U.K. BASED HEDGE FUND MANAGERS:
THE LAW, THE NEW LAW AND THE US COMPARISON
By Peter Astleford, William Yonge and Paul Weisenfeld *
London is the recognized centre in Europe for hedge fund managers. In addition to a fast
growing number of European hedge funds which have been setting up shop in London
over the past ten years, the large US based hedge funds are increasingly opening
operations in London. This article presents the major aspects of UK regulations
applicable to hedge fund managers and fund marketing and highlights the salient
differences from US regulations applicable to similar situations.
UK hedge fund managers will normally require authorisation under the Financial
Services Act 1986 (the “Act”). In practice, most achieve this by membership of the
Investment Management Regulatory Organisation Limited (“IMRO”), a self-regulatory
organisation. Accordingly, where relevant this article focuses on IMRO regulation. The
newly enacted Financial Services and Markets Act 2000 (the “New Act”) will come into
force later this year or during 2001 and the relevant regulator will then be the Financial
Services Authority (“FSA”). In practice, most IMRO functions are already carried out by
In contrast, US hedge fund managers may avoid investment adviser registration with the
Securities and Exchange Commission (“SEC”) provided they have had fewer than 15
clients in the preceding year (a fund will usually count as one) and do not “hold
themselves out” to the public as investment advisers. In addition, investment adviser
registration with the SEC is generally unavailable to managers with less than US$25
million under management. The position from State to State can vary but is generally
more relaxed than in the UK.
There are two options for establishing a business in the UK: branch or company. An
existing US operation may wish to open a branch in London rather than incorporate a
subsidiary although the latter route should shield the US parent from UK liability. Start-
ups on the other hand will normally be corporate. Those wishing to benefit from the
“European Passport” under the Investment Services Directive (“ISD”) would need to be
incorporated in Europe.
The IMRO application process
When authorising a new applicant, IMRO’s three key concerns are:
• Is its business plan viable?
• Will its capitalisation be sufficient throughout the start-up phase?
• Will it be compliant?
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The application must be made on the standard IMRO application forms accompanied by
supporting documentation such as draft customer agreements, offering documents for the
fund and a compliance manual. It generally takes around three months for IMRO to
process a fully completed application. Preparation of the forms takes between one to four
weeks with good lawyers. The IMRO application comprises an application for
membership covering the applicant’s corporate structure, a business plan questionnaire
covering the rationale for establishing the business, a compliance arrangements
questionnaire and financial resources questionnaire incorporating the financial
calculations and projections for the first year.
Applications for individual registration also have to be made for each “key” individual.
All “controllers” (shareholders owning 10% or more) need to be detailed to IMRO and
any individuals owning 30% or more must provide a net asset value statement.
The applicant must appoint a Compliance Officer who may also have other roles such as
Investment Manager or Finance Officer, provide drafts of procedures, notices and
agreements issued to staff or customers from the date of authorisation and detail the
intended internal staff training arrangements.
The applicant’s lawyers will work with its auditors to complete the financial resources
questionnaire. The financial resources requirement will depend on the proposed business
of the applicant and whether it falls within the ISD. Discretionary hedge fund managers
will usually fall under the ISD and if they do not propose to hold client money or assets
or trade for their own account will usually have a financial resources requirement of Euro
50,000 and a liquid capital requirement based on 13 weeks’ expenditure. Additional
sums may be required to reflect particular risks.
In contrast, even if regulated by the SEC, US based hedge fund managers will not be
subject to any such requirement, although certain SEC registered (and some State
registered) hedge fund managers of investment partnerships deemed to have custody over
client assets may be required to supply audited financials and be subject to annual
surprise audits unless an independent client representative is retained by the fund to
approve payments and disbursements by the fund to the manager and its affiliates.
On registration, individuals who perform “registrable activities” need to register
individually with IMRO. Registrable activities include being directors, individuals in a
senior management role (e.g. chief executive, compliance officer and finance officer),
investment managers and dealers. IMRO actively verifies information produced during
the registration process to ensure “fitness and properness”. Non-disclosure will be
looked upon gravely by IMRO.
