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9 US and EU Regulatory Responses to The Global Financial Crisis

From: The Law of Private Investment Funds (3rd Edition)

Timothy Spangler

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved.date: 30 May 2024

Regulated activities — Private fund

(p. 189) US and EU Regulatory Responses to The Global Financial Crisis

A.  Introduction

9.01  As has been frequently observed, after a financial crisis, legislators and regulators have an opportunity to adopt significant and potentially far reaching reforms, regardless of whether the reforms actually address the real causes of the immediate crisis.1 Although the 2007–08 global financial meltdown was not a ‘hedge fund crisis’ or a ‘private equity crisis’,2 in 2010 both the United States and the European Union adopted significant expansions of their regulatory regimes to address perceived shortcomings in how private investment funds and their (p. 190) managers are regulated.3 The concerns underlying the rules significantly pre-date the 2007–8 crisis and have been debated by industry members and commentators for some time.

9.02  The growth of private investment funds, and the debate over the appropriate response by financial regulators, had been a common feature of consultation papers and articles in the financial press for over a decade. However, the regulatory regime on both sides of the Atlantic remained largely static during these years, despite regular pronouncements from international organizations such as the International Organization of Securities Commissions (IOSCO) and the Financial Stability Forum.4

9.03  Only in the aftermath of the 2008 crisis was momentum permitted to build5 in favour of rules which would materially increase the ability of US and EU regulators to monitor and discipline private fund managers. Ultimately, persistent concern that private funds might comprise a ‘shadow banking system’ as well as the ramifications of the Madoff debacle, were sufficient to see the passage of Dodd-Frank in the United States and AIFMD in the European Union.6

9.04  The desire to ‘rein in’ private funds, however, sits somewhat awkwardly in the academic debate over corporate governance. As one commentator has argued:

The irony of the hedge fund regulation movement is that financial economists have, for over seventy years, been decrying, first, the lack of independent shareholder involvement in the management of public firms and, second, the lack of swift capital reallocation in American industry. Hedge funds do both, more effectively, than any financial institutions in American history perhaps, and we should not recoil in fear over the innovation.7

B.  Dodd-Frank

9.05  As Andrew J. Donohue, Director of the Division of Investment Management of the Securities and Exchange Commission (SEC) observed in 2010:

The U.S. securities laws have not kept pace with the growth and market significance of hedge funds and other private funds and, as a result, the Commission (p. 191) has very limited oversight authority over these vehicles . . . Consequently, advisers to private funds can ‘opt out’ of Commission oversight. This presents a significant regulatory gap in need of closing.8

9.06  According to Donohue, requiring the managers of these funds to be registered with the SEC would provide the regulator with the tools necessary to oversee the industry and protect investors. This would be accomplished by the managers providing the SEC with reliable and complete data about the operations of private investment funds and their impact on US securities markets, while allowing the funds to maintain flexibility with regard to their investment objectives and strategies.

9.07  Dodd-Frank can, therefore, be seen as simply the movement of the United States towards the international consensus that private fund managers should be directly regulated by the national financial regulator.9 The historic American position that ‘private’ investment advisers who had only a limited number of clients were best left outside the supervision of the SEC had become an anomaly, especially in light of the billions in assets under management that such ‘private’ advisers were able to amass.

9.08  Many domestic and international fund managers previously exempt from registration under the Investment Advisers Act are now, as a result of passage of Dodd-Frank, subject to registration with the SEC. Domestic investment advisers with assets under management of $100 million or more will need to register; however, if such advisers manage only ‘private funds’10 that do not meet the definition of a ‘venture capital fund’, the threshold is raised to $150 million or more of assets. Advisers which pass these thresholds are required to register under the Investment Advisers Act. The relatively low threshold of $150 million will ensnare many previously unregistered investment advisers to private equity and hedge funds which benefited from the 14-or-fewer clients exemption eliminated by Dodd-Frank.

9.09  Domestic advisers having less than $100 million (or $150 million where solely advisers to private funds) of assets will have to register under state ‘blue sky laws’ rather than being able to register with the SEC under the Investment Advisers Act, unless such an adviser would have to be registered in 15 or more states.

(p. 192) 9.10  An even lower threshold has been established for ‘foreign private advisers’ which will be required to register generally if they have $25 million or more of assets under management (AUM) and/or of investments in their sponsored funds attributable to US investors, or more than 15 clients domiciled in the United States.

C.  US advisers

9.11  Dodd-Frank repeals in its entirety the so-called ‘private adviser exemption’11 previously found in the Investment Advisers Act. Private equity, real estate opportunity and hedge funds have historically generally relied on this exemption to avoid registration under the Investment Advisers Act. Going forward, many of these advisers will need to register with the SEC and adopt appropriate compliance programs.12

9.12  Dodd-Frank requires that the SEC provide an exemption from the registration requirements for domestic advisers to private funds, provided assets in the United States are less than $150 million and such adviser is solely an adviser to ‘private funds’. Additionally, Dodd-Frank created new exemptions from SEC registration, including advisers to ‘family offices’ and advisers to ‘venture capital funds’.

9.13  As a result of Dodd-Frank, the number of potential SEC registrants is expected to increase significantly. The responsibility of the states for licensing, monitoring and overseeing all hedge funds and other alternative investment management firms has also been increased significantly from firms having less than $25 million in assets to firms having under $100 million in assets. This represents a substantial increase in the responsibility (and jurisdiction) of state securities departments and law enforcement officials. But states will be taking on this increased responsibility at a time when many state coffers are empty and budgets are far from balanced. Where the extra monies for personnel and supervisory infrastructure will come from is unclear; if monies are not forthcoming, an inconsistent and largely nominal oversight of a large number of domestic advisers may result.13

(p. 193) 9.14  Notably, the SEC released a no-action letter in early 2012 regarding various issues regarding the status under the Investment Advisers Act of certain private fund general partners and investment advisers that related to investment advisers that are registered with the SEC. In an earlier 8 December 2005 letter addressed to the American Bar Association’s Subcommittee on Private Investment Entities (2005 Staff Letter), the SEC took the position that certain special purpose vehicles (SPVs) created by a registered adviser are not required to register under the Investment Advisers Act of 1940 as a result of their activities as associated persons.

9.15  In that letter, the SEC took the position that it would not recommend enforcement action to the Commission under section 203(a) or section 208(d) of the Advisers Act against a registered adviser and an SPV if the SPV does not separately register as an investment adviser, subject to the following representations and undertakings (collectively, the 2005 Conditions):

  1. (a)  the investment adviser to a private fund establishes the SPV to act as the private fund’s general partner or managing member;

  2. (b)  the SPV’s formation documents designate the investment adviser to manage the private fund’s assets;

  3. (c)  all of the investment advisory activities of the SPV are subject to the Advisers Act and the rules thereunder, and the SPV is subject to examination by the SEC; and

  4. (d)  the registered adviser subjects the SPV, its employees and persons acting on its behalf to the registered adviser’s supervision and control and, therefore, the SPV, all of its employees and the persons acting on its behalf are ‘persons associated with’ the registered adviser (as defined in section 202(a)(17) of the Advisers Act).

9.16  Subject to the 2005 Conditions, the SPV would look to and essentially rely upon the registered adviser’s registration with the SEC in not submitting a separate Form ADV. The SEC stated its position that an investment adviser may file (or amend) a single Form ADV (‘filing adviser’) on behalf of itself and each other adviser that is controlled by or under common control with the filing adviser that is registering through a single registration with the filing adviser (each, a ‘relying adviser’) where the filing adviser and each relying adviser collectively conduct a single advisory business. Absent other facts suggesting that they conduct different businesses, a filing adviser and one or more relying advisers would in the SEC’s view collectively conduct a single advisory business for purposes of this letter, and thus a single registration would be appropriate, under the following circumstances:

  1. (a)  The filing adviser and each relying adviser advise only private funds and separate account clients that are qualified clients (as defined in Advisers Act rule 205-3) and are otherwise eligible to invest in the private funds advised by the filing adviser or a relying adviser and whose accounts pursue investment (p. 194) objectives and strategies that are substantially similar or otherwise related to those private funds.

  2. (b)  Each relying adviser, its employees and the persons acting on its behalf are subject to the filing adviser’s supervision and control and, therefore, each relying adviser, its employees and the persons acting on its behalf are ‘persons associated with’ the filing adviser (as defined in section 202(a)(17) of the Advisers Act).

  3. (c)  The filing adviser has its principal office and place of business in the United States and, therefore, all of the substantive provisions of the Advisers Act and the rules thereunder apply to the filing adviser’s and each relying adviser’s dealings with each of its clients, regardless of whether any client or the filing adviser or relying adviser providing the advice is a US person.

