Investment funds in UK (England and Wales): regulatory overview

A Q&A guide to investment funds law in the UK (England and Wales).

This Q&A is part of the global guide to investment funds. It provides a high level overview of investment funds in the UK (England and Wales) looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.

To compare answers across multiple jurisdictions, visit the Investment Funds Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/investmentfunds-guide.

Contents

Retail funds

1. What is the structure of the retail funds market? What have been the main trends over the last year?

Open-ended retail funds

An open-ended retail fund can be established in the UK either as:

  • An undertaking for collective investment in transferable securities (UCITS) under Directive 2009/65/EC on undertakings for collective investment in transferable securities (UCITS Directive).

  • A non-UCITS retail fund (NURS).

The vast majority are established as UCITS funds.

A UCITS or NURS can be established as an authorised investment company with variable capital (ICVC) (otherwise known as an open-ended investment company (OEIC)), an authorised unit trust (AUT) or an authorised contractual scheme (ACS)).

Open-ended retail funds are either distributed directly by managers or via third party distributors, including via independent financial advisers (who generally offer investment advice) and online facilities (which may offer investment advice but specialise in selling products without advice).

Closed-ended retail funds

Closed-ended retail funds are generally companies listed on the London Stock Exchange's (LSE's) Main Market. They are known as investment trusts, although most such funds are now in corporate form. As the LSE's Main Market is a regulated market under Directive 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading (Prospectus Directive), funds listed on the Main Market can be marketed to retail investors. These funds can be formed under special tax regimes for venture capital trusts and real estate investment trusts. Some closed-ended investment companies are listed on the LSE's Alternative Investment Market (AIM) or the LSE's Specialist Fund Market. The AIM is an exchange regulated market and is not an EU "regulated market". If the offering is limited to institutional investors only, AIM offers a less costly and quicker listing, because compliance with the EU Prospectus Directive is not required. The LSE's Specialist Fund Market is designed for specialist investment funds which target professional or institutional investors.

Following the UK's implementation of Directive 2011/61/EU on alternative investment fund managers (AIFM Directive), the vast majority of investment trusts and other listed investment companies are now classified as alternative investment funds. Therefore, although such funds are regarded as retail funds in UK terms (and can be marketed to retail investors in the EU), they are subject to EU rules on alternative investment funds. NURS are likewise classified as alternative investment funds.

Closed-ended retail funds are distributed in a similar way to open-ended retail funds, although UK financial advisers have (at least historically) been less willing to recommend closed-ended funds than open-ended funds to clients. Closed-ended retail funds have been more commonly promoted directly by the fund sponsor and specialist brokers in investment trusts.

GB£870.7 billion of assets were under management in UK retail funds as at December 2015 (Investment Association), the assets classes comprising approximately 60% equity, 15% fixed income, 1% money market funds, 14% mixed asset, 3% property and 7% other asset classes.

 

Regulatory framework and bodies

2. What are the key statutes, regulations and rules that govern retail funds? Which regulatory bodies regulate retail funds?

Open-ended retail funds

The establishment and operation of open-ended retail funds is governed by the Financial Services and Markets Act 2000 (FSMA), various statutory instruments made under FSMA and the Financial Conduct Authority's (FCA's) rules (in particular, the FCA's Collective Investment Schemes Sourcebook (COLL)).

The FCA is the regulator for open-ended retail funds and their managers.

In addition, the manager of a retail fund is subject to the rules relating to insider dealing and market abuse, money laundering, short selling and derivatives (see Question 18).

Closed-ended retail funds

Following the UK's implementation of Directive 2011/61/EU (AIFMD), most closed-ended retail funds are now classified as alternative investment funds, and their managers (if established in the UK) are subject to the rules on managing alternative investment funds derived from the AIFMD.

The FCA oversees compliance through a closed-ended fund which is listed on the London Stock Exchange's Main Market with the FCA's Listing Rules (see Question 1, Closed-ended retail funds). A fund listed on the Alternative Investment Market (AIM) or the Specialist Fund Market is governed by the rules of those markets and is not subject to FCA oversight, although its manager (if established in the UK) is subject to the FCA's rules and supervision.

 
3. Do retail funds themselves have to be authorised or licensed?

Open-ended retail funds

The Financial Conduct Authority (FCA) must authorise the establishment and marketing of any open-ended retail fund which is established in the UK. In addition, the FCA can recognise the marketing in the UK of any fund which is established in another jurisdiction, subject to conditions. Funds which are recognised by the FCA predominantly comprise UCITS funds established in other EU jurisdictions and marketed in the UK under the UCITS passporting process (see below).

The manager of a UCITS fund established in the UK must submit an application to the FCA with a:

  • Draft prospectus.

