Depositary.

The UK implementation of AIFMD allows for two types of Depositary (ignoring for the moment the ‘Depositary Lite’ model used  for non-EU AIFs).  These are the full blown Depositaries, the market for which is likely to be served by the established custodian banks, and the Private Equity AIF Depositary which is (albeit slowly) attracting some new entrants to the market.

Some prospective PE AIF Depositaries, generally existing, regulated fund administrators and third-party operators, are starting to put their head above the parapet and talk about their proposed services (and a little more reticently, their proposed pricing) but what does the Depositary role entail?

Cash Flow Monitoring
The Depositary is required to monitor all significant cash flows and quickly identify any that are inconsistent with the usual operations of the fund.  They must also reconcile all cash flows on a daily basis, although they may do so less frequently where cash movements are infrequent.

Subscriptions
The Depositary will receive information about subscription payments the same day they are received by the fund, the AIFM or a transfer agent.  The Depositary is then responsible for ensuring that the payments are booked into accounts in the name of the fund, the AIFM or the Depositary.

Safekeeping (Verification and Record Keeping)
Other rules apply where a Depositary is holding custodial assets but for non-custodial assets (such as real estate) the Depositary must verify the ownership of the assets and keep appropriate records.  What will create more complexity is the Depositary’s duty to ensure procedures are in place which prevent the assets being assigned, transferred, exchanged or delivered without the Depositary being informed, particularly as the Depositary’s responsibilities are on a ‘look through’ basis which limits the extent that these controls can be put in place in respect of structuring vehicles only.

AIFM Risk & Process Oversight
The most widely ranging responsibility of the Depositary, and the one which will require the most expertise and thought, is the duty to assess the risks of the fund’s strategy and the AIFM’s organisation and implement ongoing controls and verifications of the AIFM’s processes and procedures.

AIFM Instructions
The oversight functions of the Depositary extend to verifying the instructions of the AIFM to ensure compliance with the fund’s rules, offering documents and applicable law.

Valuation
The Depositary is required to ensure that procedures are in place for the valuation of the fund’s assets and that these are implemented effectively on an ongoing basis and reviewed periodically.

Distributions
The Depositary must ensure that the fund’s net income is handled in accordance with its rules, including ensuring that auditors’ reserves are taken into account and that any distributions are correctly made.

Many of these processes will be familiar to (better or more risk averse) regulated fund administrators and third-party operatorsSTYPERSON POPE has assisted a number of these firms to create and implement operational procedures, ensure appropriate governance, and identify and manage the risks involved in providing these services.


Alternative Investment Fund Managers Directive (“AIFMD”) Texts, Papers & Links

AIFMD is a major new Directive affecting (to a greater or lesser extent) pretty much all alternative investment fund (“AIF”) managers (“AIFMs”) of institutional funds and operators of UCIS.

Quite a bit of our time is being spent on AIFMD implementation projects, particularly early implementation for clients marketing funds around Europe after July 2013 (when the Directive is transposed into national law).  Other clients are planning to take advantage of the transitional year (between transposition and July 2014).  Careful structuring is needed to ensure that funds’ costs don’t increase unnecessarily, so called ‘grandfathering’ funds aren’t dragged into full compliance where other options are available, and existing tax effects are preserved.

We’re also assiting Depositaries making an entrance into the new market that AIFMD creates for their services.

The one certainty is that this will be a year for change and it will present considerable strategic challenges to existing business models, especially to the professional, third party operator model under which many smaller UCIS and institutional funds are managed in the UK (a model that’s unique in Europe).

Here are a few links to the key documents defining the UK’s implementation of the Directive.

European Union Commission: 


Things to Consider When Launching a Fund

The following headings cover some of the key considerations in setting up a fund which will be structured or promoted as an unregulated collective investment scheme:
Location (Tax)
Tax structuring is likely to be the driver behind the decision on where the scheme should be based.  This will be determined in part by who the investors are and where they and the assets of the scheme are located.  If the investors are based in the UK, especially if they are CGT exempt (eg through a SIPP or SSAS), a UK partnership is likely to be tax efficient without needing to look offshore.

Location (Regulation)
Some funds may consider offshore management to save on regulation however if the aim is to save on the ‘cost of regulation’, then the ‘cost of offshoring’ must be set against this.  Offshore lawyers, accountants, managers and administrators are often more expensive than their fully regulated UK equivalents.  It is also worth considering how investors will see the decision to operate off shore if it is perceived as an attempt to avoid regulation (and therefore avoid some of their protection).  Do also bear in mind that UK regulations still apply to the promotion of funds based offshore if that promotion is undertaken in, or from, the UK.