  4. (d)  The advisory activities of each relying adviser are subject to the Advisers Act and the rules thereunder, and each relying adviser is subject to examination by the SEC.

  5. (e)  The filing adviser and each relying adviser operate under a single code of ethics adopted in accordance with Advisers Act rule 204A-1 and a single set of written policies and procedures adopted and implemented in accordance with Advisers Act rule 206(4)-(7) and administered by a single chief compliance officer in accordance with that rule.

  6. (f)  The filing adviser discloses in its Form ADV (Miscellaneous Section of Schedule D) that it and its relying advisers are together filing a single Form ADV in reliance on the position expressed in this letter and identifies each relying adviser by completing a separate Section 1.B., Schedule D, of Form ADV for each relying adviser and identifying it as such by including the notation ‘(relying adviser)’.

9.17  Finally, the SEC clarified that for purposes of determining whether two advisers are ‘operationally integrated’ (e.g., for purposes of determining whether assets under management of two advisers must be aggregated for determining whether the advisers satisfy a threshold for federal registration exemption), an adviser unable to satisfy the conditions above to be a ‘relying adviser’ with respect to a ‘filing adviser’ may, nonetheless, be ‘operationally integrated’ with the ‘filing adviser’.

D.  Non-US advisers

9.18  Extraterritoriality remains a key feature of the US approach to financial regulations, and Dodd-Frank is no exception.14 Dodd-Frank exempts from registration (p. 195) any investment adviser that is a ‘foreign private adviser’, which is defined in Dodd-Frank as any investment adviser that:

  1. (a)  has no place of business in the United States;

  2. (b)  has fewer than 15 clients15 and investors domiciled in the United States in private funds advised by the investment adviser;

  3. (c)  has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million, (or such higher amount as the SEC may set by rulemaking); and

  4. (d)  neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any registered investment company.

9.19  The SEC has previously permitted a ‘regulation-lite’ approach that registered non-US advisers may observe with respect to their non-US clients (including, non-US funds in which US persons invest). Under the ‘regulation-lite’ approach, a non-US adviser is permitted to treat each non-US fund as its ‘client’ for many purposes of the Investment Advisers Act. As a result, most of the substantive provisions of the Investment Advisers Act would not apply to a non-US adviser’s dealings with a non-US fund, even if the investors in the fund included US persons.16 This has historically not been viewed as a significant loophole because non-US funds are not eligible for public distribution within the United States to retail investors as a mutual fund. As a result, only non-retail accredited investors have access to these investments.

E.  Distinction between ‘US advisers’ and ‘non-US advisers’

9.20  Importantly, the ‘private fund adviser’ exemption is applied differently for US and non-US advisers. If an adviser’s principal office and place of business is in the United States, it is a ‘US adviser’. As a result, all of the assets managed by the (p. 196) adviser are deemed to be managed in the United States. If the adviser’s principal office and place of business is outside the United States, it is a ‘non-US adviser’.

9.21  A ‘non-US adviser’ can qualify for the private fund adviser exemption so long as (i) all of the adviser’s clients that are US persons are qualifying ‘private funds’ and (ii) if the adviser has a ‘US place of business’, all of the clients whose assets the adviser manages at that place of business must be private funds and the assets managed at that place of business must have a total value of less than $150 million.

9.22  The test for whether an adviser is a ‘non-US adviser’ turns on the location of the adviser’s ‘principal office and place of business’. The definition of ‘principal office and place of business’ is, according to the SEC, ‘where the adviser controls, or has ultimate responsibility for, the management of private fund assets, and is the place where all the adviser’s assets are managed’.

9.23  For some advisers who have both front and back office operations outside of the United States, the analysis required in order to confirm the location of ‘principal office and place of business’ will be relatively straightforward. For others, with more complex or far-flung operations, the analysis may prove a bit more challenging.

9.24  The SEC has provided some further guidance to clarify the situation. The ‘non-US activities of a non-US adviser are less likely to implicate the U.S. regulatory interests and is in keeping with general principals of international comity’. The situation becomes slightly less clear if ‘control’ is split.

9.25  As a result, for some advisers, the analysis may not be entirely clear cut. What is clear, however, are the benefits to being a ‘non-US adviser’ under the rule. Under the terms of the SEC’s release, a non-US adviser may enter the US market and take advantage of the exemption without regard to the type or number of its non-US clients or the amount of assets it manages outside of the United States. Accordingly, a non-US adviser with no place of business in the United States and whose only US clients are private funds will meet this test.

9.26  The fact that the adviser may have a variety of different clients outside the United States need not be taken into account. However, the investment adviser must be comfortable that its US clients are ‘private funds’ and that, if it has a US place of business, all of the clients whose assets the adviser manages at that place of business must be private funds and the assets managed at that place of business must have a total value of less than $150 million.

9.27  For a non-US adviser with no US place of business, the analysis above is fairly straightforward. In order to rely on the exemption, every US person that the adviser advises must be a ‘qualifying private fund’. Under the exemption, US person generally (with some limited exceptions) incorporates the definition of US person from the Securities Act of 1933, as amended. For the purpose of the (p. 197) rule, ‘qualifying private funds’ includes hedge funds, private equity funds and other types of privately offered investment vehicles that rely on section 3 of the Investment Company Act.

9.28  For a non-US adviser with a ‘place of business’ in the United States, the analysis is slightly more complex. For all of the clients whose assets the adviser manages at that place of business must be private funds and the assets managed at that place of business must have a total value of less than $150 million. Similarly to the definition of ‘principal office and place of business’, the definition of ‘place of business’ is based on a facts-and-circumstances analysis. It is where the adviser ‘regularly provides advisory services, solicits, meets with, or otherwise communicates with clients’ and ‘any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients’. It should be noted that a non-US adviser would not be required to take into account private fund assets that it manages from a place of business outside the United States. This would include any assets of a US private fund that it manages. If the non-US adviser has a place of business in the United States however, and assets of clients that are not private funds are managed from this office, it will not be able to rely on this exemption.

F.  Compliance requirements

9.29  Dodd-Frank modifies the reporting requirements for various types of advisers. First, the SEC can require any registered adviser to comply with certain additional record-keeping and reporting obligations to the SEC. Importantly, Dodd-Frank deems the reports of any ‘private fund’ to which a registered adviser provides advice to be the records and reports of that adviser. Among other things reports will have to be filed with the SEC on:

  1. (a)  the amount of assets under management and the use of leverage;

  2. (b)  counterparty credit risk exposure;

  3. (c)  trading and investment positions;

  4. (d)  valuation policies and practices of the fund;

  5. (e)  types of assets held;

  6. (f)  any side arrangements whereby certain investors receive more favourable terms than other investors; and

  7. (g)  any other information the SEC determines ‘is necessary and appropriate in the public interest and for protection of investors, or for the assessment of systemic risk’.

9.30  Also importantly, Dodd-Frank imposes record-keeping and reporting obligations on advisers exempt from registration. In particular, the SEC is mandated to issue rules requiring unregistered advisers to maintain and provide to the SEC such (p. 198) reports as the SEC deems ‘necessary and appropriate in the public interest and for protection of investors’, but does not otherwise define the requirements for these records and reports.

9.31  Dodd-Frank also authorizes the SEC to promulgate rules that require a registered adviser to safeguard any client assets over which that adviser has custody. These steps could include verification of the assets by an independent public accountant. Section 206(4)-2 of the Investment Advisers Act and Rule 206(4)-2 already require examination of those assets by an independent public accountant unless an exemption applies to that adviser, so the Dodd-Frank requirement only provides incremental change.

9.32  Additionally, non-US advisers previously exempted from registration will need to become familiar with Rule 204-3 under the Investment Advisers Act, commonly referred to as the ‘brochure rule’. The brochure rule generally requires every SEC-registered adviser to deliver to each prospective advisory client a written disclosure statement, or ‘brochure’, describing the adviser’s business practices and educational and business background.

9.33  In 2011, the SEC established exemptions from Advisers Act registration, as well as reporting requirements for certain advisers relying on the so-called ‘Venture Capital Fund Adviser Exemption’ or the ‘Private Fund Adviser Exemption’ (collectively referred to as exempt reporting advisers, or ERAs). The information reported by ERAs is publicly available and may be used by the SEC to determine whether the activities of an ERA warrant further SEC attention.

9.34  At the time of the rule’s adoption, the SEC indicated that it did not expect to subject ERA to routine examinations. However, subsequent remarks from senior SEC staff indicated there could be situations where an exam of an ERA would be appropriate. For example, ERAs will most likely be included in the pool when the OCIE staff regularly analyses what entities to examine on a risk basis, in addition to responding to specific tips and complaints.