  • Key investor information document.

  • Draft instrument of incorporation (in the case of an OEIC), trust deed (in the case of an AUT) or limited partnership agreement or co-ownership deed (in the case of an ACS).

  • Application form.

  • Solicitors' certificate confirming that the constitutional documents comply with the regulations.

The FCA has two months to determine the application.

Under the passporting process, the manager provides a notification letter and the fund documentation to its home state regulator, which then (within ten working days) approves the application and provides the documents to the FCA with an attestation of compliance.

Certain schemes which the FCA regards as comparable to UK authorised schemes can also be recognised for sale by the FCA. In practice, it is rare for the FCA to recognise funds for sale from any jurisdiction other than Jersey, Guernsey and the Isle of Man.

Closed-ended retail funds

The establishment of most types of closed-ended retail funds is not subject to FCA authorisation, although the listing of a closed-ended retail fund on the London Stock Exchange's (LSE's) Main Market requires approval by the FCA in its capacity as the UK Listing Authority (see Question 2, Closed-ended retail funds). Funds listed on the Alternative Investment Market (AIM) do not require approval by the FCA. Any fund which lists on AIM must appoint an independent adviser to act as nominated adviser, which will confirm compliance with the AIM rules to the LSE on the fund's behalf.

A closed-ended retail fund which is listed on the LSE's Main Market must obtain approval from the UK tax authority (HMRC) prior to listing, to obtain exemption from capital gains tax.

 

Marketing

4. Who can market retail funds?

Open-ended retail funds

A person that markets a retail fund in the UK will usually be an FCA-authorised person, because its marketing or distribution activities will usually amount to an FCA-regulated activity (such as giving investment advice or handling investor orders and subscription amounts, which will likely amount to "arranging deals in investments"). Overseas persons that perform these activities in the UK but do not carry on such activities from a permanent place of business in the UK are exempt from this requirement, subject to conditions (in particular, compliance with the UK rules on "financial promotion").

Closed-ended retail funds

See above, Open-ended retail funds.

 
5. To whom can retail funds be marketed?

Open-ended retail funds

A UCITS or non-UCITS retail fund (NURS), once authorised or recognised, can be sold to all types of investors in the UK.

Closed-ended retail funds

Closed-ended retail funds which are listed on the London Stock Exchange's (LSE's) Main Market or Specialist Fund Market can be marketed to any type of person, by virtue of compliance with the EU Prospectus Directive. Funds listed on the LSE's Main Market (such as investment trusts) may be offered widely, subject to compliance with the EU Prospectus Directive. By contrast, a fund listed on the Specialist Fund Market will not make a retail offering because the LSE's guidance indicates that it will only admit funds to the Specialist Fund Market which are targeted at professional or institutional investors. A fund which is listed on the Alternative Investment Market (AIM) is likewise in practice usually only offered to institutional investors (a retail offering would require compliance with the EU Prospectus Directive, which such funds generally wish to avoid). However, retail investors can acquire shares in funds listed on AIM subsequent to the initial offering.

 

Managers and operators

6. What are the key requirements that apply to managers or operators of retail funds?

Open-ended retail funds

The manager of a UK UCITS fund which is established as an authorised unit trust (AUT) must be a body corporate established in the UK or another EEA state and must be independent from the trustee of the AUT. The manager of a UK UCITS fund which is established as an open-ended investment company (OEIC) will usually be the authorised corporate director of the OEIC and must be established in the UK or another EEA state.

The manager of a UK UCITS fund must be authorised by the FCA to perform the regulated activity of "managing a UCITS", or can be a firm established in another EEA state which is operating under the UCITS management passport (see Question 3, Open-ended retail funds). The trustee or a depositary of a UK UCITS fund must be authorised by the FCA to perform the regulated activity of "acting as trustee or depositary of a UCITS", and, from 18 March 2016, will need to meet the eligibility requirements under the latest iteration of the UCITS Directive (UCITS V), as implemented in the UK (subject to the transitional period for non-bank depositaries that runs until 18 March 2018). The manager of a non-UCITS retail fund (NURS) must be authorised to perform the regulated activity of "managing an alternative investment fund (AIF)".

Closed-ended retail funds

The manager of a closed-ended retail fund must be authorised by the Financial Conduct Authority (FCA), typically to perform the regulated activity of managing an AIF. Alternatively, the fund itself can be authorised as a self-managed AIF. For the requirements which apply to entities which are authorised to manage AIFs see Question 18. There is no requirement to appoint a UK manager to a closed-ended retail fund which is established in the UK.