On submission of an application to IMRO, the applicant is assigned to an IMRO officer
who reviews the forms and supporting documents, conducts enquiries both directly with
the applicant’s lawyers and with third parties. IMRO will visit the applicant’s offices and
interview key personnel to assist in determining whether the applicant and key personnel
are fit and proper.
Provided the final interview goes well, IMRO will suggest a date on which the
application will be considered by IMRO’s Authorisation Committee. If the Committee is
satisfied that the necessary requirements for authorisation are present, it will authorise the
applicant but may impose a number of special conditions such as independent quarterly
compliance reviews or a limit on the number of customers.
Training and Competence
Authorised firms must identify staff engaged in investment management, advice or
certain senior administration functions. These individuals must be categorised as either
“threshold competent” (able to perform their role without direct supervision) or
“trainees” (supervision required).
To achieve threshold competence an individual must generally have passed an
appropriate IMRO approved, recognised or accredited exam and an assessment by his
employer to determine that he possesses the requisite knowledge and experience. In the
case of persons with substantial investment experience outside the UK, IMRO may waive
the examination requirement but practice has shown that unless the individual has
experience of UK regulation, he will nonetheless be required to pass the regulatory
The SEC has no equivalent requirements for investment managers, although a number of
States do have examination requirements.
Ongoing annual membership fees are set every year and depend on gross annual income
and the amount of funds under management. For the period April 1999 to March 2000,
they ranged from £820 to £2,475 (fixed fee) plus a further fee (0.005581%) of funds
under management. Managers must restrict their business to that which has been
specifically agreed by IMRO. A newly authorised manager will be monitored by the
IMRO Corporate Admissions team for the first 6-12 months. IMRO will then proactively
work with the manager to help it focus on the practical realities of compliance.
Thereafter it will be subject to more stringent (but less frequent) IMRO member
A brief overview of the main rules is given below.
Conduct of business rules: Managers must comply with the conduct of business rules in
areas such as:
• investment advertisements, inducements and soft commissions;
• establishing whether customers have private or non-private status (the non-private
customer regime is lighter) and contents of customer documentation;
• trade allocation;
• timely and best execution; and
• disclosure of material interests.
Financial records and reporting rules: Managers must submit audited annual financial
returns,auditor’s reports and, usually, unaudited quarterly financial returns to IMRO.
Compliance, reporting, records and complaints rules: Managers must have written
compliance procedures. This requirement is normally satisfied through the compliance
manual. We can draft compliance manuals which contain procedures which enable
compliance with more than one regulator’s requirements, e.g., SEC and IMRO.
Managers must ensure that employees are suitable, adequately trained and properly
supervised. At least annually, managers must provide IMRO with confirmations as to its
business, compliance with rules and complaints statistics, etc.
Managers must take reasonable steps to ensure that staff conform with the regulatory
system, the statutory restrictions on insider dealing and propriety in personal dealings.
This will necessitate a personal account (“PA”) dealing procedure which will be set out in
the compliance manual and provision for prior clearance of most PA dealing.
Records must be kept, e.g. as to rule breaches, complaints and corrective action. These
records must normally be kept for a minimum of 3 years and may be inspected by IMRO.
There is an obligation to notify serious rule breaches immediately to IMRO.
Certain events require notification to, or pre-clearance by, IMRO. For example,
clearance events include a change of controller or chief executive. IMRO will visit
managers for compliance inspections and make ad hoc visits concentrating on a particular
IMRO have the power to investigate managers which can lead to disciplinary
proceedings. IMRO may:
• issue private written warnings;
• exercise powers of intervention, for example prohibiting a firm from carrying on
investment business and, if appropriate, with publicity;
• levy summary fines; and/or
• close down the business.
