A Q&A guide to investment funds law in the UK (England and Wales).
This Q&A is part of the PLC multi-jurisdictional guide to investment funds. It provides a high level overview of investment funds in the UK (England and Wales), looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.
The funds market in the UK is mature. Retail funds are launched either as:
Undertakings for collective investment in transferable securities (UCITS) funds.
Non-UCITS retail funds (NURS).
They can be structured as open-ended investment companies (OEICs) or authorised unit trusts (AUTs). Funds of alternative investment funds (FAIFs) can also be launched (these are funds sold to retail but which can invest in unregulated schemes, such as hedge funds).
Qualified investor schemes (QIS) can also be established but cannot be sold to retail.
GB£546.7 billion of assets were under management in UK funds as at September 2011 (Investment Management Association) (as at 1 November 2011, US$1 was about GB£0.6).
There is a discernable reduction in the trend for new fund launches and the focus is more on consolidation and amendments to existing products. The implementation of Directive 2009/65/EC on undertakings for collective investment in transferable securities (UCITS) (UCITS IV Directive) and, in particular, the Key Investor Information Document (KIID) has been a key focus for many fund houses over the last year.
The market for closed-ended retail funds is long established.
As at 1 November 2011, the Association of Investment Companies (the trade body representing closed-ended funds) had 350 member companies and the industry had total assets of approximately GB£89.9 billion.
Closed-ended funds can be formed under special regimes for venture capital trusts and real estate investment trusts. Closed-ended funds in other jurisdictions, including Guernsey, are also marketed.
Regulatory framework. The main legislation governing funds includes:
The Financial Services and Markets Act 2000 (FSMA).
The Open-ended Investment Companies Regulations 2001 (OEIC Regulations), for OEICs only.
Various statutory instruments made under FSMA including the:
Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO);
Financial Services and Markets Act 2000 (Regulated Activities) Order (RAO).
All retail funds must also comply with regulations made by the Financial Services Authority (FSA) in the Handbook of Rules and Guidance (FSA Rules), the most relevant of which is the Collective Investment Schemes Sourcebook (COLL).
Regulatory bodies. The regulator for open-ended retail funds is the FSA. The FSA will be split into three bodies at the end of 2012 and open-ended retail funds will come under the remit of the Financial Conduct Authority (FCA).
Regulatory framework. The key provisions are the:
Companies Act 2006 (CA 2006).
Corporation Tax Act 2010 (TA).
Investment Trust (Approved Company) (Tax) Regulations 2011 (ITR).
Listing Rules, that is, the following combined FSA Rules:
Listing Rules (LR);
Disclosure and Transparency Rules (DTR).
Conduct of Business Sourcebook Chapter 4 (COBS 4) in relation to marketing.
Regulatory bodies. The regulatory bodies are:
FSA for listing and marketing requirements.
The Department for Business, Innovation and Skills (BIS) for CA requirements.
HM Revenue and Customs (HMRC) for taxation requirements.
To be sold to retail investors in the UK, collective investment schemes must either be:
Authorised by the FSA, if a UK domiciled fund.
Recognised by the FSA under FSMA if established in another jurisdiction.
There are slight differences in the application process for AUTs and OEICs but in practice the process of authorisation is very similar. An application must be made to the FSA with the following documents:
Draft instrument of incorporation (OEIC) or trust deed (AUT).
Application form (including a three year business plan).
KIID for a UCITS.
Solicitors' certificate confirming that the constitutive documents comply with FSMA and OEIC Regulations.
The FSA has two months to consider a UCITS application and up to six months to consider a NURS application. In practice a NURS application typically takes between eight to 12 weeks.
Funds established in the EU can be recognised for sale in the UK under section 264 of the FSMA. This process is carried out regulator-to-regulator using a streamlined process introduced under the UCITS IV Directive. The home state regulator must be provided with the following documents relating to the fund to be recognised:
Instrument constituting the fund.
Latest annual report and any subsequent half yearly report.
Notification letter to regulator.
The home state regulator then passes the documents to the FSA.