 

Assets portfolio

7. Who holds the portfolio of assets? What regulations are in place for its protection?

Open-ended retail funds

Open-ended retail funds must appoint a trustee (for an authorised unit trust (AUT)) or a depositary (for an open-ended investment company (OEIC) or authorised contractual scheme (ACS)) to hold their assets, and to perform various other oversight duties. A trustee or depositary must be independent from the manager and established in the UK (or, if established in another EEA state, have a place of business in the UK). The FCA's COLL sourcebook sets out the duties of depositories and trustees.

Trustees and depositaries are subject to the FCA's CASS sourcebook on custody of assets, which ensures that custodians observe professional standards of care and diligence, in particular when they appoint sub-custodians. In addition, depositaries are subject to the new rules on depositary liability for loss of safe custody assets in the latest iteration of the UCITS Directive (UCTIS V), as implemented in the UK.

Closed-ended retail funds

As most closed-ended retail funds are classified as alternative investment funds, under Directive 2011/61/EU (AIFMD) the fund must appoint a depositary, if the fund is established and managed in the EEA. Depositaries are subject to rules in the AIFMD on their duties. In particular, the AIFMD contains a new standard of liability for depositaries that delegate custody to third parties (see Question 18). Closed-ended retail funds which are not required under the AIFMD to appoint a depositary will in practice appoint a custodian where they hold assets (such as listed securities) which require a custodian for settlement purposes.

 

Legal fund vehicles

8. What are the main legal vehicles used to set up a retail fund and what are the key advantages and disadvantages of using these structures?

Open-ended retail funds

A retail fund will generally be established as an open-ended vehicle qualifying as a UCITS fund (an exchange traded fund (ETF) is often structured as a UCITS fund which is listed on a stock exchange) (see Question 1, Open-ended retail fund). Less commonly, in the UK, an open-ended retail fund can be established as NURS, which is a non-UCITS fund authorised by the FCA for distribution to retail investors. Both types of fund can be established as an open-ended investment company (OEIC), an authorised unit trust (AUT) or an authorised contractual scheme (ACS):

  • An OEIC is a type of company. It is formed with an instrument of incorporation, a single director (which may be a corporate director) (or directors) and shareholders.

  • An AUT is a trust without separate legal identity. It is established on the basis of a trust deed between the trustee and the manager. The trustee holds the assets on trust for the beneficiaries, which are known as the unitholders (as their beneficial interest is represented by units).

  • An ACS is a tax transparent vehicle, which can be established either as a co-ownership scheme or as a limited partnership. A co-ownership scheme is established on the basis of an agreement between the fund manager and depositary under which the investors hold beneficial title to the scheme's property as tenants in common.

Any of these vehicles (excluding an ACS established as a limited partnership) can be established with underlying sub-funds (an umbrella fund). The property of a sub-fund of an umbrella fund can only be used to discharge the liabilities of that sub-fund, allowing ring-fenced liability between sub-funds.

There are few practical differences between OEICs and AUTs. In European terms, OEICs are a more familiar vehicle to investors.

ACSs are intended to offer a tax-transparent vehicle for UCITS funds, and have in particular been designed to act as master funds into which other UCITS funds can combine their assets, giving economies of scale. A tax-transparent fund can also allow investors (such as pension funds) to take advantage of double tax treaty benefits. ACSs can only be issued to professional investors (within the meaning of Directive 2004/39/EC on markets in financial instruments (MiFID)) or large investors (an investor which invests at least GB£1 million).

Closed-ended retail funds

Closed-ended retail funds will generally take the form of companies listed on the markets described in Question 5.

Compared to an open-ended retail fund, the advantages of a listed closed-ended fund are:

  • There are few investment or borrowing restrictions (although real estate investment trusts must observe investment and borrowing restrictions to preserve their tax exemptions).

  • The manager can pursue the fund's investment policy without regard to the liquidity of the underlying assets.

  • A listed closed-ended fund represents (from the manager's perspective) a permanent pool of capital.

A disadvantage of a listed closed-ended fund is that shares in the fund can trade at a discount to the fund's net asset value. Shares in the fund can also trade at a premium to net asset value; it is usually not possible to achieve exact equivalence to net asset value, as with an open-ended fund. This can mean that they are perceived to carry higher risk.

 

Investment and borrowing restrictions

9. What are the investment and borrowing restrictions on retail funds?

Open-ended retail funds

UCITS funds. The investment and borrowing powers for UCITS funds are set out in the FCA's COLL sourcebook (which implements Directive 2009/65/EC (UCITS Directive)). A UCITS fund can invest in the following asset classes:

  • Transferable securities or money market instruments traded on an EU regulated market. Transferable securities comprise shares, debt securities and other traded securities, such as depositary receipts. An EU regulated market is an EU stock exchange which is classified as a regulated market under EU directives. UCITS funds can also invest in non-EU markets, subject to conditions.

