Funds regulation in the Americas
December 2013 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
FW moderates a discussion on funds regulation in the Americas between Marina Procknor at Mattos Filho, Veiga Filho, Marrey Jr. e Quiroga Advogados, Stephanie M. Monaco at Mayer Brown LLP, and Jonathan Fitzgibbons at Solomon Harris.
FW: Could you provide a brief overview of recent developments in funds regulation in your region? What major changes have emerged?
Procknor: The financial crisis, intense foreign exchange and interest rate volatility and an increasing demand for alternative investments has encouraged the Brazilian Securities and Exchange Commission (CVM) to amend the applicable regulatory regime in important ways. In order to ensure stronger protection of, and information for, retail investors, several changes and improvements involving conflicts of interest and disclosure have been raised. Hedge funds and private equity funds that are targeted at qualified and sophisticated investors continue to have safe harbours and a more flexible regulatory framework. However, the Brazilian investment funds industry has always been heavily regulated and there are no signs that this scenario will change in the near future.
Monaco: Since the Dodd-Frank Act in 2010 we have seen several significant changes to fund regulation in the US. One of the biggest changes is that now many managers of private funds are required to register with the Securities and Exchange Commission (SEC) as investment advisers and file reports concerning their funds on Form PF, and, depending on their activities, possibly face regulation as ‘commodity pool operators’ due to rule changes from the Commodity Futures Trading Commission. The SEC has also restricted the ability of funds to make private offerings in the US if the fund sponsor or other related persons are subject to disciplinary action, but it has eased prohibitions on advertising their offerings, provided certain conditions are met. We await final rules implementing the Volcker Rule, which will significantly impact fund sponsors that are affiliated with banks, and will also affect the ability of banks to invest in funds.
Fitzgibbons: Onshore there is a general trend towards greater reporting and tax transparency and greater regulation of alternative investment funds and managers. The US Foreign Account Tax Compliance Act (FATCA), the EU Alternative Investment Fund Managers Directive (AIFMD) and Form PF – under the US Dodd-Frank Act – are the three major developments that have added the most to the compliance burden. In the Cayman Islands there are a number of ongoing regulatory changes that are intended to ensure this jurisdiction remains the primary domicile for alternative investment funds. Developments include industry consultations on new corporate governance regulations; consultation on the regulatory fees; consideration of legislative changes that will introduce new types of corporate vehicles for the funds industry to use; executive measures such as the implementation of a model one inter-governmental agreement and a new tax information exchange agreement with the US to simplify compliance with FATCA; and cooperation agreements with EU member states to enable Cayman funds and managers to continue to be offered to European investors in compliance with AIFMD.
FW: What regulatory considerations should fund managers make when exploring options for registering, domiciling and structuring their funds?
Monaco: Very often, tax implications drive client decisions on how to structure and where to domicile their funds. These issues range from choosing jurisdictions with favourable tax rates and treaties, to avoiding ‘unrelated business taxable income’ for tax-exempt US shareholders, to ensuring that the fund and its sponsor are comfortable with FATCA and other potential US tax reporting matters. Managers also need to consider US registration and regulation consequences simply by marketing the fund to US prospects. Choosing to operate a ‘registered’ fund in the US, which some alternative fund managers have recently begun doing, is a significant undertaking that involves additional regulatory complexities – specifically, the Investment Company Act – but does allow a fund to access a wider, ‘retail’ investor base.
Fitzgibbons: There are a number of important considerations here. The first consideration should be the jurisdictions in which the fund will be offered. The fund has to be domiciled in a jurisdiction that does not preclude fundraising in the targeted countries. The second most important consideration is likely to be tax efficiency. Establishing the fund in a tax neutral jurisdiction like the Cayman Islands ensures that returns to investors can be maximised. From there it is important to consider the regulatory burden in each domicile: whether the fund or the manager needs to be licensed or registered, the cost and lead time in doing so, and the ongoing reporting obligations. The regulatory regime in Cayman is structured to ensure that funds domiciled here can be marketed as widely as possible, and to ensure we remain compliant with international anti-money laundering, tax-exchange and reporting obligations without over-regulating the industry or forcing fund managers to navigate through too much red tape.
Procknor: Any distribution of investment funds in Brazil are deemed to be public offerings of securities; therefore, all and any local investment funds must be registered before the CVM. Brazilian regulation establishes that local funds can only be structured and managed by registered asset managers. Therefore, when exploring options for registering, domiciling and structuring their funds, managers should consider operational costs and timing to set up a registered entity in Brazil or to form a joint venture or partnership with a local manager. Marketing and compliance policies of investment funds are also subject to registration and disclosure rules.