Structure
Tax will again be important in determining the structure of the fund but assuming that the investors are principally based in the UK and include some CGT exempt investors and some tax payers, a typical structure would involve a Limited or Limited Liability Partnership (which is tax transparent) with a UK Unit Trust feeder (for the SIPP and SSAS investors).  Various other vehicles might be used to achieve specific tax planning objectives such as allowing overseas investors to avoid withholding tax or allowing income to be rolled up into capital gains.

Operator
Establishing, operating and winding up an unregulated collective investment scheme is a regulated activity.  This means, where the fund is operated (run) from within the UK, the person doing so must be authorised by the FSA.  Some would-be fund managers become authorised directly, others employ a professional operator to run the fund on their behalf.
The decision on which route to take will depend on the experience available in-house, the size of the fund envisaged and whether it is likely to be one of many future funds.  If the fund is small, a one-off, or the fund manager lacks experience, the costs of becoming authorised and therefore having to buy in expertise, pay fees to the FSA, and maintain regulatory capital are likely to outweigh the costs of buying in a professional operator.

Administration
This activity covers a broad range of services from receiving and processing subscriptions (which can be regulated) to producing call notices, effecting transfers, paying distributions, maintaining statutory books and registers, and issuing updates to investors (which are generally not regulated).  Professional administrators have the expertise necessary to deal with administratively complex funds like hedge funds but others which trade only occasionally or which do not permit transfers or redemptions of their units may be easier to administer in-house.  Once the fund is up and running, certain communications are laid down by regulations and advice may be required on how these should be put together.

Accounting
Again, the need for an external accountant will depend on the complexity of the funds’ activities and the commitments made to investors about when financial information will be circulated.  Simple funds can be accounted for in house, while complex funds may need experienced personnel, specialist systems and a good understanding of models of returns and carried interests.

Promotion (Documents)
Within (and from) the UK, the promotion of unregulated collective investment schemes is very tightly restricted.  This is an area which many funds overlook in their planning but it is, of course, vital to achieving a successful launch.  Every fund needs a clear route to market and a strong offering to both investors and intermediaries.
Most funds will prepare an IM; great care (and good advice) should be taken in ensuring that the IM appropriately addresses the workings of the fund, the financial model, the parties involved, and (perhaps most importantly) the risks it carries.  Even if the IM is not going to be issued or approved by an authorised firm, having it verified by an experienced advisor might be very useful and save considerable cost in the long run.
In some cases, the IM may need to take the form of a prospectus which is a much more tightly prescribed document and, if this is the case, the cost of preparing it may be considerably higher.  Whether this is necessary will depend on the strategy for promoting the fund, its overall size, its minimum investment, and the legal status of the fund vehicles involved.
Unauthorised promoters of funds may be able to use documents approved by an authorised firm but whoever carries out the promotion, the categories of permitted recipient are few and tightly defined.  Great care must be taken to remain within these.

Promotion (Activity)
As well as the documents being used, attention must also be paid to whether the activity of promoting the fund is a regulated activity and therefore requires FSA authorisation in its own right.  It is likely that promotions which do not involve authorised intermediaries will be extremely difficult to undertake.

Next Steps
Knowing the following information will be helpful in addressing the considerations above:
  • What are the fund’s investments in? Asset class, location, &c.;
  • Who are the investors? Individuals, institutions, pension schemes, location, &c.;
  • How may investments will you receive?  Minimum, maximum, total number, &c.;
  • How may investments will you make?  Frequency, size, &c.;
  • Will you distribute income?  Size and frequency of distributions, &c.; and
  • What is your route to market?  Are intermediaries authorised, where are they based, &c..
To discuss any issues related to launching a fund as an unregulated collective investment scheme, please contact Simon Webber, StypersonPOPE’s MD, on 07710 260 717 or sw@strategic-compliance.co.uk.


Trusts & Money Laundering – HMRC AML registration for a TCSP

We’ve recently been doing some work with a couple of trusts which, because the investment returns aren’t shared with the trust’s settlors, are not collective investment schemes.  This means that the managing trustees don’t need to be regulated (although there are regulated custodians and investment managers involved) and therefore don’t automatically apply anti-money laundering measures.  This raises an important question…

What steps should non-investment trusts take under the Money Laundering Regulations 2007?

Well, as so often with compliance… it depends.

The first consideration is whether they should be regulated by the FSA.  This will depend on the intention of the trust.  If it is for investment purposes (such as a unit trust), and it has more than one settlor, it may well be a collective investment scheme (CIS) and therefore require an Operator.  One we’ve worked on was for the provision of funerals; these aren’t a CIS but are separately regulated unless they meet a number of detailed exemption criteria.