Certain schemes (equivalent to UK authorised schemes) established in Jersey, Guernsey and the Isle of Man can be recognised for sale in the UK under section 270 of the FSMA, subject to submission of the following:
Instrument constituting the fund.
Latest annual report and any subsequent half yearly report.
Any other document affecting the rights of participants in the scheme.
Certain comparable funds from other jurisdictions can also be recognised for sale in the UK using section 272 of the FSMA. For this to happen, the FSA must be satisfied that:
Adequate protection is given to investors.
Provisions for the fund's constitution and management are adequate.
The powers and duties of the operator and the trustee (if any) are adequate.
In practice, it is very rare for funds to be recognised under this provision.
UK-based investment trusts are structured as English or Scottish public limited companies (PLCs). They do not need FSA authorisation.
They must obtain the HMRC's approval (Chapter 4, Part 24 CTA), to be classified as investment trusts for tax purposes in order not to be taxed on their capital gains (see Question 13). To obtain this approval their shares must be listed on the London Stock Exchange.
Once a plan is authorised or recognised it can be sold freely to the public either through the fund operator or through a distributor or other, usually, authorised person.
The same rules apply as for open-ended retail funds (see above, Open-ended retail funds).
Retail funds once authorised or recognised can be sold to all categories of investor in the UK.
Investment trusts can be freely marketed to UK retail customers.
The FSA requires a manager to be authorised to manage funds. Foreign managers can manage local retail funds if they fulfil the requisite criteria (see below).
In addition to the respective requirements below, the COLL also sets out the duties and functions of retail fund managers.
AUTs. The FSMA sets out specific requirements for key criteria for AUT managers.
An AUT manager must:
Be independent from the trustee.
Be a body corporate incorporated in the UK or another European Economic Area (EEA) state, and its affairs must be managed in the country in which it is incorporated.
Have a place of business in the UK or another EEA state.
Have the relevant FSA permissions to act as a manager.
OEICs. The OEIC Regulations set out specific requirements for key criteria for OEICs' authorised corporate directors (ACDs).
If an ACD of an OEIC is the sole director it must:
Be a body corporate which is an authorised person.
Have permission under the FSMA to act as sole director of an OEIC.
Investment trust managers must be authorised by the FSA if carrying on business in the UK (see also Question 3, Closed-ended retail funds). They are subject to some of the FSA Rules, including the Sourcebook on the Senior Management Arrangements, Systems and Controls (SYSC) and COBS.
Foreign managers can manage UK investment trusts. Investment trust directors must report annually whether the continued appointment of the manager is in the shareholders' interests as a whole (LR 15.6.2(2)).
Retail funds must appoint an entity to hold the assets that must be either a:
Trustee, if the structure is an AUT.
Depository, if the structure is an OEIC.
The FSMA and the OEIC Regulations set out the requirements for trustees and depositaries respectively. COLL sets out the duties of depositories and trustees. The Client Assets Sourcebook (CASS) sets out custody of asset requirements
AUTs. Trustees must be:
Authorised as a trustee.
Independent from the manager.
Established in the UK or another EEA state and have a place of business in the UK.
OEICs. Depositories must:
Be a body corporate established in the UK or another EEA state.
Have a place of business in the UK.
Have their affairs administered in the country in which they are incorporated.
Be authorised persons.
Have permission to act as a depository.
Investment trust assets are generally held by either:
Custodians do not have to be separate from managers. Single firms can act as both manager and custodian. Custodians must be authorised by the FSA and are subject to the FSA Rules, in particular the rules relating to custody of assets under the CASS.
Legal vehicles. Funds in the UK can be set up with a company structure (OEIC) or as a trust structure (AUT).
An OEIC has an instrument of incorporation similar to the memorandum and articles that govern companies. OEICs have many of the usual characteristics of a company, for example they have:
A separate corporate identity.
A single director or directors.
OEIC shareholders do not own the OEIC's property, they own shares in the OEIC, which gives them a number of legal rights. OEICs can be structured as single funds or as umbrella funds, split into a number of separate sub-funds, each treated as an OEIC in its own right.