Interestingly, the UK regulators do not appear to have hardened their attitude towards
hedge fund managers despite publicised scandals relating to the industry in the United
As noted above, SEC investment adviser registration is largely voluntary for many hedge
fund managers operating in the United States. Advisers that do not provide investment
advisory services outside of the fund context, advise fewer than 15 funds and do not hold
themselves out to the public as investment advisers are not required to register with the
SEC as investment advisers. Hedge fund managers registered with the SEC must comply
with certain regulatory restrictions that require the manager to obtain client consent for
principal and agency trades between the manager (or its affiliates) and the fund, to
comply with certain restrictions on advertising, to limit the charging of performance-
based fees to certain high net worth individuals and to comply with a rule governing the
manager's ability to pay cash solicitation fees for the referral of clients to the manager.
Registered managers also will generally maintain written compliance procedures and are
subject to periodic examinations by the SEC staff. In addition, regardless of whether a
hedge fund manager is registered with the SEC, the manager will be subject to the
antifraud provisions under applicable law.
Following an initial examination, on-site examinations will typically occur every four
years. In this regard, books and records of the manager must generally be maintained for
a period of no less than five years. Aside from certain quarterly reporting requirements
on securities holdings that are only applicable to larger investment advisers (regardless of
the status of investment adviser registration), SEC registered investment advisers are
required to complete a Uniform Application for Investment Adviser Registration - or
Form ADV (the form of which is currently in the process of being amended), subject to
annual amendments and interim amendments in certain circumstances. However, absent
extraordinary circumstances, the SEC’s regulatory involvement in the day-to-day
operations of hedge fund managers tends to be more disclosure based and far less “hands-
on” than its UK counterparts. SEC-registered hedge fund managers are, however,
burdened with detailed requirements and an obligation to disclose (in the Form ADV)
their business practices in respect of, inter alia, areas such as soft commissions, trade
allocations and participation or interest in client transactions.
The ISD is one of a series of directives designed to implement a single market in
financial services throughout the European Economic Area (“EEA”). While no European
retail hedge fund product exists, UK hedge fund managers authorised by IMRO as ISD
firms may conduct business throughout the EEA following certain registration
formalities. As noted, a UK branch of a non-EEA business will not be eligible for the
passport. Accordingly, a US business which wishes to set up a business in Europe to
benefit from the passport will need to be incorporated locally.
The manager’s services may be structured outside the ISD requirements with
consequential lower capital adequacy requirement but this will lead to inflexibility of
operation and lose the benefits of the passport.
UK financial regulatory reform
The various financial services regulators have, in practice, already been rolled into one,
the FSA. When the New Act comes into force, the existing regulators will finally fall
away. The FSA will be solely responsible for regulating all firms that conduct
investment business including management of hedge funds. In due course rules and
guidance in relation to hedge fund managers will be found in a new FSA Handbook.
A code of market conduct (the “Code”) will be brought into effect to support the FSA’s
role in policing market abuse. The Code may prove of particular relevance to certain
hedge fund managers (for example, highly leveraged funds with strategic positions in a
The FSA will have increased disciplinary powers, e.g.:
• unlimited civil fines in the case of market abuse;
• orders to disgorge profits and compensate victims; and
• the power to take action against individuals or companies whether regulated or not
and to require anyone to answer questions and to produce documents.
The combination of the FSA’s abilities to levy unlimited fines and the new Code should,
according to Michael Foot, Head of Financial Supervision at the FSA, “further enhance
London’s reputation for clean and fair markets”. Other commentators have suggested it
may make London a harsh place in which to do business.
Civil fines and profit disgorgement of profits are remedies that are also available to the
SEC to combat abuses committed by hedge fund managers. The anti-fraud provisions of
the US Investment Advisers Act of 1940, as amended (the “Advisers Act”), apply to all
firms and persons meeting the definition of investment adviser, whether registered with
the SEC, a state securities authority, or not at all. These provisions prohibit
misstatements or misleading omissions of material facts and other fraudulent acts and
practices in connection with the conduct of an investment advisory business. As a
fiduciary, a hedge fund manager owes its clients undivided loyalty, and may not engage
in activity that conflicts with a client’s interest without fully disclosing the conflict of
interest to its clients. In recent years, the SEC has become more zealous in its
enforcement of the anti-fraud provisions of the Advisers Act and, on occasion, has even
brought enforcement proceedings against private investment advisers who were not
registered under that Act.