9.35  On 14 June 2016, the SEC issued a final order to adjust for inflation the ‘qualified client’ thresholds from $2 million to $2.1 million. The definition is relevant when a registered investment adviser charges a performance fee in reliance on Rule 205-3.17 Because the effect of inflation on AUM threshold was less than the rounding threshold, the AUM remains at $1 million.

9.36  Section 205 of the Advisers Act prohibits investment advisers from charging performance fees, based on the theory that such fees might encourage advisers to take undue investment risks.18 However, section 205(b) exempts certain (p. 199) investment advisory clients from the general ban on performance fees, including those with section 3(c)(7) funds and non-US residents. Section 205(e) authorizes the SEC to create exemptions from the general performance fee prohibition where the SEC determines that an investor or particular class of investors does not require protection.

9.37  In 1985, pursuant to section 205(e), the SEC adopted the Rule 205-3, which permits an adviser to charge performance fees, provided the advisory contract is with a ‘qualified client’.19 A ‘qualified client’ is a client that meets financial thresholds either based on the client’s AUM with the adviser or the client’s overall net worth.20 Qualified clients are thought to have sufficient financial expertise and stability to bear the risk of performance fees.21

9.38  Dodd-Frank amended section 205 to require that the SEC regularly adjust the qualified client thresholds to account for inflation rounding to the nearest $100,000.22 Pursuant to the first round of adjustments, in July 2011, the AUM threshold was increased from $750,000 to $1,000,000, and the net worth threshold was increased from $1,500,000 to $2,000,000.23 Based on the 2016 calculations, the AUM threshold remained at $1,000,000, because the calculated inflation adjustment was not large enough to round up to the next multiple of $100,000. However, the net worth inflation calculation was significant enough to require an adjustment and was increased from $2,000,000 to $2,100,000.

G.  SEC reporting requirements

9.39  As of 31 October 2011, the SEC and the Commodity Futures Trading Commission (CFTC) jointly approved proposed Rule 204(b)-1 under the Investment Advisers Act of 1940. Under Rule 204(b)-1, any investment adviser (whether inside or outside of the United States) required to register with the SEC that advises one or more private funds with at least $150 million in private fund assets under (p. 200) management must file Form PF. A ‘private fund’ is defined as an issuer that would be an investment company as defined in section 3 of the Investment Company of Act, but for section 3(c)(1) or 3(c)(7) of the Act. Rule 204(b)-1 separates private fund advisers that are ‘Large Private Fund Advisers’ from all other private fund advisers.

9.40  Large private fund advisers are those which:

  1. (a)  manage hedge funds with US$1.5 billion in assets;

  2. (b)  manage liquidity funds and have combined liquidity and registered money market funds of at least US$1 billion; and

  3. (c)  manage private equity funds that collectively have at least US$2 billion in assets.

9.41  Rule 204(b)-1 exempts from the reporting requirements those private fund advisers that rely on an exemption from registration created by the Dodd-Frank Act or are otherwise not required to register. Furthermore, if an adviser’s principal office and place of business is outside the United States, the adviser may exclude any private fund that, during the adviser’s last fiscal year, was not a US person (as defined in Regulation S), was not offered in the United States, and was not beneficially owned by any US person.

9.42  All private fund advisers would be required to report the following information annually:

  1. (a)  gross and net asset value of each private fund;

  2. (b)  monthly and quarterly performance data of each private fund;

  3. (c)  investor concentration;

  4. (d)  notional value of derivative positions; and

  5. (e)  total borrowings (including a breakdown of the fund’s borrowings among US and non-US financial institutions and non-financial institutions).

9.43  Private fund advisers that manage hedge funds would also be required to report the following:

  1. (a)  investment strategies;

  2. (b)  the percentage of the fund’s assets managed using computer-driven trading algorithms;

  3. (c)  significant counterparty exposure (including the identity of the counterparty); and

  4. (d)  trading and clearing practices.

9.44  All private fund advisers must file Form PF annually within 120 days of the end of the fiscal year of such adviser, other than Large Private Fund Advisers, which must file as set forth below.

9.45  More detailed information is required to be reported by a Large Private Fund Adviser depending on what types of assets are managed by the adviser.

(p. 201) 9.46  In the case of a managed hedge fund, a Large Private Fund Adviser must provide aggregate information about the hedge funds it advises, including aggregate market value of assets invested (on a short and long basis) in different types of securities and commodities, duration of fixed income portfolio holdings, assets’ interest rate sensitivity, portfolio turnover rate and geographical breakdown of investments. Large Private Fund Advisers to hedge funds will be required to file Form PF within 60 days of the end of each fiscal quarter (instead of 15 days, as in the January 2011 original proposal).

9.47  In the case of a private equity fund, for each private equity fund managed, a Large Private Fund Adviser must provide information on borrowings and guarantees and provide disclosure on each fund’s portfolio companies, including increased disclosure for financial industry portfolio companies and a breakdown of investments by industry and geography. Large Private Fund Advisers to private equity funds will be required to file Form PF within 120 days of the end of each fiscal year (instead of 15 days on a quarterly basis, as in the January 2011 original proposal).

9.48  The SEC indicated that it will create certain controls and safeguards to ensure that the information contained in Form PF is provided to other parties only on a need-to-know basis and for regulatory purposes.24

9.49  Form PF provides the Financial Stability Oversight Council with information necessary to monitor the systemic risk created by private funds and to determine if any fund should be designated as ‘systemically important financial institutions’.25 However, since FSOC was established under Dodd-Frank, no private investment fund has yet been designated a Systematically Important Financial Institution.26

9.50  Unsurprisingly, the private fund categorization system established by Dodd-Frank initially proved difficult to implement consistently in practice. The plethora of investment styles were subject to constant innovation and evolution, which meant that clear categorization was difficult and different managers had different views as to what they were actually doing in connection with the management of their funds.

9.51  In June 2012, the SEC provided guidance on Form PF, relating to the categorization of hedge funds and private equity funds under the Rule. According to the (p. 202) SEC, an adviser should not categorize a private fund as a ‘commodity pool’ if the private fund’s commodity interest positions satisfy the de minimis tests in CFTC Regulation 4.13(a)(3)(ii). Since a hedge fund is defined to include any commodity pool, this meant that private funds falling within the de minimis exemption will not automatically be considered hedge funds for SEC reporting purposes.

9.52  Where a fund is authorized to either employ large amounts of leverage or sell assets short in its constitutional documentation but has not yet begun to exercise such power, the SEC guidance made clear that a private fund that should be categorized as a ‘hedge fund’ despite the fact that such fund does not currently, and does not currently intend to, employ leverage or sell assets short.

9.53  In September 2016, the SEC adopted several significant amendments to Form ADV and to Rule 204-2 relating to disclosure and record-keeping.27 One focus of the amendments was on the operations of investment advisers. The amendments required disclosure of any social media accounts used by the adviser where the adviser controls the content, including the addresses of the adviser’s social media pages. While there is no definition of ‘social media platforms’, the Amended Form ADV and Schedule D include Twitter, Facebook, and LinkedIn.

9.54  The amendments also required that advisers report the total number of offices where they offer investment advisory services and the 25 largest offices (by number of employees). The amendments further required an adviser to report whether or not its Chief Compliance Officer (CCO) is compensated or employed by any person other than the adviser for providing chief compliance officer services to the adviser. If applicable, the adviser would be required to disclose the name and Internal Revenue Service (IRS) Employer Identification Number of that service provider.

9.55  The amendments also focused on the clients of advisers. Advisers were required to report the number (rather than percentage) of clients and the amount (rather than percentage) of RAUM attributable to each category of client. Notably, advisers with fewer than five clients in a particular category need not disclose the actual number of clients, and can instead check a box indicating that they service fewer than five of a particular client type. To better understand the adviser’s relationship with non-US clients, the amendments required reporting the approximate amount of an adviser’s total RAUM attributable to clients that are non-US persons.

H.  CFTC issues

9.56  On 9 February 2012, the CFTC adopted a final rule removing certain exemptions from registration and increasing its oversight of certain market (p. 203) participants.28 Namely, the CFTC rescinded the exemption from registration that rule 4.13(a)(4) provides to commodity pool operators (CPOs) and commodity trading advisers (CTAs) whose investors are qualified purchasers or accredited investors. These amendments were enacted in order to bring the activities of CPOs and CTAs under the regulatory oversight of the CFTC. As the exemption from registration was widely relied upon, the amendment imposes significant compliance requirements for many funds.