AUTs have trust deeds made between managers and trustees. Unitholders own the unit trust's investments, which are held on trust by the trustee for the benefit of unitholders. AUTs can be structured as single funds or umbrella funds, which each sub-fund treated as an AUT in its own right.
In OEICs and AUTs the share or unit price is directly related to the value of the underlying investments.
The FSA has sought to level the playing field between OEICs and AUTs over the years such that there are few differences between them.
Advantages. The advantage of OEICs is that they tend to be more marketable in other jurisdictions due to familiarity with the company structure.
An advantage of AUTs is that trust law ring-fences sub-funds of umbrella unit trusts, which means that each separate sub-fund is protected from the liabilities of other sub-funds.
Disadvantages. Umbrella OEICs do not currently have ring-fencing between sub-funds, although a protected cell regime is due to be implemented in 2012 (see Question 14).
Unlike an OEIC, because of its trust structure an AUT is less marketable in other jurisdictions.
Legal vehicles. Generally, investment trusts are structured as English or Scottish PLCs and their shares are listed and traded on the London Stock Exchange's main market.
Investment companies quoted or traded on the Alternative Investment Market (AIM) or other markets do not qualify for investment trust tax status.
Advantages. There are two main advantages of investment trusts for investment managers:
Investment trusts are not FSA authorised and therefore have considerable freedom in setting their investment policies and borrowing powers (see Question 9).
Managers can pursue the trust's investment policy without needing to sell assets to meet investor redemptions.
Disadvantages. The stock market determines the price at which shares in an investment trust trade. It is more common for shares to trade at a discount than at a premium to net asset value (NAV).
UCITS. The investment and borrowing powers for UCITS funds are set out in the UCITS Directive and are implemented in the COLL sourcebook. A UCITS scheme can invest up to 100% of the portfolio in the following asset classes:
Money market instruments.
Cash and near cash (for example, bank deposits and treasury bills).
Collective investment schemes.
Derivatives and forward transactions.
Schemes are subject to certain requirements including spread and concentration.
The main spread requirements for UCITS are as follows:
Up to 5% can be invested in transferable securities or money market instruments issued by a single body. The 5% limit can be raised to 10% for 40% of the portfolio.
Up to 20% can be invested in deposits with a single body.
Exposure to any one counterparty in a derivatives transaction cannot exceed 5% except where the counterparty is an approved bank where the exposure can be up to 10%.
No more than 20% can be invested in transferable securities and money market instruments issued by the same group.
No more than 20% in value can be invested in units of any one collective investment scheme.
Not more than 35% can be invested in government or public securities unless certain provisions are complied with including:
only 30% of scheme property can be invested in a single issue;
the securities must come from six different issuers;
the names of the issuers must be set out in the prospectus.
UCITS funds can borrow up to 10% of the fund's value on any day on a temporary basis.
NURS. A NURS can hold up to 100% of the fund in real property and invest up to:
10% in transferable securities issued by a single issuer.
10% in gold.
20% in unlisted securities.
35% in other collective investment schemes.
Up to 100% in a range of unauthorised collective investment schemes such as hedge funds, in the case of a FAIF.
A NURS can borrow up to 10% on a permanent basis.
Unlike open-ended funds, investment trusts' ability to invest or borrow are not subject to any FSA limitations. However, to maintain its London Stock Exchange listing an investment trust must both:
Have a published investment policy relating to asset allocation, risk diversification and gearing.
Obtain the prior approval of its shareholders for any material change to that policy.
An investment trust must also comply with requirements of the CTA, the ITR (from January 2012) and sections 833 and 834 of the CA 2006.
Retail funds buy and sell shares or units on each dealing day. There must be two dealing days a month.
Retail funds can be limited issue (that is, only a limited number of shares/units are issued or shares/units are only issued for a limited time (or both)).
Limited redemption can be imposed in NURS funds only where the NURS:
Is a property fund.
Offers some form of capital protection.
Is a FAIF.
Redemptions can be limited for up to six months.