Promotion of hedge funds in the UK
The promotion of hedge funds in the UK is currently regulated by Sections 56, 57 and 76
of the Act. Section 56 prohibits the making of unsolicited telephone calls or personal
visits with a view to promoting investment except as permitted by regulations.
Section 57 prohibits the publication of investment advertisements in the UK unless they
have been issued or approved by an authorised person in accordance with the rules of its
regulator. An authorised person must ensure that advertisements are fair and not
misleading and that appropriate expertise has been applied in composing the
advertisement or approving itand that any relevant risk warnings are included.
There are a number of exemptions from Section 57 which, in effect, allow hedge funds to
be promoted to or through:
• persons authorised under the Act, e.g. to private client, investment managers and
• investment firms established in other EEA states carrying on passported business in
the UK under the ISD;
• financial journalists;
• governments, local and public authorities;
• companies which have (or any of whose subsidiaries or parent companies have)
called up share capital of not less than £5 million (or £500,000 provided the company
or its holding company has more than 20 shareholders);
• unincorporated associations with net assets of not less than £5 million; and
• trusts which have (or have had during the last two years) cash and investments
(before deductions) with an aggregate value of not less than £10 million or, even if
they do not qualify under this size test, whose trustee itself qualifies under the above
There are a number of other smaller exemptions. The Act does not regulate non-UK
marketing. However, these categories do not include private customers in the UK no
matter how wealthy or experienced they may be, unless they meet one of the criteria set
out above. As part of the consultation process on regulatory reform, the Government
suggested including an exemption for individuals who satisfy a net worth test. A
decision is expected shortly.
UK authorised persons may also, where appropriate, market hedge funds to, inter alios:
investors in similar funds; an “established customer” for whom the investment is suitable;
and individuals sufficiently experienced and knowledgeable to waive the protections
normally afforded to private customers.
Generally, the promotion of hedge funds in the US is regulated by the US Securities
Exchange Act of 1934, as amended (the “Exchange Act”), the US Securities Act of 1933,
as amended (the “Securities Act”), and the US Investment Company Act of 1940, as
amended (the “Company Act). Under the Exchange Act, parties promoting the sale of
interests in a hedge fund are generally required to be registered as or associated with an
appropriately licensed broker-dealer, unless an exemption therefrom is available. The
exemption most frequently relied upon is a safe-harbour commonly referred to as the
“issuer-exemption,” which may be available to persons sufficiently close to the hedge
fund itself (i.e., a senior executive of the general partner of a limited partnership hedge
fund), whose compensation is not based upon the sale of such interests (i.e.,
commissions) and are not otherwise affiliated with a registered broker-dealer.
In the context of the Securities Act and the Company Act, the manner in which a hedge
fund is promoted must not, inter alia, constitute any form of general solicitation or
general advertising. Promotions that constitute a general solicitation or general
advertising would subject the fund to registration under the US Investment Company
Act , and the sale of its interests to registration under the Securities Act . SEC rules,
interpretations and case law have established various factors to consider in determining
whether a general solicitation or general advertising has taken place, or whether a
particular offering is public or private, all of which are consistent with the notion that the
sale of interests in a hedge fund must generally be conducted by means of a private
placement of the securities of the hedge fund. Not surprisingly, additional regulatory
concerns will be raised in the context of any promotion of a hedge fund where the
promoter, sponsor or any similar party fails to state a material fact or otherwise materially
misstates the facts relating to the offer of securities, or engages in any other fraudulent
Note: the contents of this article are of general application only. Readers must rely on
specific advice received on their individual position.
* Peter Astleford is a partner with international law firm Dechert. William Yonge is a
senior associate at Dechert in London and Paul Weisenfeld is an ex. senior associate of
our Dechert New York office.