  • Cash and near cash (for example, bank deposits and treasury bills).

  • Units of other UCITS and other non-EEA collective investment schemes, subject to conditions.

  • Derivatives and forward transactions, subject to conditions, in particular that the assets underlying the derivative are asset classes which the fund is permitted to invest in.

A UCITS fund is subject to spread and concentration requirements, including:

  • Up to 5% of the fund's assets can be invested in transferable securities or money market instruments issued by a single body. The 5% limit can be raised to 10% for 40% of the portfolio.

  • Up to 20% of the fund's assets can be invested in deposits with a single body.

  • Exposure to a derivatives or broker counterparty cannot exceed 5%, except where the counterparty is an approved bank, where the exposure cannot exceed 10%.

  • No more than 20% of the fund's assets can be invested in transferable securities and money market instruments issued by the same group.

  • No more than 20% of the fund's assets can be invested in units of any one collective investment scheme.

  • No more than 35% of the fund's assets can be invested in government or public securities, subject to conditions, including:

    • only 30% can be invested in a single issue;

    • the securities must come from six different issuers; and

    • the names of the issuers must be set out in the prospectus.

A UCITS fund can borrow up to 10% of the fund's assets on a temporary basis.

Non-UCITS retail fund (NURS) funds. A NURS has broader investment powers. It can invest in those investments permitted for UCITS schemes. It can also hold:

  • 100% of its assets in real property.

  • 10% of its assets in transferable securities issued by a single issuer.

  • 10% in gold.

  • 20% in unlisted securities.

  • 35% in other collective investment schemes (including other non-UK schemes whose investment and borrowing powers are equivalent to, or more restricted than, those of a NURS, and alternative investment funds, provided that the combined value of unapproved securities and unregulated schemes does not exceed 20% of the NURS's value).

  • In addition, a NURS which is authorised as a fund of alternative investment funds (FAIF) can invest in a range of alternative investment funds. A NURS can borrow up to 10% on a permanent basis. A NURS is subject to a number of concentration restrictions which are similar to but less stringent than a UCITS fund (for example, a NURS can invest up to 35% in any one target fund and up to 10% in transferable securities or money market instruments issued by a single body).

Closed-ended retail funds

Listed closed-ended retail funds are not subject to restrictions on investment or borrowing, although they must have a published investment policy covering asset allocation, risk diversification and gearing as a condition to listing. In practice, a fund will draw up its own set of investment restrictions and will need shareholder approval to amend them.

A UK closed-ended retail fund that is listed on the London Stock Exchange's (LSE's) Main Market must satisfy certain conditions, including an investment condition in order to qualify for special tax treatment, namely that the business of the company consists of investing its funds in shares, land or other assets with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds.

 
10. Can the manager or operator place any restrictions on the issue and redemption of interests in retail funds?

Open-ended retail funds

Open-ended retail funds must offer issue and redemption of shares or units on each dealing day, and there must be at least two dealing days in each month. Subject to that, retail funds can limit the number of shares or units in issue or the number of shares or units issued for a particular month. It is also possible for retail funds which have a daily dealing day to defer redemptions of shares or units to the next valuation point, if redemption requests for a particular valuation point exceed 10%, subject to certain conditions. Dealing in open-ended retail funds can be suspended in exceptional circumstances and where justified in the interests of unitholders, and must be notified to the FCA. In practice, these restrictions are rarely applied, other than as a last resort, because applying these restrictions is likely to seriously damage investor goodwill, counteracting investor expectation that they can easily redeem their interest.

Non-UCITS retail funds (NURS) can impose limited redemption arrangements (to limit redemptions up to every six months) where the NURS is a property fund, offers some form of capital protection, or is a fund of alternative investment funds.

Closed-ended retail funds

Listed closed-ended retail funds are traded on the exchange on which they are listed. The fund can operate repurchases of its shares, which may reduce any discount of the trading price below underlying net asset value.

 
11. Are there any restrictions on the rights of participants in retail funds to transfer or assign their interests to third parties?

Open-ended retail funds

Managers can impose restrictions on shareholders or unitholders to ensure shares or units are not transferred to ineligible investors, such as US holders. Otherwise, shares in open-ended retail funds can be freely transferred.

Closed-ended retail funds

Investment trust shares are freely traded on the stock market. It will usually be a condition to listing a fund and admitting the fund's interests to a settlement system that there are no restrictions on transfer, although settlement systems can accommodate limited restrictions (such as restrictions on transfer to US holders).

Reporting requirements

12. What are the general periodic reporting requirements for retail funds?

Open-ended retail funds

Managers of open-ended retail funds must provide reports and accounts to investors bi-annually. The manager must prepare the following for each annual accounting period and half yearly:

  • Short reports which are sent to all holders, including various information about the fund's investment activity and performance.