It is also possible for retail funds that have a dealing point each business day to defer redemptions to the next valuation point (that is, the time each day that an investment fund is valued) if redemption requests in relation to a particular valuation point exceed 10%, subject to certain requirements.
Dealing in retail funds can be suspended. Generally, this only happens in exceptional circumstances and it is in the interests of all the fund's unitholders. The FSA and holders must be told of the suspension and holders must be kept up to date about the suspension and its duration.
The suspension must be formally reviewed every 28 days and the FSA informed of the results.
Investment trust shares are traded on the stock market and therefore, the investment manager has no influence over the buying or selling of the shares once they are in issue. The investment manager controls issues of new shares and share buybacks under the board of trust's supervision.
Managers can impose restrictions on shareholders or unitholders to ensure shares or units are not transferred to ineligible investors. Otherwise, shares in OEICs can be freely transferred.
Units in AUTs can be transferred if:
The registrar of the AUT approves the transfer.
The trust deed permits the transfer.
There is no stamp duty reserve tax payable or the trustee has been paid the amount of stamp duty reserve tax (SDRT) payable.
Investment trust shares are freely traded on the stock market and there are no restrictions on shareholders' rights to transfer or assign their interests to third parties. Share buybacks take place at the discretion of the trust and shareholders generally have no right to redeem their shares.
Investors. Reports and accounts must be provided to investors bi-annually. The following must be prepared for each annual accounting period and half yearly:
Short reports that are sent to all holders and include various prescribed information including the fund's investment activity and performance.
Long reports that are available to investors on request. Long reports must include certain prescribed information including the accounts and a report from the auditor and both the manager and trustee or depositary.
Regulators. Depositories and trustees must regularly report to the FSA.
Investors. Investment trusts must report twice a year to shareholders, with a long report every 12 months. The reports must meet the requirements of:
LR chapters 9 and 15.
Chapter 4 of the DTR.
Regulators. Investment trusts must file an annual report and accounts with the Registrar of Companies. The annual report must satisfy the FSA's LR. Investment trusts must also apply to HMRC for approval of investment trust status.
Funds. Authorised investment funds (AIFs) are generally exempt from UK tax on gains on the disposal of investments (including interest-paying securities, derivatives and certain offshore funds).
AIFs are generally exempt from UK tax on dividends, but taxable at 20% on other income (after deduction of expenses and, where relevant, interest distributions). No or little tax is generally paid. There are special tax regimes for certain types of AIF.
SDRT applies to transactions in shares or units and is generally borne by the AIF. The maximum rate is 0.5% but the effective rate is generally much less and often nil.
Resident investors. Generally, the basic position is that AIFs pay/accumulate dividend distributions. Individuals receive them with a tax credit and they are taxable at progressive rates (from 10% to 42.5%, which reduce to nil to 36.11% taking the tax credit into account). Corporate investors stream them (with the streams reflecting the make-up of the AIF’s income) and the dividend stream is generally tax-exempt, while the remainder is taxable at a rate of 26% until 31 March 2012, then 25%.
An AIF will pay/accumulate interest distributions when its interest-paying investments exceed 60% of its investments. These are generally paid/accumulated net of tax. Resident individuals are liable to income tax on interest distributions at progressive rates (from 10% to 50%, which reduce to nil to 37.5% taking the tax credit into account) depending on their personal circumstances. Corporates treat holdings in interest-paying AIFs as loan relationships, with the result that the income is taxable at 26% (reducing to 25%) and they must bring any contingent profits/losses on their holding into their profit and loss account for corporation tax purposes each year.
Residents are liable to capital gains tax (CGT) on gains realised on disposals (except where the loan relationship provisions apply).
Non-resident investors. Non-residents are generally exempt from UK tax on income from AIFs and from CGT on gains realised. There is also a special exemption from inheritance tax for non-UK domiciled investors (that is, very broadly those whose long-term base is in another country).
Funds. Closed-ended retail fund taxation is generally similar to the open-ended regime (see above, Open-ended retail funds). The tax rate is 26% (reducing to 25%), but in practice little if any tax is paid.