9.57  Hedge funds that invest in commodities futures, whose operators are regulated by the CFTC as CPOs and advisers are regulated as CTAs, have long availed themselves of the exemption from registration with the CFTC under rule 4.13(a)(4). Upon the final rules effectiveness, funds were required to: (i) cease all commodity trading activity that falls within the rubric of the amended rule; (ii) seek to qualify under rule 4.13(a)(3)’s de minimis exemption by reducing trading volume and filing for an exemption with the National Futures Association; or (iii) comply with the amended rule and register the fund as a CPO or CTA.

9.58  Customers of registered CPOs and CTAs will have the benefit of the investor protections in the Dodd-Frank Act. Registration allows the CFTC to have greater access to information about commodities funds and their investment activities thereby allowing them to better monitor the systemic economic risks posed by the commodities markets.

9.59  The CFTC maintained a de minimis exemption to the registration rules, allowing CPOs and CTAs who trade a de minimis amount of commodities to maintain an exemption from registration. The threshold set by the CFTC, found in §4.13(a)(3)(ii)(B), requires the fund to have: (i) no more than 5 per cent of the fund’s portfolio in aggregate comprising initial margin and premiums on commodity interest positions; or (ii) an aggregate net notional value of commodity interest positions not exceeding 100 per cent of the liquidation value of the pool. The CFTC did adopt one notable revision to the de minimis exception to include swaps in the de minimis threshold calculation.

9.60  The amended rule includes enhanced reporting requirements and the creation of two forms for CPOs and CTAs to use in reporting information to the CFTC. The enhanced reporting requirements enacted are consistent with the reporting requirements under Dodd-Frank for entities registered with both the CFTC and the Securities and Exchange Commission. CPOs and CTAs that are not dual (p. 204) registrants are required to file reports on Forms CTA-PR and CPO-PQR detailing their direction of and disposition of commodity pool assets. These newly required reports must include detailed descriptions of the CPO’s and CTA’s operations, including the amount of assets under management, leverage, exposure to credit risk, and trading and investment positions for each pool.

I.  JOBS Act

9.61  In April 2012, President Barack Obama signed into law the Jumpstart Our Business Startups (JOBS) Act, which made it significantly easier for companies to market their securities to investors. In September 2013, rules mandated by the JOBS Act and adopted by the SEC went into effect that loosen the decades-old prohibitions on general solicitation efforts such as cold calling, mass mailing, and running certain commercials. The rules apply to both start-up companies, and to hedge funds, private equity funds, and other alternative investment funds.

9.62  The JOBS Act is based on the idea that the government should make it easier for companies to grow. Loosening restrictions on private fundraising could make the initial public offering (IPO) process easier, which could lead to more IPOs, which could lead to growth. To do this, however, the legislation reversed decades of precedent requiring anyone approaching prospective investors in connection with privately placed securities to already have a relationship with them. Investors couldn’t sell securities privately if they published advertisements in a magazine. With the JOBS Act, private companies are now able to advertise as much as they want, as long as those who eventually invest qualify as accredited investors—under Regulation D.

9.63  The advertising liberalization had its critics, who pointed to the possible rise in fraud that could result from unscrupulous individuals being able to market Ponzi schemes and scams posing as legitimate investment funds through cold calls and mass emails. SEC Commissioner Luis Aguilar made this case in a strongly worded dissent when the agency adopted the rules. The advertising ban had been based on the sensible premise that private offerings, by virtue of being private, should not be advertised publicly, and that investors will be better protected if they deal only with people they already know.

9.64  Given that the adoption of the JOBS Act overlapped with the anti-hedge-fund rhetoric of the 2012 Presidential campaign, during which Obama compared executives at Bain Capital to vampires, critics pointed out the inconsistency of including hedge funds and private equity funds in the advertising liberalization. But there were also arguments for removing the advertising limitations for hedge funds and private equity funds.

(p. 205) 9.65  By allowing hedge funds and private equity funds to benefit from the JOBS Act’s advertising provisions, the United States allowed these funds to provide more information to would-be investors. These funds have often been described as shadowy and secretive partly because of the ban on advertising, which prevented them from openly discussing their investment activities with the media and the public. Lawyers had historically advised managers of these funds that any decision to speak with journalists or publish information about their activities could be misconstrued by the SEC and the courts as an illegal ‘general solicitation’ for their funds.

J.  Future outlook for Dodd-Frank

9.66  Although Dodd-Frank represents the most significant attempt to reform US financial services regulation in over 70 years, the laws’ ultimate effectiveness remains unclear.29 The SEC remains central to the US approach, but its limitations and shortcomings are acknowledged.30 Even before the 2008 financial crisis, questions concerning the adequacy of the SEC’s resources to perform its required functions were being called into question.31 Since the financial crisis and the increase in its responsibilities under Dodd-Frank, the issues are even more noteworthy.

9.67  Perhaps most disappointing to many observers, Dodd-Frank does not attempt to rationalize or improve the US regulatory infrastructure. As one commentator has observed:

Critically, the Act fails to reconfigure in any significant way the fragmented US regulatory structure, which currently encompasses 50 state-banking and securities regulators as well as multiple federal agencies.32

9.68  The changes brought by Dodd-Frank largely leave the governance of private investment outside their scope. To the extent that definitive steps are to be taken (p. 206) to address deficiencies in the governance structure of such funds, they will need to be taken by the investors themselves. As one commentator has observed:

There has been a growing consensus that there should be more regulation of hedge funds and private equity funds, although there is a substantial difference between the United States and the European Union as to what the scope and content of that regulation should be. [Dodd-Frank] takes a minimalist approach.33

Europe, however, has decided on a more ‘maximalist’ approach.


9.69  AIFMD attempts to harmonize regulatory requirements for sponsors and managers of AIFs across the European Union.34 AIFs are broadly defined to cover all CISs not authorized under the UCITS directive. As a result, hedge funds, private equity funds and a wide variety of other investment vehicles are AIFs and their management and administration fall within AIFMD.

9.70  After over 18 months of wrangling, AIFMD was finally passed in November 2010. AIFMD affects managers and promoters of AIFs and its reach extends to managers and advisers based outside as well as inside the European Union (respectively EU managers and non-EU managers).

9.71  The road to AIFMD was not a straight one. Instead it was filled with twists and turns due to the numerous power struggles that broke out along the way, both between the European Parliament and the European Commission, and between key member states. Criticisms of the legislative process that led to the final adopted test of AIFMD include (a) that the ‘one size fits all’ approach failed to differentiate the different risks posed by different types of funds; (b) that the EU’s reaction was disproportionate to the industries’ actual significance; and (c) that protectionist preference were the primary motivation behind the directive.35

9.72  Importantly, AIFMD continues with the traditional regulatory approach followed on both sides of the Atlantic by regulating the fund manager and not the fund itself. In addition to the expansive definition of AIFs, the geographic scope of AIFMD is also particularly broad, with all fund managers based in the European Union covered, as well as any non-EU managers who market their funds in the European Union. The AIFs themselves may be based either within (p. 207) the European Union or outside of the European Union. The primary focus of AIFMD is on establishing consistent standards for the authorization and ongoing oversight of fund managers, including requirements related to conflicts of investment, risk management and liquidity. As a result of such harmonization, a pan-European passporting regime is available, which serves as a ‘carrot’ to complement the ‘stick’ of further regulation.

9.73  AIFMD has not been without its critics. As one commentator has observed:

The European Union has failed to mount a persuasive case for why the Directive represents an improvement over existing national regulatory regimes or prevailing market practices in several key areas. Furthermore, by attempting to shoehorn an economically, strategically and operationally diverse population of financial institutions into a single, artificial class of regulated actors, the European Union has established what is in many respects a conceptually muddled regulatory regime.36

9.74  Of possible relevance to the governance challenge is the inclusion of detailed disclosure requirements. Investors are entitled to receive additional information from managers on a periodic basis.

9.75  However, what AIFMD lacks is any attempt to address the manner in which private funds are governed. No attempt was made as part of AIFMD adoption process to better empower fund investors to effectively intervene in the operation of the funds in which they invest, in order to address concerns which may have arisen or restrict the ability of the fund manager to act in a particular way under particular circumstances.

9.76  The effectiveness of AIFMD to address systemic risk concerns are outside the scope of this book. Clearly, such concerns are a valid basis on which to adopt the identification and containment of regulation or adapt existing regulation. But systemic risk is fundamentally separate from concerns relating to investor protection, and within those latter concerns, effective governance.