  • Long reports which are available to investors on request. Long reports must include certain information, including the accounts and a report from the auditor and both the manager and trustee or depositary.

Closed-ended retail funds

Closed-ended retail funds which are listed on the London Stock Exchange's (LSE's) Main Market, Specialist Fund Market or the Alternative Investment Market (AIM) must report twice a year to shareholders, with a long report every 12 months. A closed-ended retail fund which is listed on the LSE's Main Market must also obtain approval from the UK tax authority (HMRC) to obtain special tax treatment (see Question 13, Closed-ended retail funds) and make ongoing notifications to HMRC in relation to this approval.

 

Tax treatment

13. What is the tax treatment for retail funds?

Open-ended retail funds

The UK tax rules applying to authorised unit trusts (AUTs) and open-ended investment companies (OEICs) have been criticised for their complexity. Subject to special rules for tax-elected funds, AUTs and OEICs are generally exempt from UK tax on gains on the disposal of investments but are subject to corporation tax at 20% on income (although dividend income is exempt, subject to conditions, and there are deductions for certain amounts distributed by funds which are primarily invested in debt securities (bond funds)).

UK resident individual investors in AUTs or OEICs which are not bond funds will generally receive distributions with a tax credit which reduces the investor's income tax liability on the distribution (the treatment is broadly the same as applies on the receipt of dividends from a UK company). From April 2016 the tax credit is set to be abolished and replaced with a GB£5,000 dividend allowance. Such distributions are generally exempt for UK companies.

UK resident individual investors in AUTs or OEICs which are bond funds will generally receive distributions after withholding at 20%, which is creditable against income tax. UK companies will not be subject to withholding tax but will be subject to corporation tax broadly in accordance with their accounting treatment.

UK resident investors are subject to capital gains tax on gains realised on disposal of an interest in an AUT or an OEIC.

UK non-resident investors are generally not directly subject to UK tax (including by withholding).

Funds which are structured as authorised contractual schemes (ACSs) are not taxable entities for UK purposes. Investors will be treated broadly as if they had invested directly in the underlying assets in the case of an ACS structured as a partnership, whereas an ACS structured as a co-ownership scheme is transparent for income tax purposes but opaque for capital gains.

Closed-ended retail funds

UK investment trusts are exempt from tax on chargeable gains but are otherwise generally subject to UK corporation tax. Investors are taxed in the same way as shareholders in other EU companies. However, the rules have recently been modernised, including the introduction of an election for investment trusts to be treated in broadly the same way as AUTs and OEICs which are bond funds (see above, Open-ended retail funds) to the extent that they receive interest income.

 

Quasi-retail funds

14. Is there a market for quasi-retail funds in your jurisdiction?

Non-UCITS retail funds (NURS) and the types of closed-ended retail fund discussed in Questions 1 to 13 are UK quasi-retail funds. A limited number of managers have introduced NURS funds as more risky investments, suitable for more sophisticated investors. There are a number of exchange traded funds (ETFs) structured as NURS funds.

Managers in the UK can obtain from the FCA the European long-term investment fund (ELTIF) designation for an AIF on the basis of the European Long-Term Investment Funds Regulation, which applied from 9 December 2015. ELTIFs may be either closed or open-ended funds which invest in infrastructure and other long term projects which can be marketed to retail investors in the EU, subject to conditions, such as a check on whether investment is suitable for the investor and a cap on the amount which the investor invests as a proportion of his or her total assets. It is not yet known how popular the ELTIF designation will be.

 

Reform

15. What proposals (if any) are there for the reform of retail fund regulation?

Open-ended retail funds

The latest iteration of the UCITS Directive (UCITS V) broadly aligns the UCITS Directive with Directive 2011/61/EU (AIFMD) in terms of the depositary's role and liability and the rules on manager remuneration, with additional protections to reflect the UCITS' retail investor base. It also includes new EU-wide rules on sanctions and penalties for breaches. It will be implemented into UK law and take force as of 18 March 2016, with a transitional period until March 2018 to allow the UCITS manager to put in place the new depositary requirements.

There are no current domestic proposals for reform of regulation of open-ended retail funds.

The EU's next iteration of MiFID (MiFID II), will likely take effect in January 2018. MiFID II contains significant new rules on fund distribution and related responsibilities for product manufacturers. MiFID II will also limit the ability of EU investment firms to distribute "structured UCITS" on an execution only basis (by requiring firms to apply an appropriateness" when distributing structured UCITS).

Closed-ended retail funds

There are no current proposals for reform of regulation of closed-ended retail funds.