Resident investors. Residents are also generally in the same position as in open-ended retail funds (see above, Open-ended retail funds). The main exceptions are that:
Corporates are generally exempt from tax on their dividends.
Corporate streaming and loan relationship provisions do not apply.
Non-resident investors. Closed-ended retail funds for non-residents are treated similarly to open-ended funds, but without the inheritance tax exemption (see above, Open-ended retail funds).
Retail fund regulation was dominated in 2011 by the implementation of the UCITS IV Directive.
The main change proposed is the introduction of protected cell legislation in relation to UK OEICs at the end of 2011 or early 2012 (see Question 8). Currently, if a sub-fund is unable to meet its liabilities in an umbrella OEIC, a creditor may have access to the assets of other sub-funds in the OEIC to settle the liability (this is known as contagion).
The proposed legislation will ensure that an umbrella OEIC's sub-funds are ring-fenced from the liabilities of other sub-funds. The regime will be compulsory and there is likely to be a 12-month transitional/implementation period. Legislation is not required for AUTs as trust law already provides the required ring fencing.
There are no current material proposals for the reform of closed-ended retail funds.
Hedge funds are domiciled outside of the UK, usually in tax efficient jurisdictions (the Cayman Islands and Luxembourg, for example). However, London is widely recognised as a centre for hedge fund management houses.
The last year was a difficult year for a number of industry participants, although more recently there has been an increased level of activity.
There are numerous proposals for significant changes to the regulatory environment as it applies to hedge funds, including:
EU initiatives on Directive 2011/61/EU on alternative investment fund managers (AIFM Directive).
The central clearing of derivatives transactions.
The increased transparency on short selling.
The ban on short selling member states' debt.
There are a number of similar proposals currently being discussed in the US. These initiatives affect the way that hedge funds are structured, where they are domiciled and how they are operated.
Separately, some UCITS run strategies similar to hedge funds. QISs can use most of the investment strategies used by hedge funds.
The main statutes and regulations that govern UK-based hedge fund managers of offshore hedge funds are the:
Financial Services and Markets Act 2000 (Promotion of Collective Investment Schemes) (Exemptions) Order 2001.
FSA Rules, in particular the COBS.
The main regulatory body is the FSA, which regulates UK hedge fund managers.
There is currently no specific regulation in this area. The AIFM Directive will introduce regulation that will apply to the manager and will govern the operation of hedge funds (see Question 27). Managers of hedge funds will be required to:
Demonstrate the robustness of their risk management arrangements to the FSA.
Disclose information to the FSA on a regular basis.
There is currently no specific regulation in this area. The AIFM Directive will introduce requirements on managers. Separately, the Alternative Investment Management Association has issued a Guide to Best Practice for Hedge Fund Administrators.
There is currently no regulation of the hedge fund itself. However, the hedge fund manager, as an FSA-authorised person, must comply with the FSA SYSC. This, among other things, requires:
Appropriate individuals to fulfil controlled functions.
Appropriate conflicts of interest policies.
A proper system of record keeping.
A hedge fund manager carrying on business in the UK is subject to the:
FSMA and the FSA rules on market conduct (specifically market abuse).
Criminal Justice Act 1993.
A hedge fund is typically a private fund. As such, there is little regulation on transparency. There are no specific rules on the disclosure of the fund's accounts, performance data or other details of the fund beyond what is contained in the fund's offering documents. Following implementation of the AIFM Directive, there will be increased transparency requirements which will involve disclosure of information to both investors and the FSA.
The FSA's Money Laundering Regulations 2007 apply to hedge fund managers. As most hedge fund administrators are located outside the UK, administrators must comply with local anti-money laundering laws when dealing with subscriptions to or redemptions from a hedge fund.
The FSA has extended the disclosure regime for significant net short positions in the shares of UK financial sector companies that was originally due to expire on 30 June 2009. Disclosures must be made if a net short position either:
Exceeds 0.25% of a company's issued share capital (defined by the FSA for this purpose as a significant short position).