L.  Scope of application

9.77  The scope of AIFMD is exceptionally broad.37 An AIF is defined to include essentially all pooled investment vehicles other than UCITS funds, and covers most private investment funds.

9.78  For managers located outside of the European Economic Area (EEA)38 seeking to raise money in the EEA, there are three options. First, they can take (p. 208) advantage of the existing marketing passport if they establish an EEA fund and EEA AIFM. As discussed below, outsourcing platform providers can deliver the required AIFM infrastructure on a turnkey basis for those managers who do not want to establish their own fund vehicles and obtain the necessary authorizations themselves.

9.79  The second option involves accepting European investors only the basis of ‘reverse solicitations’ which fall outside the AIFMD regime. In order to qualify, the placement must be at the investor’s initiative. Reverse solicitation is not about the fund manager actively finding investors, but rather about allowing investors to reach out to the fund manager. Firms that can document compliant reverse solicitations can validly accept investment from EEA investors. However, the concept of reverse solicitation is approached differently by different member state regulators. Managers seeking to rely on reverse solicitation must maintain a robust compliance procedure that can provide documented evidence should the sale be questioned by a regulator or a disgruntled investor.

9.80  Finally, private placement regimes had been adopted by most EEA countries, but vary significantly from country to country. In general, these regimes permitted registered marketing to professional investors.

9.81  The impact of AIFMD on jurisdiction selection for private funds in Europe was quickly evident. The Cayman Islands had served as the jurisdiction of choice for global private funds over the decades. However, the adoption of the AIFMD raised strict limitations on marketing funds established outside of the EEA. As a result, many firms began considering whether to establish funds within the EEA if they wanted to target European investors.

9.82  As a result of AIFMD, funds established in the EEA and managed by an EEA-based AIFM for the purposes of the AIFMD may be marketed, following a simple registration process, into other EEA jurisdictions pursuant to a passport. However, funds established outside of the EEA may only be marketed into EEA countries pursuant to such country’s private placement regime.

9.83  Prior to AIFMD, non-EEA investment advisors typically relied on the private placement rules of each EEA member state to reach investors. Unfortunately, many EEA member states have either withdrawn or significantly restricted their private placement rules upon the implementation of AIFMD. Although UCITS have been particularly successful in distributing via the UCITS passport and building a trusted brand in Europe, and around the world, it remains to be seen whether funds established in accordance with AIFMD will have the same success in raising capital in Europe via the marketing passport available under AIFMD.

9.84  At present, the marketing passport provided for under AIFMD is not available to investment advisors of non-EEA funds. It is possible that the marketing passport (p. 209) will become available to EEA investment advisors marketing non-EEA funds.39 However, this is dependent on: (i) the European Securities and Markets Authority recommending the taking of such action to the European Commission; and (ii) the European Commission adopting a delegated act to provide for such passporting. Three years after such delegation there is a possibility that the marketing passport will be further extended to non-EEA investment advisors which would include the post-Brexit UK and could possibly extend to US investment advisors.40 Unfortunately there has been slow progress in the extension of the passport.

M.  Reverse solicitation

9.85  Reverse solicitation is founded on the premise that AIFMD should not restrict investors from approaching investment managers at their own initiative. Where an investor takes the initiative in this way, this should not be considered marketing under AIFMD, although other local laws or regulations may still apply.

9.86  Since there is no clear consensus as to the scope of reverse solicitation, reliance on reverse solicitation involves some degree of risk. If a non-EEA investment advisor wishes to rely on reverse solicitation, it is important to understand the regulatory approach in the relevant jurisdiction, and to have in place compliance procedures that can provide the appropriate backup should the sale be questioned in the future.

9.87  Where an existing fund has EEA investors, requests from them for information about another fund could in certain circumstances be classified as reverse solicitation. However, the ability to rely on reverse solicitation is very limited. Most investment advisors will find it difficult to attract significant capital through this means alone.

N.  Private placement

9.88  AIFMD allows each EEA member state to maintain a private placement regime until a decision is made whether or not to allow EEA and subsequently non-EEA investment advisors to take advantage of the marketing passport. These private placement regimes are a patchwork of rules that vary widely. Some member states require prior notification, while others require full local authorization. In some (p. 210) member states there is no framework in place to enable private placement. With AIFMD, several EEA member states have either withdrawn the ability to market on a private placement basis within their jurisdiction or have severely limited the ability to do so.

9.89  In addition to each country’s private placement rules, Article 68 AIFMD lays down five requirements that non-EEA investment advisors must meet before marketing on a private placement basis in the EEA:

  1. (a)  A cooperation agreement must be in place between the EEA member state in which the fund is being marketed, the regulator of the jurisdiction of the fund and the regulator of the jurisdiction of the non-EEA investment advisor, relating to the sharing of information and the cross-border supervision of the fund.41

  2. (b)  The jurisdiction of the fund must not be listed as a non-cooperative jurisdiction by the Financial Action Task Force.42

  3. (c)  The investment advisor must report annually on each of the funds that it markets in the EEA.43

  4. (d)  The non-EEA investment advisor must comply with certain disclosure obligations concerning risks and fees.44

  5. (e)  The investment advisor will need to report annually to the regulator of the EEA state to disclose information about the fund’s trading.45

9.90  These are the minimum requirements that must be met by a non-EEA investment advisor marketing in the EEA on a private placement basis. Since AIFMD affords member states the freedom to ‘impose stricter rules on the AIFM in respect of the marketing of units or shares of non-EU AIFs to investors in their territory’,46 some member states have taken steps to put rules in place that go beyond the minimum requirements.

O.  Marketing passport

9.91  The AIFMD marketing passport was designed to be an efficient way of marketing an AIF across the EEA. The passport is currently only available to AIFMs whose registered office is located within the EEA and are intending to market an EEA domiciled fund. The main advantage is that the AIFM will only have to comply (p. 211) with one set of rules under AIFMD, avoiding the arduous task of complying with the national private placement rules of multiple EEA member states.

9.92  The marketing passport allows EEA AIFMs to market EEA funds to professional investors throughout the EEA, subject to authorization by the EEA member state in which the AIFM is regulated. Once authorized, the EEA AIFM will notify its regulator of the EEA member states in which it wishes to market the fund.

9.93  The regulator then notifies the regulators in each of these EEA member states within 20 working days. Once this notification has been made, the EEA AIFM will be able to market the fund in the SEC EEA member states.

P.  Non-EEA AIFMs and non-EEA AIFs

9.94  If an EEA domiciled fund did not have an EEA investment advisor as its AIFM, it could appoint a third-party AIFM service provider. For a fee, the designated AIFM would then delegate the portfolio management function to the non-EEA investment advisor.

9.95  Alternatively, if a non-EEA investment advisor appoints an EEA sub-advisor to assist with the fund, a decision will need to be made as to whether the non-EEA investment advisor or the EEA sub-advisor will be the designated AIFM for the purposes of AIFMD. Under AIFMD, there can only be one AIFM. To the extent that the non-EEA investment advisor is the AIFM, the non-EEA investment advisor would fall largely outside the scope of AIFMD.

9.96  In order for an EEA sub-advisor to qualify as the AIFM, it would need to show sufficient substance. The non-EEA investment advisor would need to delegate sufficient portfolio and/or risk management duties to the EEA sub-advisor in respect of the fund being managed. The substance requirements do not require the EEA sub-advisor to carry out the majority of the portfolio or risk management functions. Rather, the sub-advisor must just have enough substance such that it is not deemed a ‘letterbox’ entity.

9.97  To reduce the costs of setting up a new fund, an investment adviser could launch on an existing AIFMD compliant platform. The key advantages of utilizing an existing platform are that: (i) it is possible to launch the fund within a shorter timeframe; (ii) it can take advantage of the marketing passport under AIFMD; and (iii) it potentially makes available the platform provider’s capital introduction services.

9.98  There are, however, advantages in a fund manager establishing its own fund structure. While this may take slightly longer and cost more initially, it prevents the fund and investment management business from being tied commercially to a third-party platform and its fee structure. In practice, it permits greater freedom as to how the (p. 212) fund is managed and marketed, but the fund manager would also need greater internal compliance and operational support within such a business.

9.99  It would be possible to initially utilize a third-party platform provider and then move to a proprietary structure in the event the business grows. Unfortunately it is often difficult to effect a truly universal tax-efficient switch for all investors from one fund to another fund structure.

Q.  FCA implementations

9.100  On 28 June 2013, the FCA published its Policy Statement 13/5 containing its final rules and guidance on the implementation of AIFMD. The Policy Statement included the new Investment Funds sourcebook (FUND), which transposes the majority of the AIFMD’s operating and compliance requirements on AIFMs.