FW: How are regulatory developments changing the way funds carry out their daily operations and liaise with their investors?
Fitzgibbons: Once AIFMD is fully in force, non-EU funds with non-EU managers will need to take care over where and how those funds are offered within Europe. Where a cooperation agreement is in place between the Cayman Islands and the relevant member state, a fund will be able to continue to be marketed under the private placement rules applicable to that member state, at least until 2015, or by way of reverse solicitation, as defined by the relevant member state. Non-EU managers of non-EU funds will have to understand and comply with the private placement and reverse solicitation rules of each member state where they are looking to raise money. In some cases, EU member states may choose to impose additional restrictions on private placement or reverse solicitation or may not permit them at all. Particularly where investments are made by way of reverse solicitation, the fund manager will have to ensure it can prove that investments were sought out by the investor in compliance with local regulations and not as the result of active marketing. These changes are likely to impact how the manager communicates with prospective investors within the EU. Additionally, disclosure documents will need to be amended to ensure the appropriate level of transparency as required by the AIFMD.
Procknor: Some regulatory developments are increasing costs and expenses of managers and other service providers, as well as eliminating high-risk investment strategies to retail funds. Therefore, managers and other service providers of retail funds will have to be cost efficient to deliver and maximise returns to investors. Funds focused on real estate or infrastructure projects, for example, still present tax benefits to local and non-resident investors.
Monaco: Now that many managers of private funds are registered as investment advisers, there has been a great deal of additional scrutiny regarding marketing materials – and offering materials – for funds. Although these are not ‘new’ rules regarding advertising, they are now being applied in new and different ways – existing SEC guidance is not always a good fit for the types of performance information and other material that alternative fund managers had been accustomed to providing to fund investors and prospects. At the same time, this additional scrutiny on performance information also results in scrutiny of how funds value their investments, particularly for any hard to value or illiquid holdings. Having a clear valuation methodology – and following it – is crucial. Similarly, creating and implementing compliance policies and procedures to address custody of client assets, conflicts of interest, and other compliance responsibilities, frequently surprise managers when faced with the reality of greater regulation.
FW: In light of recent regulations, are you seeing fund managers adopt any particular strategies and practices to maximise returns to investors? How successful have they been?
Fitzgibbons: The regulatory changes we have seen have not really impacted the strategies that managers employ. Marketing practices will change, however. We have always seen a substantial number of funds that were closed to US investors. We are likely to see the same thing in respect of EU investors, or at least the investors from certain EU member states, once AIFMD is fully implemented.
Procknor: Fund managers are adopting new strategies and practices to maximise returns, including cost efficiency, and high yield and alternative investments to qualified investors. 2013 has been one of the most challenging years for the industry and players are pessimistic about the near future.
FW: How heavy is the financial burden that additional regulations are placing on fund managers? What long-term impact do you expect this to have on the industry?
Procknor: The Brazilian capital markets have always been heavily regulated and fund managers working here or willing to access the Brazilian market need to understand the costs and the timeframe involved in structuring a local fund. Over time, we have seen the CVM issue rules that place burdens and restrictions on the development of certain fund structures that are commonly used in other jurisdictions. However, as the regulators have become aware that certain regulatory requirements have had the effect of restricting access to the capital markets, consequently increasing capital costs, the authorities have reviewed application of the regulation on a case-by-case basis, granting waivers as to specific issues. An example is the recent amendment to the private equity funds regulation that allows funds to provide collateral, something that was forbidden before. Recent developments have confirmed that the CVM is willing to engage in dialogue with the industry and is sensitive to its needs.
Monaco: Because many fund managers now have to register as investment advisers in the US, there are barriers to entry that did not exist before. A thoughtful compliance infrastructure needs to be in place from the start of business, and that has costs associated with it. Registered investment advisers are required to have a chief compliance officer (CCO) and a compliance program with written compliance policies and procedures tailored to the adviser’s business. The financial burden for hiring an experienced CCO and maintaining an up-to-date compliance program can be quite expensive, but the SEC expects firms to devote resources to the compliance function, as demonstrated by its aggressive enforcement focus. Over the long term, it is likely that the cost of regulation will increase to the point that only start-up firms with significant financial backing can survive. Indeed, as regulations grow, we expect the investment management business to constrict.