Increases by 0.1% bands above that (for example, the net short position reaches 0.35%, 0.45% and so on).
On 15 November 2011, the European Parliament voted into law a regulation on short selling and credit default swaps, which is intended to:
Regulate short selling and trading in credit default swaps (including disclosure and transparency requirements). (Under a credit default swap, the seller must compensate the buyer in the event of a loan default.)
Introduce a ban on certain credit default swap trades (for example, on sovereign debt of member states).
The new regulation must be formally approved by the European Council and will come into force in November 2012.
An authorised person can market hedge funds in accordance with COBS 4.12, which provides exemptions to the restrictions on marketing collective investment schemes in section 238 of the FSMA.
An unauthorised person can market hedge funds so long as the recipient or intended recipient falls within one or more of the exemptions contained in FPO.
Subject to certain restrictions set out in the FPO, both authorised and unauthorised persons can market hedge funds to certain types of investors, including:
Investment professionals (authorised persons, for example).
Certified high net-worth individuals, provided that the fund invests predominantly in unlisted investments.
High net-worth companies including unincorporated associations (unincorporated associations or partnerships that have net assets of not less than GB£5 million, for example).
Self-certified sophisticated investors.
In addition, only authorised persons can market hedge funds to the groups of investors that fall within the exemption in COBS 4.12, for example:
Persons who are already participants in unregulated collective investment schemes.
Persons for whom the firm has taken reasonable steps to ensure that investments in collective investment schemes are suitable and who are established or newly accepted clients of the firm or of a person in the same group as the firm.
Only investors to whom hedge funds can be marketed can invest in them (see Question 19).
There are also specific rules on who is eligible to invest in a QIS. Broadly, the restrictions are similar to COBS 4.12 (see Question 19).
A hedge fund's assets are usually held by the fund's prime broker. Many of the London-based prime brokers (that is, investment banks) act as prime broker to hedge funds that are managed out of London. Where the hedge fund's assets are held by prime brokers located in London, the CASS applies to those prime brokers.
Some hedge funds have a separate custodian who holds certain assets and, following the implementation of AIFM Directive, all hedge funds located in or sold into the EU will be required to have a separate depository.
The key disclosure or filing requirements are governed by the filing requirements that apply in the fund's location. For the disclosure and filing requirements for UCITS and QIS, see Question 3.
UK hedge fund managers must comply with COBS and SYSC. This is the case irrespective of where the fund is located. Hedge funds are not domiciled in the UK, but UK hedge fund managers regularly manage hedge funds located offshore.
There are no onshore hedge funds in the UK. There are UCITS that implement hedge fund type strategies in the UK (see Question 8). QIS can also use most of the strategies used in offshore hedge funds (see Question 8).
Hedge funds are formed outside the UK and are generally structured to avoid any UK tax arising.
Residents are subject to income tax on capital gains realised on the disposal of holdings unless the fund is certified by HMRC as a reporting fund through either distributing or reporting its income annually to UK investors who pay tax on it, if gains are subject to CGT. The income is deemed to be interest and corporates are subject to the loan relationships provisions if the fund holds over 60% interest-paying investments (see Question 13).
Typically, interests can be transferred, subject to any restrictions contained in the fund's offering documents.
The AIFM Directive was approved by the European Commission and the European Parliament on 10 November 2010. Member states must bring it into force by 22 July 2013.
The AIFM Directive applies to all hedge fund managers except managers who only manage small funds, that is, those whose assets under management do not exceed:
EUR100 million (if the fund uses leverage) (as at 1 November 2011, US$1 was about EUR0.7).
EUR500 million (if the fund does not use leverage and there are no redemption rights exercisable during a period of five years from the date of initial investment in the fund).
The AIFM Directive will place obligations on fund managers in respect of risk management, treatment of investors, leveraged funds, and marketing in the EU. It also requires that a hedge fund appoint a depository.
The proposals for central clearing of derivatives are likely to come into force towards the end of 2012. These will require hedge funds to centrally clear derivatives transactions.