9.101  The FCA clarified that ‘marketing’ under AIFMD occurs when ‘an offering or placement takes place where a person seeks to raise capital by making a unit available for purchase’. The FCA confirmed that an offering or placement does not therefore include secondary trading in an AIF. The FCA also confirmed that a listing of an AIF will not in itself constitute an offering or placement, although it may well be accompanied by such an offering or placement.

9.102  The FCA reiterated its earlier view that communicating with investors on the basis of promotional presentations or draft documentation does not fall within the meaning of ‘offer’ or ‘placement’ for the purpose of AIFMD, provided such documents cannot be used by a potential investor to make an investment in the ALF.47

9.103  The FCA also finalized its Perimeter Guidance on the meaning of AIF—in line with ESMA’s final guidelines on this topic—and on managing an AIF. For example, a UK firm will not be ‘managing an AIF’ if it performs functions that have been delegated to it, provided that the delegating entity is not a ‘letterbox’ entity. A key consideration for the FCA is the importance of the tasks carried out by the delegating manager, along with its right to exercise oversight and control and the degree to which it actually does so.

9.104  With regards to ‘looking through’ investors, the FCA clarified that the reference to ‘investor’ should be regarded as a reference to the person who will make the decision to invest in the AIF. Where the legal subscriber is a nominee or custodian, the AIFM should ‘look through’ to the underlying investor who has made the decision to invest. Where a discretionary manager invests on behalf of (p. 213) an underlying investor, it is not necessary to look through, since the manager is considered the investor.

9.105  In terms of reverse solicitation, the FCA liberalized its position even further. AIFMs may rely on a confirmation from the investor that the approach is at the investor’s initiative, with the caveat that this cannot be relied on if it has been obtained by the AIFM to circumvent the requirements of AIFMD.

R.  Reporting

9.106  On 1 October 2013 ESMA published its final report setting out detailed guidelines relating to the reporting obligations mandated in Annex IV of the European Commission’s AIFMD Level 2 Regulation.

9.107  EEA AIFMs must provide reporting to their home regulator in relation to themselves and all AIFs that they manage to their home regulator. Non-EEA AIFMs marketing under Article 42 of AIFMD must report only on each of the AIFs that they are marketing. The reporting obligation is owed to each member state in which Article 42 marketing is being conducted by the non-EEA AIFM.

9.108  Feeder AIFs are reported individually, and not aggregated with the underlying master fund. The report for a feeder fund does not look through to the master fund and report on the master fund’s underlying investments. Fund of fund does not look through underlying funds when reporting. Master AIFs whose feeders are either EEA AIFs or marketed in the EEA may need to be reported separately, regardless of whether or not the master AIF is itself an EEA AIF or marketed in the EEA. Umbrella AIFs must be reported on a sub-fund by sub-fund basis.

9.109  AIFMs of AIFs established in the EEA or AIFMs marketing into the EEA AIFs established outside of the EEA must comply with Articles 22 and 23 of AIFMD.48 Historically, disclosure requirements were driven by the jurisdiction where an AIF was established or the requirements of any stock exchange on which the AIF’s interests were listed. These legal requirements were reinforced by industry standards and voluntary codes of conduct. With AIFMD, a minimum level of disclosure must now be provided to prospective and existing investors in an EEA AIF.49 AIFMD provides for investor transparency by requiring three types of (p. 214) disclosure: (i) point of sale or pre-investment disclosure;50 (ii) periodic disclosure;51 and (iii) regular disclosure.52

Pre-investment disclosure requirements include:

  1. (a)  the AIF’s investment objective, strategy, restrictions, and risks;

  2. (b)  use of leverage and collateral arrangements;

  3. (c)  service providers and fees;

  4. (d)  delegation arrangements;

  5. (e)  dealing terms and liquidity management;

  6. (f)  valuation procedure and net asset value calculation;

  7. (g)  fair treatment and preferential treatment of investors; and

  8. (h)  how periodic and regular disclosure will be made available.

9.110  Any material change to this information must also be made available prior to investment. The requirements relating to periodic disclosure include the following:

  1. (a)  the percentage of assets that are subject to special arrangements arising from their illiquid nature;

  2. (b)  any new liquidity management arrangements;

  3. (c)  the risk management profile of the AIF; and

  4. (d)  the risk management systems of the AIFM.

Regular disclosure is required in relation to any changes to:

  1. (a)  the maximum level of leverage;

  2. (b)  any right to collateral; or

  3. (c)  any guarantees.

9.111  In addition to the above pursuant to Article 24 of AIFMD, an AIFM for each EU AIF it manages and each AIF it markets into the EEA is required to make an annual report available to investors within six months of the end of the financial year. The accounts must be audited and prepared in accordance with the accounting standards of the home member state of the AIF or the country where the AIF is established. The annual report must include, in addition to traditional financial statements:

  1. (a)  a report on the activities of the financial year;

  2. (b)  any material changes to the information disclosed pursuant to Article 23;

  3. (p. 215) (c)  information regarding the remuneration paid by the AIFM to its staff during the relevant period; and

  4. (d)  where the AIF acquires individually or jointly control over a non-listed company, information regarding the target company’s business development.

S.  AIFMD platforms and governance challenges

9.112  Since the adoption of AIFMD, third-party platforms have become popular for investment advisors launching AIFMD-compliant funds. Umbrella fund structures allow other previously unaffiliated investment managers to enter into a sub-investment management agreement for their own separately managed sub-fund. As the cost involved in a new fund launch have expanded over the years, managers seeking access to European investors by way of onshore AIFMD funds rather than the traditional offshore routes have turned towards third-party platforms.

9.113  The process begins with the appointment of an EEA-domiciled AIFM whose services will include risk management, thereby allowing portfolio management to be delegated to sub-advisors appointed to a specific sub-fund. A platform will be established with specified key service providers (such as the administrator, custodian, or depositary) already in place. However, in relation to other service providers (such as brokers and trade counterparties), there can be some flexibility.

9.114  Cost savings is often presented as one of the main advantages of joining a platform. Certain overheads and costs can be spread across the entire platform. In addition, a platform can take advantage of economies of scale to obtain lower fee rates from service providers. Finally, the launch of a new sub-fund on an established structure can be just a much smaller project than the establishment of a new fund vehicle.

9.115  As discussed above, the primary advantage of an EEA fund is distribution under a pan-European AIFMD passport. Some platforms promise an established distribution network, as well as introductions to new investors. Some investors may even look favourably on the due diligence conducted by the platform as part of the on-boarding process. Platforms can also be responsible for ongoing compliance, regulatory, and corporate governance requirements for the AIFMD-compliant sub-fund.

9.116  There can also be significant disadvantages associated with using these platforms. First, anticipated cost savings may not be achieved over the medium and long term. With fees calculated on an AUM basis, the platform model can be significantly more expensive for larger funds then simply launching your own fund. Costs related to the on-boarding process can sometimes approximate (p. 216) those of a new launch. In addition, joining a platform essentially means that a portfolio manager is a service provider to a structure created and operated by a third party.

9.117  Appointment as a sub-advisor would also be subject to termination in accordance with the terms of the sub-advisory agreement. Termination provisions are often a more important commercial consideration than cost to many managers. If a platform is an interim measure undertaken while they initially grow their fund to a certain size, it is essential that the agreement reflects the portfolio manager’s intention to exit the platform at some future time. A portfolio manager leaving a platform to set up a standalone fund will be seeking a means to bring existing investors along, to use the track record built up while on the platform, and use a similar name to the existing fund.

9.118  Most platform agreements are typically unlimited in duration. However, providing for a fixed term, with potential renewal rights, is useful if the portfolio manager expects to eventually exit the platform. Platforms may request the inclusion of non-compete provisions, at least within the same product range. Including a provision guaranteeing a certain capacity in the new stand-alone fund to the platform instead of a non-compete clause may be a satisfactory compromise.

9.119  A platform will typically require the inclusion of liability provisions in the agreement appointing the on-boarding manager, and the standard will normally be negligence, fraud, or wilful misconduct.

T.  Brexit

9.120  The ultimate impact of Brexit on the UK private investment fund industry is still unclear and will likely remain so for some time.53 Equally true is that the impact of Brexit on the scope and tone of EU financial regulation will also be unclear for some time—although the potential for significant change there is quite evident. The potential for upheaval in the private funds industry has many observers concerned.