 

Hedge funds

16. What is the structure of the hedge funds market? What have been the main trends over the last year?

Hedge fund managers are now subject to significantly increased regulation. In particular:

  • All hedge fund managers that are established in the UK must be authorised as alternative investment fund managers (AIFMs).

  • Hedge fund managers are subject to an increased amount of regulatory reporting, comprising:

    • quarterly or half-yearly reporting under the AIFMD of a large amount of data on their positions and exposures;

    • derivatives reporting under Regulation (EU) 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR);

    • reporting of short positions under Regulation (EU) 236/2012 on short selling and certain aspects of credit default swaps (EU Short Selling Regulation); and

    • reporting of securities financing (repurchase (repo) and reverse repo) transactions under Regulation (EU) 2015/2365 (EU Securities Financing Transactions).

  • Hedge fund managers are subject to the requirements which apply to over-the-counter (OTC) and exchange traded derivatives under EMIR.

  • In light of the powers of UCITS funds to use derivatives, it is possible to run some hedge fund strategies within a UCITS fund, using derivatives to achieve, for example, leveraging and short positions, which would be prohibited other than through the use of derivatives.

 

Regulatory framework and bodies

17. What are the key statutes and regulations that govern hedge funds in your jurisdiction? Which regulatory bodies regulate hedge funds?

Regulatory framework

Managers of hedge funds are authorised as alternative investment fund managers (AIFMs) by the Financial Conduct Authority (FCA) in the UK, and are subject to UK law implementing Directive 2011/61/EU (AIFMD). A number of requirements under the AIFMD apply indirectly to the fund (such as the requirement to appoint a depositary). In addition, certain types of non-retail funds may qualify as European Venture Capital Funds (EuVECA) and European Social Entrepreneurship Funds (EuSEF), under the EU regulations governing those entities. The designation of a fund as a EuVECA and EuSEF fund is available to UK AIFMs. In particular, sub-threshold AIFMs may obtain such a designation to allow marketing of the fund to professional investors in the EU on the basis of an EU passport, without opting in to full authorisation under the AIFMD.

It is possible to establish an authorised unit trust (AUT), authorised investment company with variable capital (ICVC) or authorised contractual scheme (ACS) as a qualified investor scheme (QIS), which is a type of scheme authorised by the FCA which can be promoted to certain types of qualified investor. In practice, few QISs have been established. As a QIS will constitute an AIF under the AIFMD, and would in any event require authorisation by the FCA under the AIFMD for marketing to professional investors, it is uncertain whether a QIS will be an attractive vehicle in the future.

Regulatory bodies

The main regulatory body is the FCA, which regulates UK hedge fund managers as UK AIFMs.

 
18. How are hedge funds regulated (if at all) to ensure compliance with general international standards of good practice?

Risk, conduct and transparency

Following implementation of Directive 2011/61/EU (AIFMD), managers of hedge funds are subject to special requirements, to the extent they exceed the threshold fund assets under management (EUR100 million). The Financial Conduct Authority's (FCA's) rules (in particular, the FCA's FUND sourcebook, which implements the AIFMD) contain rules on (among other things):

  • Appropriate individuals to fulfil controlled functions.

  • Capital, risk and liquidity management.

  • Conflicts of interest.

  • Record-keeping.

  • Valuation.

  • Delegation.

  • The appointment of a depositary for the fund.

  • Regulatory reporting.

  • Investor disclosure.

  • Anti-asset stripping for managers of private equity funds.

These rules represent international best standards of practice for alternative fund managers, and in particular for hedge fund managers.

The manager of a non-retail fund must also have regard to the rules of the domicile in which the fund is established. For example, Ireland imposes rules on governance and reporting required for funds established in Ireland.

Insider dealing and market abuse

A hedge fund manager carrying on business in the UK is subject to the:

  • Financial Services and Markets Act 2000 (FSMA) and the FSA rules on market conduct (including insider dealing and market abuse), implementing Directive 2003/6/EC on insider dealing and market manipulation (market abuse) (Market Abuse Directive) and, from 2 July 2016, Market Abuse Regulation (Regulation 596/2014). The Market Abuse Regulation will update the EU market abuse regime with tougher sanctions, including criminal sanctions, and will extend the market abuse regime to new markets (such as EU organised trading facilities (OTFs)) and trading strategies.

  • Rules on insider dealing in the Criminal Justice Act 1993.

Money laundering

The Money Laundering Regulations 2007 apply to hedge fund managers. Administrators must comply with local anti-money laundering laws when dealing with subscriptions to or redemptions from a hedge fund. In practice, most hedge fund administrators are located outside the UK.