If the trust’s activities don’t require regulation by the FSA, it may still require registration with HMRC as a Trust or Company Service Provider (several of our clients fall into this relatively new and quite wide category).  This will be the case where an individual or company acts, or arranges for others to act, as a trustee by way of business.  Charities and trusts created by wills are generally excluded but a lot of trusts used for tax planning or asset protection will be caught.

If a trust or its managing trustees require regulation by the FSA or registration with HMRC, then the Money Laundering Regulations 2007 (MLR) will apply.

This will generally mean that they have to identify, and then verify the identity of, anyone with whom they do business.  Depending on the nature of the relationships, this is likely to include the settlors (the people who give money or property to the trust), the beneficiaries (the people to whom the trust gives money or property), the trustees themselves, and possibly others as well.

The depth of these checks will depend on the risks the trust faces of being used for money laundering and financial crime.  The first priority of any company subject to the MLR is to assess this risk according to the requirements of the regulations.

Even if the trust doesn’t require regulation or registration, if it deals with individuals as settlors or beneficiaries, the trustees should seriously consider implementing some procedures to identify and verify the people on whose behalf they act.  These can be a lighter touch version of the MLR requirements but they provide an excellent template for best practice and identification techniques.

If you’re involved in the management of a trust and would like to discuss the Money Laundering or Regulated Activity Order regulations which apply to you, do please contact Simon Webber, StypersonPOPE’s MD, on 07710 260 717 or sw@strategic-compliance.co.uk.


Marketing Funds: Promoting Unregulated Collective Investment Schemes

This is a long one but it’s a very complicated and misunderstood area… print it off, have a coffee, and take a deep breath…

The Financial Services and Markets Act (FSMA) imposes a restriction on unregulated collective investment schemes being marketed to the public but it also creates three sets of exemptions, each of which has its advantages and disadvantages.  (These all define to whom the fund can be promoted and by who, there are separate rules about the documents which must be used – click here for more information on when a prospectus is required.)

1. The Financial Promotions Order defines how an unauthorised firm can promote a scheme using unapproved documents.  Essentially, it allows promotion to some institutional investors and to Certified Sophisticated Investors (and, depending on the scheme’s investments, occasionally to self-certified high net worth or sophisticated investors).

Advantages to this approach are that:

  • Fees tend to be lower because,
    • the document used does not need to meet the FSA’s requirements for financial promotions, and
    • no FSA authorised firm has to take responsibility for the document.

Disadvantages are that:

  • an unauthorised (and therefore probably less expert firm) takes all of the responsibility,
  • the documents do still need to meet certain FSMA and common law requirements,
  • schemes can only be promoted to institutional and certified sophisticated investors,
  • the person making the communication has to establish that the investor is certified before making any promotion, and
  • authorised firms (eg IFAs) may not be able to pass on the promotion.

2. The Promotion of Collective Investment Scheme (Exemptions) Order contains one of the sets of exemptions to Section 238 of FSMA which restricts how an authorised firm can promote a Collective Investment Scheme. The exemptions here are very similar (but not identical) to those under the Financial Promotions Order (above).

Advantages are that:

  • an authorised firm is involved, giving comfort to partners in the fund by taking on some of the responsibility;
  • investors will feel more comforted knowing that a UK-based, FSA-authorised body is involved in the communication; and
  • the document does not have to meet the full requirements of the FSA’s financial promotion rules;
  • an authorised firm can approve the promotion to be made by unauthorised persons (but there’s little point because the promotion would be limited to the same people the unauthorised person cold promote it to anyway under the Financial Promotions Order).

Disadvantages are that:

  • fees will be higher because the firm will have to ‘verify’ the contents of the promotional material – they have a responsibility to investors to ensure that it is fair clear and not misleading;
  • schemes can still only be promoted to institutions and certified sophisticated investors;
  • the person making the communication still has to establish that the investor is certified before making any promotion; and
  • even some authorised firms (eg IFAs) can not pass on the promotion – eg if it would constitute MiFID business for them.

3. The FSA’s rules provide the final route for promotion. These define eight categories of investor to whom a scheme can be promoted without breaching the restriction in FSMA. Some of these are very specific exemptions for unusual types of schemes (like Church Funds and Lloyds underwriters) but two in particular are of more use.

