Regulatory outlook for the private fund industry in 2015
By Don Seymour, Founder, DMS Offshore Investment Services
Published: 31 March 2015
Regulatory initiatives from the U.S. Securities and Exchange Commission (SEC) will continue to dominate the private fund agenda through 2015, but the industry will also need to pay close attention to developments from the European Securities and Markets Authority (ESMA) and tax authorities like the IRS and the Cayman Islands Tax Information Authority (TIA). In this article, I examine three key themes – regulation, institutionalization and customization – that will underpin fund governance practices this year.
Annual Compliance Review
Registered investment advisers under the Investment Advisers Act of 1940 (the “Act”) are required to conduct an annual compliance review pursuant to Rule 206(4)-7 of the Act.
Rule 206-(4)-7 is now 10 years old and continues to be one of the single most important annual considerations – and risks – for any registered adviser. As the industry is continually evolving, it is crucial that “policies and procedures be reviewed and updated as business changes, as regulations change, and as new guidance is issued”.
According to industry sound practices, the annual compliance review includes evaluating the capabilities of fund service providers, including its directors. Such annual compliance reviews often ensure that the fund’s directors have adopted sufficient internal controls and procedures that are consistent with applicable rules and regulations surrounding risk management, independence, data security (particularly MNPI), business continuity, recordkeeping and of key business controls that relate to the ability of the adviser to meet its obligations under SEC rules and regulations. Under this Rule, service providers – including fund directors – to investment funds managed by registered investment advisers are required to have “implemented effective compliance policies and procedures administered by competent personnel and should provide the compliance officer with periodic reports”.
It is important for an adviser to maintain proper documentation of the annual compliance review as it is a focal area of the SEC National Exam Program.
Conflicts are typically disclosed prior to investing in the fund, but unforeseen conflicts do arise after the investor has invested. These are usually resolved by the independent board members of conflict committees so it’s important to continually assess the independence and any conflicts of interest of the committee members.
Independent board members are often required to review any instances of reliance on SEC exemptive orders. SEC exemptive relief is extensive and, in many circumstances, can provide a hedge fund with significant advantages. However, advisers expecting to rely on any SEC exemptive relief must carefully ensure compliance with the applicable SEC rules and regulations, including SEC independence standards. The SEC maintains strict independence standards that include, among others, the requirement that the independent directors not be affiliated with its legal counsel, an unconventional legacy practice remaining in some offshore funds.
Recent SEC inspections have revealed that hedge fund directors need to remain vigilant about “flip-flopping” or “cherry picking” valuation practices. The good news is that the SEC is finding fewer deficiencies among hedge fund firms than among private equity firms, where the deficiency rate was more than 50%.
There is increased use of novel inspection practices such as the telephone ‘examination’, a high level ‘review by interview’ of the adviser’s business operations. This practice emerged in the second half of 2014 in one SEC regional office and other regional offices have now adopted the practice, so expect its use to increase in 2015.
After the issuance of the SEC Risk Alert in April 2014, cybersecurity governance became a critical aspect of fund governance and a “top priority” for the SEC who believes that “cyber threats are becoming more common, sophisticated and dangerous”, and in particular, warned about the necessity of “procedures for assessing cybersecurity risks posed by third-party contractors”. What sounded ominous and overblown now sounds precise and prescient after the recent disastrous developments at Sony and Target. In fact, the SEC appears downright visionary.
Empirical evidence from around the fund industry points to a marked increase in registered hedge fund advisers hiring cybersecurity consultants to conduct comprehensive risk assessments and document compliance on cybersecurity policies and procedures surrounding the cyber risk controls of their third-party contractors, including fund directors. Expect this trend to continue into 2015 as fund directors will need to have comprehensive cybersecurity programs to reduce any vulnerabilities inherent in the fund governance process to ensure information security.
European Securities and Markets Authority (ESMA)
The much discussed Alternative Investment Fund Manager Directive (AIFMD) became fully effective in July 2014 and many investment managers are still considering their options as the dust settles on the largest piece of regulation ever to impact European alternative funds. While nearly all EU-based investment managers were caught under AIFMD, and had to become registered or authorized as AIFMs (Alternative Investment Fund Managers), non-EU managers had to consider their options and determine their marketing strategy for EU investors. Investment managers now have to contend with the range of obligations placed upon them by AIFMD, from segregation of duties, to risk and regulatory reporting to various governance and compliance requirements. Non-EU managers, i.e. the typical U.S. manager with a Cayman fund, have settled across three camps. First, those with minimal interest or potential in raising capital in the EU have “opted out” of AIFMD and relied on reverse solicitation, i.e. waiting for EU investors to approach them, to avoid any issues down the line. Second, many managers have availed themselves of the National Private Placement Regime (NPPR) to target specific EU countries and have found a wide variance in process, cost and timing between the national regulators in different countries. Accordingly managers have focused on certain countries such as U.K. and Netherlands which have a simpler process and biggest potential for capital raising. Third and most important, the preference for European investors, particularly institutional investors, to invest only into EU-domiciled funds has led to continued growth in AIFs in Ireland and Luxembourg. Non-EU managers generally unwilling to be authorized as an AIFM in Europe, are electing to partner with specialized AIFMs in Europe who offer this service. Fund Platforms and stand-alone funds have both been popular and are seen as practical and cost effective methods to operate in Europe due to the local expertise of an EU AIFM, and the ability to market the AIF across the EU, thanks to the “passport” process.