Short selling

The European regulation on short selling and credit default swaps imposes restrictions on the short selling of EU equity financial instruments and sovereign debt, and bans entry into uncovered sovereign credit default swaps (CDS). Hedge funds must disclose to the relevant regulator net short positions (above certain thresholds) in EU sovereign debt and equities traded on EU trading venues.

Derivatives

Hedge fund managers are subject to the requirements which apply to over-the-counter (OTC) and exchange traded derivatives under Regulation (EU) 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR), relating to reporting of transactions and clearing and risk mitigation requirements relating to OTC transactions.

 

Marketing

19. Who can market hedge funds?

There are no restrictions on the types of persons who can market hedge funds. In practice, entities which market or distribute hedge funds on a commercial basis will usually be Financial Conduct Authority (FCA)-authorised entities, as their activities will amount to an FCA-regulated activity (see Question 4).

As an alternative investment fund (AIF), the marketing of a hedge fund in the UK either requires notification to the FCA or authorisation from the FCA, depending on whether the fund is marketed under the UK's private placement regime or under a marketing passport provided by Directive 2011/61/EU (AIFMD).

The marketing restrictions under the AIFMD will not apply where the investor invests at its own initiative (known as the reverse solicitation exemption).

 
20. To whom can hedge funds be marketed?

Following implementation of Directive 2011/61/EU (AIFMD), hedge funds can only be marketed in the UK to professional investors (which is an investor which is a professional client within the meaning of Directive 2004/39/EC on markets in financial instruments (MiFID), including individuals which satisfy the conditions to be treated as professional investors). In addition, the UK allows hedge funds to be marketed to a number of other types of institutional and private investor which may not qualify as professional investors. In particular, UK authorised firms can market hedge funds to various classes of individual investor (such as certified high net-worth investors, certified sophisticated investors and self-certified sophisticated investors). Such investors will usually be clients of the authorised firm to whom the authorised firm owes a responsibility to ensure that the investment recommended is suitable.

 

Investment restrictions

21. Are there any restrictions on local investors investing in a hedge fund?

There are no restrictions on local investors investing in a hedge fund, provided the marketing restrictions are adhered to (see Questions 19 and 20).

 

Assets portfolio

22. Who holds the portfolio of assets? What regulations are in place for its protection?

The Directive 2011/61/EU (AIFMD) requires an EU manager of an EU hedge fund to appoint a depositary to hold the fund's assets and perform other oversight duties, such as monitoring the fund's cash accounts and net asset value calculation. The AIFMD introduced new rules to govern the circumstances in which a depositary is liable for loss of the fund's assets (in particular, for loss by a sub-custodian of the fund's assets). The depositary will also be subject to the Financial Conduct Authority's (FCA's) CASS sourcebook on custody of assets, which ensure that custodians observe professional standards of care and diligence, including where they appoint sub-custodians.

An EU manager of a non-EU hedge fund which is not marketed in the EU need not appoint a depositary. An EU manager of a non-EU hedge fund which is marketed in the EU must appoint one or more entities to perform the depositary functions (known as depositary-light), without application of the AIFMD depositary liability regime. The depositary liability regime establishes a depositary's liability for loss of assets (particularly for loss of assets held by sub-custodians), other than in narrow circumstances such as where the loss arose from an external event beyond the reasonable control of the depositary or where the depositary has managed to transfer its liability to a sub-custodian.

In practice, a hedge fund's assets are usually held by the fund's prime broker. Different models have emerged to allow prime brokers (and the prime broker's own sub-custody network) to continue to hold a fund's assets and a fund to appoint a depositary required by the AIFMD, typically by arranging for the prime broker to hold the fund's assets as sub-custodian to the depositary, with a transfer of liability for loss of assets from the depositary to the prime broker and/or an indemnity granted by the prime broker to the depositary for loss of assets.

 

Requirements

23. What are the key disclosure or filing requirements (if any) that must be completed by the hedge fund?

Following implementation of Directive 2011/61/EU (AIFMD), the manager of an alternative investment fund (AIF) must:

  • Prepare an annual report in respect of each EU AIF it manages and each AIF it markets in the EU. The annual report contains the fund's financial statements and a disclosure of various aggregate amounts of remuneration paid to various groups of individuals by the manager.

  • Disclose information regarding the AIF (such as side letter terms) to investors before they make their investment, and disclose information regarding the AIF (such as changes in liquidity or leverage) to investors on a periodic basis.

  • Regularly report to the Financial Conduct Authority (FCA) on, among other things, its principal exposures, risk profile and categories of assets.

 
24. What are the key requirements that apply to managers or operators of hedge funds?

Following implementation of Directive 2011/61/EU (AIFMD), managers of hedge funds are subject to special requirements in AIFMD Level 2 and the FCA's rules (in particular, the Financial Conduct Authority's (FCA's) FUND sourcebook) (see Question 18). This is the case irrespective of where the fund is located.