Advantages of utilising these rules are that:

  • the scheme can be promoted to other groups of investors, including
    • persons assessed as suitable by an authorised firm (probably their IFA),
    • persons who have undergone an adequate assessment of their knowledge, experience and expertise by an authorised firm;
  • the scheme can be promoted in such a way as to reduce as far as possible the risk of someone making an investment who does not fit an exemption (this will mean controlling the promotion, dissuading ineligible persons from applying, and checking that applicants are eligible but unlike the other routes above, this does not need to be done ahead of making initial contact with an investor);
  • an authorised firm will take responsibility for the document; and
  • an authorised firm can approve the document for distribution by unauthorised persons.

Disadvantages of this approach are that:

  • the document will need to be more thorough, meeting all of the FSA’s requirements for financial promotions;
  • fees will be higher because the document will need to be verified by the authorised firm; and
  • an authorised firm will need to have processes and procedures in place to ensure that ineligible applicants are not permitted to participate in the scheme.

As you can see, each approach has its ‘pros and cons’ and each route is therefore suitable for certain types of schemes.

Routes 1 and 2 are most suitable for institutional schemes (ie funds where all of the investors are investment professionals, authorised firms, or high net worth companies and unincorporated associations).

If you are thinking of pursuing either of these routes and the fund is looking for investment from individuals then make sure that you or your distribution network already know a good number of Certified Sophisticated Investors (be careful to ask the right question and get the right answer because Self-Certified Sophisticated Investors, probably won’t count and certificates that do not cover unregulated collective investment schemes are useless to you).

If in any doubt, we recommend that you pick a sample of your target audience, say 20 investors, and (without telling them anything about the fund), ask them if they have a certificate and if they do, to fax it over to you.We can take a quick look at these and make sure that they are the right kind.Once you know what percentage of your target audience has these certificates then you’ll know how restricted you’ll be in promoting your fund.

Route 3 is likely to be more expensive because the authorised firm (probably the operator of the scheme) is going to be more involved – they will verify the document (as indeed they will for route 2 and you will for route 1), they will ensure it meets the FSA’s higher standards, they will approve it for distribution by you, and they will have in place process and procedures designed to stop ineligible investors from participating.

On the other hand, this route will allow more effective promotion of the scheme on the basis that investors will be protected by the assessments carried out by authorised firms (be they the operator or an IFA). If you want to promote the scheme to individuals who don’t already hold a Certificate of Sophistication covering unregulated collective investment schemes, these protections will need to be in place.

Above, I said the fact that “the document will need to be more thorough, meeting all of the FSA’s requirements for financial promotions” was a disadvantage. It might equally be seen as an advantage, both for the investor, who is better informed and therefore better protected, and for the promoter who can draw the attention of their distribution network to the involvement of an authorised firm.

StypersonPOPE can help you to determine the most effective route to employ in promoting a scheme. If you would like to discuss scheme promotion, please do contact Simon Webber,StypersonPOPE’s Managing Director, either by telephone or e-mail.


Investor Certificates: Sophisticated Investors & High Net Worth Individuals

Some communications about financial services (particularly those by unathorised firms or those related to funds) are restricted to ‘certified’ investors.  It’s important not to mix these up with an investor’s categorisation as Retail or Professional or whether they are a Qualified Investor – these are three quite separate regimes of classification.

The differences between the certificates are subtle but vital to understand. For instance, just taking sophisticated investors, there are three different types of certificate depending on what the promotion is about and who is making it – it’s possible that a single investor might hold all three and yet still not count as a ‘Certified Sophisticated Investor’ in respect of any particular investment.

Financial Promotions Order Certificates include:

  • Certified Sophisticated (signed by an authorised firm)*
  • Self-certified Sophisticated**
  • Self-certified High Net Worth**

* Only in respect of the investments the certificate lists
** Only in respect of debentures and shares in unlisted securities

Promotion of Collective Investment Scheme (Exemptions) Order Certificates cover the same categories but have slightly different content.

When relying on certificates, the promoter must ensure that the investor holds the relevant certificate before making any promotion. We recommend that they see a copy of the certificate either by post, fax or scan. This can be difficult in practice but it is the only route available to firms under these regimes.

To establish whether your target audience is likely to have the required certificates, we recommend that you pick a sample, say 20 investors, and (without telling them anything about the investment), ask them if they have a certificate and if they do, to fax it over to you.

StypersonPOPE can take a quick look at the certificates you receive and determine which ones you can rely on.

Once you know what percentage of your target audience has these certificates then you’ll know how restricted you’ll be in promoting your investment opportunity. If it proves to be unworkable, there are alternative routes available which circumvent the need for certificates entirely.

In any case, StypersonPOPE can help you to determine which certificates are appropriate and what percentage of your target audience holds them. If you would like to discuss scheme promotion, please do contact Simon Webber, StypersonPOPE’s Managing Director, either by telephone or e-mail.