9.121  Historically, many AIFs that were sold into the EEA were based in offshore tax havens. For a variety of commercial, tax, and legal reasons (including of course AIFMD), the offshore method of accessing the EEA is becoming less favoured. Increasingly, offshore funds are giving way to funds established in Ireland, Luxembourg, or Malta. These AIFs can be marketed throughout the EEA to professional investors, while delegating investment management back to firms (p. 217) in the United Kingdom and United States. This trend will most likely continue after Brexit.

9.122  There may actually be little change in the means by which UK investment managers access their EEA investors other than a continuing decline in the use of tax haven-based funds. The corollary of this is that EEA investors increasingly have less access to the full range of globally available, alternative investment management products. Ultimately, one core question of Brexit with regards to AIFMD is whether on 29 March 2019 UK funds and UK managers will be treated as non-EEA AIFs and non-EEA AIFMs.

9.123  Under AIFMD there is provision for countries outside the EEA to gain recognized status. In principle, this could be used by UK-based funds and managers to access the EEA. There has been considerable discussion as to whether the United Kingdom will be able to take advantage of this, post-Brexit. Of course, immediately post-Brexit, relevant UK and the EEA laws will be identical. However, these provisions were originally included in AIFMD for the benefit of various UK-linked tax havens in order to lessen UK resistance to the new directive. The European Union has missed its deadlines on implementation in this area. Of course, the United Kingdom has less influence in pushing this agenda now. Meanwhile Ireland, Luxembourg, and Malta have no national interest in accelerating the admission of new competitors and the rest of the EEA has little interest in this area.

9.124  At present, UK-based investment managers can passport their operations into the European Union and vice versa. These reciprocal rights will likely disappear with Brexit.

9.125  Many observers believe the most likely outcome for the Brexit negotiations is an agreement for a transitional position for several years after Brexit. This would allow time for a comprehensive agreement to be entered into before the March 2019 deadline. If there is a transitional period, the business of investment managers could continue largely as normal in the short term. If a favourable separation arrangement is agreed, there is even less reason for concern.

U.  Conclusion

9.126  As a result of the 2008 financial crisis, widespread attention has been paid to the nature and scope of financial regulation. This is an exception to the general rule, as one commentator has noted:

Regulation has been described as ‘low politics’—the world of mundane technicalities far below the ‘high’ politics of international diplomacy or national party politics. Yet regulation has recently taken political center stage, not least as the credit (p. 218) crunch has exposed the contradictory demands of regulated firms and others for both less and more regulation, and the limits of governmental capacity to provide either, or at least not in the right places and in the right ways.54

9.127  When evaluating government regulation, it is important to bear in mind three potential disadvantages:

  1. (a)  whether such regulation will be counter-productive, or simply redundant because of actions taken by market participants in reaction thereto;

  2. (b)  whether defects in the processes of adoption, implementation and/or enforcement undermine its effectiveness; and

  3. (c)  whether such regulation unduly restricts the rights and freedoms of persons affected thereby.55

9.128  A comprehensive critique of Dodd-Frank and AIFMD, and its impact on private investment funds, is beyond the scope of this book. However, these three disadvantages remind us that no piece of legislation or regulation can realistically hope to provide a complete solution to a problem. There inevitably remains room for private actors to evaluate and supplement the rules, with their own additional actions and precautions. As commentators have observed:

Financial regulation is often reactive. New regulation seals up leaks in the financial system—usually following a crisis, a shift in markets or other change that threatens financial stability.56

9.129  In the United States, for example, the modern financial regulatory system was created as a direct result of the Great Depression. The Dodd-Frank reforms, like numerous reforms preceding it, was borne from the 2008 financial meltdown,57 the most serious recession in the United States since the Great Depression.

9.130  Wide-ranging reforms were proposed and adopted in numerous countries to attempt, after the fact, to correct perceived shortcomings and omissions in their regulatory regimes.58

(p. 219) 9.131  Regardless of the financial regulatory model that a particular country follows,59 there will always be a tension during a period of reform between making a fundamental change to a country’s regulatory model, and simply making incremental changes within the current financial model.60 Neither Dodd-Frank nor AIFMD attempt to directly address governance deficiencies in private investment funds or shift their regime away from the traditional ‘we regulate the managers, not the fund’ approach. Although each regulatory reform package makes significant changes to the scope and detail of existing rules, the focus is on different regulatory priorities such as systemic risk. Even where concerns about investor protection are addressed, the rules do so in a customary manner, in line with past approaches.

9.132  The reforms introduced some incremental improvements in the regulatory regime, although as noted in this chapter, the extent to which they provide for greater protection of fund investors beyond that which would be provided by good market practice remains limited. Private funds carry with them inherently complex questions about jurisdictional reach and the effectiveness of regulation outside the country of origin.61 Importantly, even with increased coordination and harmonization at the international level,62 government regulators will be subject to de jure or de facto jurisdictional limitations on their effectiveness. By contrast, private actors can pursue their investments across national boundaries as they need arises.63

9.133  In addition, the enforcement centralized, top-down rules would still reveal a systemic disadvantage that the SEC, the FCA and all financial regulators face—namely, hiring and retaining adequate talent. As one commentator has observed:

[I]n order to enhance their professional expertise, government agencies have to hire the best available specialists in relevant areas and offer these experts compensation high enough to lure them away from potentially lucrative employment at investment banks and hedge funds. Competing with the private sector on these terms is hardly a viable proposition for government agencies.64

(p. 220) 9.134  Despite much discussion and debate,65 ultimately US and EU legislators and regulators decided to limit their reform efforts to a number of important changes involving the regulatory status of the fund manager and some potentially significant other claims in the applicable marketing instructions. In doing so, they ultimately favoured reforms in line with the traditional regulatory approach that they have historically followed in this area. However, by default, they have sent a clear message to all investors in private investment funds—responsibility for establishing appropriate governance mechanisms within your funds rests with you, the investors.


1  See Eilis Ferran, ‘The Regulation of Hedge Funds and Private Equity: A Case Study in the Development of the EU’s Regulatory Response to the Financial Crisis’, Legal Studies Research Paper Series, University of Cambridge Faculty of Law, Paper No. 10/2011 (February 2011).

2  See Daniel Awrey, ‘The Limits of EU Hedge Fund Regulation’ 5:2 Law and Financial Markets Review 8 (2011) (‘[A]lternative investment funds were not a proximate cause of the [global financial crisis], nor have the substantial number of fund failures which have followed in its wake triggered systemic instability’).

3  Ibid. at p. 9 (‘The financial crisis that began in 2007 did not involve systematically important hedge fund collapses or private equity-backed corporate failures’).

4  See, e.g., Jesse Westbrook, ‘SEC Didn’t Act After Spotting Wall Street Risks Documents Show’, Bloomberg.com (5 May 2010) available at <http://www.bloomberg.com/news/2010-05-05/sec-did-n-t-act-after-spotting-wall-street-risks-documents-show.html>.

5  See Cristie Ford, ‘New Governance in the Teeth of Human Frailty: Lessons from Financial Regulation’, 2010 Wisconsin Law Review 101, 102 (2010) (‘For students of financial market regulation, the global financial crisis of 2007–09 (GFC) has been a sobering illustration of human greed and short-sightedness, and regulatory failure’).

6  See, e.g., Nouriel Roubini, ‘The Shadow Banking System is Unravelling’, FT.com (21 September 2008), available at <http://www.ft.com/cms/s/o/622 acc93-87f1-11dd-b11 4-0000779fo18c.html>.

7  Dale Osterle, ‘Regulating Hedge Funds’, 1 Entrepreneurial Business Law Journal 1, 39 (2006).

8  Andrew J. Donohue, ‘Regulating Hedge Funds and Other Private Investment Pools’, Speech to 3rd Annual Symposium on the Regulation of Investment Funds (19 February 2010).

9  See Wulf A. Kaal and Dale Oesterle, ‘The History of Hedge Fund Regulation in the United States’, Handbook on Hedge Funds, Oxford University Press (2016).

10  ‘Private funds’ are defined as entities that would be an ‘investment company’ under the Investment Company Act of 1940, as amended (the ‘1940 Act’), but for the exceptions set forth in sections 3(c)(1) and 3(c)(7) of the 1940 Act.

11  Any investment adviser that has had fewer than 15 clients during the preceding 12-month period and does not hold itself out to the public as an investment adviser.

12  See Kenneth J. Berman and Gregory T. Larkin, ‘Dodd-Frank’s Impact on Private Fund Managers’, The Deal Magazine, 16 November 2010 (available at <http://www.thedeal.com/newsweekly/community/dodd2.php>) (‘While not as onerous as other regulatory schemes, life under the Investment Advisers Act may bring significant change for currently unregistered advisers. It is not too soon for these advisers to begin their preparation for registration, including the preparation of compliance policies’).