ESMA, the body of EU national regulators, is conducting consultation review across the industry to assess various aspects of AIFMD over 2015. These include the effectiveness of the AIFMD marketing passport system and the potential for a passport for non-EU AIFs. Politics in Europe will influence the outcome of this process, but in the meantime the choice and availability of managers to EU investors is considered to have been reduced since AIFMD and many managers are exploiting this dynamic created by a piece of regulation in the short to medium term.
The economic and financial events of recent years have highlighted inadequate risk management practices within many firms, as well as the need for systemic oversight. In response, the SEC, CFTC and European regulators have mandated transparency reports such as Form PF, CPO-PQR, and Annex IV.
Such reports have placed a huge burden on the amount of data that firms must generate, consume and manage. In response, many have found that outsourcing the production of these activities allows them to focus on their core competencies of managing money.
Cayman Islands Monetary Authority (CIMA)
While there is evidence of rigorous compliance with the CIMA Statement of Guidance, some areas of frictional noncompliance remain, but no further guidance has been issued by CIMA and no public, material enforcement efforts have been undertaken during 2014 in relation to fund governance.
The industry should expect that the ‘transitory’ or ‘good faith’ compliance period should be considered over. Like all regulators worldwide, CIMA is adding experienced industry staff resources and focusing on increasing enforcement efforts.
Cayman Islands Tax Information Authority (TIA)
Under the Cayman Islands Intergovernmental Agreement, FATCA registration remains with the IRS, but the compliance and reporting responsibilities shift to the TIA.
Complying with the Foreign Account Tax Compliance Act (FATCA) is a serious governance concern as the withholding penalties and other consequences are severe and potentially irreversible as withholding penalties for non-compliance are generally non-refundable. During 2015, all registered deemed-compliant investment funds will need to properly implement international tax compliance “arrangements” to comply with the various Cayman Islands international tax compliance regulations.
Institutional investors continue to drive positive changes in the hedge fund industry that benefit the interests of all investors. New investor advocacy groups of influential institutional investors formed during 2014 will add new perspective to the debate in 2015 and beyond. Key fund governance considerations remain around board performance and the quality of fund documentation.
Board and committee performance continues to be a focal point of institutional investors and should be assessed in-depth at least annually. Consider whether the composition of the board, the capacity of its members, plus the frequency (and location) of its meetings, transparency reporting and other governance output meet stakeholders’ expectations. Direct interactions with board members have continually increased since the 2008 financial crisis with board members now providing greater transparency and more information to explain board performance.
The most important assessment, however, is of the control of the board and the scope of its authority. If the voting shares of the fund are not held by an independent party, or the fund is a feeder into a master fund that is not governed independently, or the fund documents impose undue constraints, the board may be rendered impotent or severely hampered in achieving effective fund governance. In these instances, board composition, capacity and other performance considerations become less relevant.
Review the tax status of the board members annually. Ensure that any directors or officers of the fund that are U.S. persons have provided the fund with proof that the director or officer has made any required personal tax filings to the IRS. U.S. citizens and U.S. residents who are officers, directors, or shareholders in certain foreign corporations (including offshore investment funds) may be responsible for filing Form 5471 Information Return of U.S. Persons With Respect to Certain Foreign Corporations. The form and attached schedules are used to satisfy the reporting requirements of transactions between foreign corporations and U.S. persons under sections 6038 and 6046 of the Internal Revenue Code. Substantial penalties exist for U.S. citizens and U.S. residents who are liable for filing Form 5471 and who failed to do so.
The location of the board meetings is also important. In recent years, a series of U.S. court decisions have found that the centre of main interests (COMI) of various Cayman Islands funds was not in the Cayman Islands. An important consideration of these courts in determining the COMI, included the finding that “none of the directors resided in the Cayman Islands and there was no evidence of any board meeting taking place there”. If a Cayman Islands fund is assumed by an official authority to not conduct a trade or business in the Cayman Islands, it may cause adverse tax and regulatory consequences for the fund. It is generally accepted that “substantially all” of the board meetings of a Cayman Islands fund be conducted in or from the Cayman Islands.
Fund Document Review
Material fund documents, including marketing and performance advertising information, should be reviewed at least annually to ensure the documents are fully and fairly informing investors of current practices, considering the pace of regulatory changes in the industry and fiduciary obligations. Consult with your professional advisors on any proposed changes, including benchmarking current and proposed practices against industry-leading trends, to ensure fund documents remain compliant with best industry practices.
There are over 1.7 million investors in Cayman Islands hedge funds and they are leaving their fingerprints all over the industry. Like fingerprints, side letters are unique and no two are the same as each investor has different investor preferences. However, that preference should not become a disadvantage to the other investors in the fund taken as a whole. This continues to be one of the most challenging (and controversial) issues in fund governance (i.e. when does an investor preference become an unfair advantage or prejudicial to the interests of the fund?). One very salient issue with side letters is that investors are focused on obtaining more transparency, not only as it relates to the portfolio, but also to significant capital activity by other “large investors”.
As side letters proliferate, fund directors need to ensure that there are mechanisms in place to adequately and effectively monitor the terms of the side letter, and to also ensure that despite the desire of the investment manager to attract capital, this is not being done in a manner that prejudices other investors.
Single Investor Funds
Single investor funds and pooled funds remain popular because they provide attractive options between the commingled fund and managed account. Both products still demand independent fund governance oversight to enforce the investment management agreement and other service agreements. It is also common for these products to voluntarily register with CIMA for the added layer of regulatory compliance.
These run alongside commingled funds with differing liquidity terms but notably, there is no independent oversight or supervision of the investment management agreement. Fund governance over these structures is limited to purely moral suasion, if a situation develops that may threaten the interests of the commingled fund, such as a concern regarding liquidity and best execution and allocation practices.