 

Legal fund vehicles and structures

25. What are the main legal vehicles used to set up a hedge fund and what are the key advantages and disadvantages of using these structures?

Hedge funds are almost invariably established outside the UK as offshore tax exempt companies, trusts or (less commonly) limited partnerships. Popular offshore jurisdictions are Ireland, Luxembourg and the Cayman Islands.

 

Tax treatment

26. What is the tax treatment for hedge funds?

Funds which are structured as partnerships are typically exempt from UK direct taxes. Broadly, investors are taxed as if they had invested directly into the underlying assets.

Funds which are structured as offshore companies are typically not subject to UK direct taxes, provided that where their activities would otherwise constitute trading for UK tax purposes, the manager qualifies for the UK's investment management exemption.

Under the offshore funds rules, UK resident investors are generally subject to income tax on gains realised on the disposal of holdings of offshore companies, unless, very broadly, the fund either distributes or reports (and is certified by HMRC as a reporting fund) its income annually to UK investors. In this case, UK resident investors pay capital gains tax on gains but will be subject to tax on income (where applicable) on a current basis. Special rules can treat distributions from bond funds broadly as if they were interest for tax purposes.

 

Restrictions

27. Can participants redeem their interest? Are there any restrictions on the right of participants to transfer their interests to third parties?

Redemption of interest

Typically, an investor in an offshore hedge fund can redeem its interest, subject to the restrictions contained in the fund's offering documents; in particular, most hedge funds limits the frequency at which investors can redeem their interests and impose a notice period for any redemptions. Directive 2011/61/EU (AIFMD) does not contain any minimum requirements for the frequency at which the investor can redeem.

Transfer to third parties

Typically, an investor in an offshore hedge fund can transfer its interest, subject to any restrictions contained in the fund's offering documents, such as a US investor governed by the Employee Retirement Income Security Act (ERISA).

 

Reform

28. What (if any) proposals are there for the reform of hedge fund regulation?

The EU's next iteration of MiFID (MiFID II), will likely take effect in January 2018. MiFID II contains significant new rules on, inter alia, high-frequency and algorithmic trading, best execution, the use of dealing commission to pay for research from brokers, fee disclosure, transaction reporting and fund distribution.

The European Commission is due to review Directive 2011/61/EU (AIFMD) by 22 July 2017. It is likely that rules in the AIFMD will be aligned to equivalent rules in MiFID II (in particular, rules on conduct of business and distribution) as part of this review.

Separately, the European Commission has started the process to grant the AIFMD marketing "passport" to allow non-EU AIFMs from specified third countries to market their funds in the EU, subject to full compliance with the AIFMD. The European Securities and Markets Authority (ESMA) recommended to the European Commission in July 2015 that the third country passport be extended to managers established in Jersey, Guernsey and Switzerland. The Commission confirmed to ESMA in December 2015 that it will make a decision on the grant of the passport to third country managers after ESMA has finished its country-by-country assessment work (including assessment of United States, Hong Kong, Singapore, Australia, Canada, Japan, Cayman Islands, Isle of Man and Bermuda) in June 2016.

The Commission will then adopt legislation (a "delegated act") within three months of making this decision, which will specify the in-force date of the provisions in AIFMD which apply to third country managers exercising the passport. There is then a three month period for the European Parliament to object to the delegated act. Given this process, the earliest time that the passport will be granted to third country managers is during the first half of 2017.

 

Online resources

Financial Conduct Authority (FCA)

W www.fca.org.uk

Description. The FCA's website contains all documents (including consultations and policy documents) published by the FCA, copies of the FCA's rules, and the register of FCA-authorised firms. It also contains dedicated pages on legislation (such as the AIFMD) with links and guidance.

legislation.gov.uk

W www.legislation.gov.uk

Description. The UK government's legislation website contains copies of all UK legislation, including statutory instruments, as revised.

HM Treasury

W www.gov.uk/government/organisations/hm-treasury

Description. The UK government's HM Treasury website contains all documents (including consultations and guidance) published by the UK Treasury.



Contributor profiles

Michelle Moran, Partner, Investment Management

Ropes & Gray International LLP

T +44 20 3 201 1638
F +44 20 3 201 1838
E michelle.moran@ropesgray.com
W www.ropesgray.com

Andrew Howard, Counsel, Tax

Ropes & Gray International LLP

T +44 20 3 201 1538
F +44 20 7 201 1791
E andrew.howard@ropesgray.com
W www.ropesgray.com

John Young, Associate, Investment Management

Ropes & Gray International LLP

T +44 20 3 201 1589
F +44 20 7 201 1899
E john.young@ropesgray.com
W www.ropesgray.com


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