13  Reports of the failure of Congress to adequately fund the SEC, leading to claims by critics of a ‘stealth repeal’ of Dodd-Frank have been appearing regularly in the US financial press.

14  Elizabeth Pfeuti, ‘Extraditions Could Soar with Dodd-Frank’, Financial News (11 October 2011). (‘New American financial regulations may result in more international financiers, including fund managers, numbering among those being surrendered to the U.S. justice system in the future. Fund managers have been prime targets as investors of U.S. based money’.)

15  Traditionally, a ‘person’ is counted as a single client if it was a corporation, partnership, trust or other entity that receives investment advice based on its investment objective rather than the individual investment objectives of its own beneficial owners. In December 2004, the SEC adopted Rule 203(b)(3)-2 that requires hedge fund managers to register as investment advisers under the Advisers Act, despite open dissents from two of the five Commissioners. The broad exemption enjoyed by US hedge fund managers has always been anomalous. The overwhelming majority of developed international financial markets in which non-US managers are predominantly based have historically required formal registration.

16  For example, a non-US adviser would not be required to comply with the following rules under the Advisers Act as to non-US clients: (a): rule 206(4)-7 (the ‘compliance’ rule), (b) rule 206(4)-2 (the ‘custody’ rule) and (c) rule 206(4)-6 (the ‘proxy voting’ rule).

17  Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No IA-4421 (14 June 2016).

18  Investment Adviser Performance Compensation, Release No IA-3372 (15 February 2012).

19  Exemption to Allow Registered Investment Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client’s Account, Release No IA-996 (14 November 1985) (1985 Adopting Release).

20  Net worth excludes a natural person’s primary residence and any liability on such residence.

21  1985 Adopting Release supra note 11.

22  The Dodd-Frank Act requires that the SEC ‘shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010 and every 5 years thereafter, adjust for the effects of inflation’. Adjustments are subject to rounding to the nearest $100,000. No adjustment takes place if the adjustment would be below the rounding threshold.

23  Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No. IA-3236 (12 July 2011).

24  For concerns about the ultimate effectiveness of Form PF information, see Mark D. Flood, ‘Gauging Form PF: Data Tolerances in Regulatory Reporting on Hedge Fund Risk Exposures’, Office of Financial Research, Working Paper Series 15-I3 (30 July 2015).

25  Unfortunately, there are concerns that Form PF allows funds with dissimilar profiles to appear similar in their risk exposures to regulators. See Flood, ‘Gauging Form PF’.

26  See Cary Martin Shelby, ‘Closing the Hedge Fund Loophole: The SEC as the Primary Regulator of Systemic Risk’, 58 Boston College Law Review 639 (2017).

27  Form ADV and Investment Advisers Act Rule, Rel. No IA-4509 (25 August 2016).

28  The SEC and the CFTC operate in adjacent (and at times overlapping) areas of functional jurisdiction. See Jerry W. Markham, ‘Merging the SEC and CFTC – A Clash of Cultures’, 78 University of Cincinnati Law Review 537 (2009). Some have argued that the distinction is a hindrance to effective market oversight and the two regulators should be merged. See Roberta Skarmel, ‘The Future of the Securities and Exchange Commission as a Market Regulator’, 78 University of Cincinnati Law Review 501 (2009).

29  See Stephen M. Bainbridge, ‘Dodd Frank: Quack Federal Corporate Governance Round II’, 95 Minnesota Law Review 1779 (2011).

30  Edward F. Greene, ‘Dodd-Frank: A Lesson in Decision Avoidance’, 6 Capital Markets Law Journal 29, 59 (2010) (‘The Act evidences a love/hate relationship with the SEC. It assigns to the agency more rule makings and studies to be conducted than to any other agency, reflecting the Congress’ reluctance to make hard decisions. At the same time, the Act imposes structural changes and controls, which suggests the Congress’ lack of trust in the agency partly inspired by the SEC’s failure to detect the Madoff scandal’).

31  See Martin E. Lybecker, ‘Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deserves Serious Reconsideration’, 83 Wash Uni Law Quarterly 1045, 1087 (2005) (‘The scandals of 2003–2004 are unique in the history of the SEC’s administration of the Investment Company Act but appear to validate the concern that the Commission still has insufficient resources adequately to survive the securities industry and to catch wrongdoers among those that it is responsible for regulating before serious harm has been done’).

32  Ibid. at 75.

33  Edward F. Greene, ‘Dodd-Frank: A Lesson in Decision Avoidance’, 6 Capital Markets Journal 29, 64 (2010).

35  Eilis Ferran ‘The Regulation of Hedge Funds and Private Equity: A Case Study in the Development of the EU’s Regulatory Response to the Financial Crisis’, Legal Studies Research Paper Series, University of Cambridge Faculty of Law, Paper No 10/2011 (February) at 15.

38  The European Economic Area comprises the 28 member states of the European Union plus Iceland, Liechtenstein, and Norway.

39  AIFMD Article 67.

40  See Chapter 17.

41  AIFMD Article 42(1)(b).

42  AIFMD Article 42(1)(c).

43  AIFMD Article 42(1)(a).

44  AIFMD Article 42(a)(a).

45  Article 42(1)(a). This regulatory reporting requirement is known as ‘Annex IV Reporting’ and is similar in many respects to Form PF.

46  AIFMD Article 36(2).

47  The FCA did emphasize, however, that a unit in the AIF should not be made available for purchase as part of the capital raising of the AIF only on the basis of draft documentation in order to circumvent the marketing restriction.

48  These articles set out the core requirements relating to investor transparency and are supplemented by Articles 103 through 109 of the Commission Delegated Regulation (EU) No 231/2013.

49  AIFMD states in Recital 94 that its objective is:

[T]o ensure a high level of investor protection by laying down a common framework for the authorisation and supervision of AIFMs …

The importance of investor disclosure is emphasized throughout the Commission Delegated Regulation (EU) No 231/2013 (the ‘Delegated Regulation’ also known as ‘Level 2’) adopted pursuant to the Directive.

50  AIFMD Article 23(1).

51  AIFMD Article 23(4).

52  AIFMD Article 23(5).

53  See Chapter 17.

54  Julia Black, ‘Forms and Paradoxes of Principles Based Regulation’, Capital Markets Journal 3(4) at 7 (2008).

55  Brian R. Cheffins, Company Law: Theory, Structure and Operation (Oxford University Press 1997) at 163.

56  Charles Whitehead, ‘Reframing Financial Regulation’, 90 Boston University Law Review 1, 2 (2010).

57  Ibid. at 36 (‘The current financial crisis highlighted gaps in financial regulation, principally arising from changes in the markets over the last thirty years’).

58  See, e.g., Randall D. Gwynn, ‘The Global Financial Crisis and Proposed Regulatory Reform’, BYU Law Review 421, 422 (2010) (‘There is a widespread belief that the financial crisis was caused by the free markets being too free. If we had better government regulation and supervision, and more of it, according to this way of thinking, we could have avoided the financial crisis and would prevent future crises from ever happening again. These beliefs may or may not be correct, but governments are moving ahead as if they were’).

59  Generally speaking, the four global models are: (a) institutional regulation, based on type of firm; (b) functional regulation, based on the function that is being performed by a firm; (c) a ‘twin peaks’ model, where one regulator is responsible for conduct of business supervision and another regulator for prudential supervision; and (d) an integrated model, where a single regulatory agency is responsible for all sectors. Ibid. at 462.

60  Ibid. at 463. See, e.g., Renee M. Jones, ‘Back to Basics: Why Financial Regulatory Overhaul is Overrated’, 4 Entrepreneurial Business Law Journal 391 (2010).

61  As one commentator has noted: ‘The issue of jurisdiction is also complicated in the transactional context: such regulators do not fit neatly within existing legal and territorial jurisdictional boundaries’. Black, ‘Constructing and Contesting Legitimacy and Accountability in Polycentric Regulatory Regimes’, 2 Regulatory and Governance 1 at 13–14 (2008).

62  See Chapter 16.

63  See ibid. at 692 (‘[P]rivate economic actors—financial institutions and investors—are not constrained by jurisdictional considerations and are able to oversee and manage their business affairs across national borders much more seamlessly than any government agency’).

64  Saule T. Omarova, ‘Rethinking the Future of Self-Regulation in the Financial Industry’, 35 Brooklyn Journal Int’l Law 665, 686–7 (2010).

65  See Awrey, ‘Limits’ at 19. (‘Understanding the [AIFM] Directive as the product of not only a policy process—but also a political one—serves to shed considerable light on many of its apparent shortcomings’).