Fitzgibbons: The financial burden is substantial. Just to amend the OMs to accommodate AIFMD language will be a cost to the funds. When you add in additional monitoring, AIFMD and FATCA reporting obligations, and documenting activities in order to respond to enquiries from regulators, and consider the likely costs of obtaining an AIFMD passport to operate in Europe, it is clear that compliance costs are going to increase significantly. Additionally, service providers like administrators and banks will have to pass on the costs of their own additional compliance obligations. Steps are being taken within the Cayman Islands to try and minimise the burden. For example, the model 1 inter-governmental agreement between the Cayman regulator and the US means that each individual investment fund that is deemed to be a ‘Foreign Financial Institution’ under FATCA will not need to enter into an individual FFI Agreement with the IRS.
FW: Some critics of new fund regulations are sceptical about their effectiveness. Do you believe that the provisions and principles behind recent legislation will achieve the objectives of protecting investors and preventing another financial crisis?
Monaco: In the US, ‘new fund regulations’ is a misnomer – new regulations have impacted fund managers, not the funds themselves. The question is whether the unregistered status of fund managers, and a lack of transparency into the activities of the funds they managed, contributed to the financial crises. We do not believe these factors led to the last crisis, or that the imposition of regulation and greater reporting will forestall another crisis in the future – although additional reporting by fund managers on Form PF will provide regulators with information on market activity and leverage that could be helpful in understanding forces impacting the financial markets. We disagree with the current initiative to consider imposition of another layer of ‘prudential’ regulation on certain large asset managers as ‘systemically important financial institutions’. We believe existing regulation of these managers is sufficient, particularly since they were not at the centre of the last crisis.
Fitzgibbons: I absolutely do not think that the legislative objectives will be achieved. Hedge funds were affected by the 2008 financial crisis but they were not responsible for it, in fact they acted as an additional source of liquidity at a time when it was desperately needed. The new regulations are more about seeking a greater control of capital and information to maximise tax receipts. The withholding taxes charged in the US under FATCA, and the taxes from more managers and investment funds having to domicile or set up parallel structures in Europe to comply with AIFMD, will benefit those jurisdictions. Investors themselves will be faced with less choice, more due diligence, less privacy and higher costs, and it is highly questionable whether they will get any additional protection in return.
Procknor: The Brazilian capital markets have always been heavily regulated. Therefore, the financial crisis has not caused a significant impact on our regulatory framework. Changes and improvements have been made over the years, but asset managers, distributors and funds have always been registered in Brazil and subject to ongoing supervision by the CVM. I am not so sure that provisions and principles behind recent legislation will achieve the objectives of protecting investors, but heavy supervision, high transparency, disclosure and suitability rules seems to be the best way to go.
FW: What developments in funds regulation do you expect to see over the coming years? Can we expect additional oversight and scrutiny of fund manager and their activities?
Procknor: The CVM is willing to engage in dialogue with the industry and is sensitive to its needs, to allow new structures and products targeted at qualified and sophisticated investors, and to learn by successful initiatives from other jurisdictions. However, I do expect additional oversight and scrutiny of fund managers and their activities in the near future, especially with respect to retail funds.
Monaco: The final Volcker Rule will impact the fund industry, although what impact is unclear. If adopted as proposed, many banks will divest their fund management businesses, and will be limited in the amount of capital support they can provide funds. Although the SEC has liberalised private funds’ ability to conduct ‘general solicitations’, the SEC and state regulators will likely increase scrutiny of fund marketing materials and compliance with limitations imposed on advertised offerings. Another focus of the SEC is technology and how funds use it in executing investment strategies – for example, high-frequency trading. The SEC is also trying to build up its own technology – such as the new ‘consolidated audit trail’ – to better understand market events like the ‘flash crash’ of 2010 and the trading activity of market participants. The greater the SEC climbs on its own learning curve, the more we can expect to see in regulation through rulemaking and enforcement.
Fitzgibbons: There is a current trend towards increased reporting obligations, more tax information sharing, and greater regulation of alternative investment funds and managers. It is likely we will see FATCA-style legislation from the UK and possibly other jurisdictions in the near future. The funds industry will survive and perhaps ultimately be strengthened by these changes, but in the short to medium term the cost is likely to be a changing regulatory landscape and a significantly increased compliance burden. Offshore jurisdictions like the Cayman Islands will continue to adapt their regulatory regime and cooperate with onshore regulators in order to remain the preferred domicile for alternative investment funds.
© Financier Worldwide
Mattos Filho, Veiga Filho, Marrey Jr. e Quiroga Advogados
Stephanie M. Monaco
Mayer Brown LLP