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The Jersey Law Review – June 2005

INVESTMENT FUNDS IN THE CHANNEL ISLANDS -

COMPETITION REKINDLED

Simon Howard

1       At a time when increasing reference is being made to the need for greater co-operation between Jersey and Guernsey on economic and governmental initiatives it is interesting to note that the spirit of competition between the islands is alive and well in at least one area of financial services activity which is common to both islands.  A general view has prevailed for some time in Jersey that Guernsey has offered certain advantages over Jersey as a domicile for investment fund vehicles, and has also enjoyed advantages in the area of servicing the operational needs of investment funds established outside the Channel Islands.  In the course of 2004, however, a determined effort was made by the Jersey Financial Services Commission, in its role as the regulatory body for investment fund business, working in conjunction with the Jersey investment funds community, to end the regulatory arbitrage which had opened up between the islands.  In the process we have witnessed move and counter-move between the islands in the past eighteen months as each has introduced a series of rapid reforms to their regulatory regimes to increase the appeal of each island as a location for setting up and servicing investment fund structures.  The success of the Jersey initiatives is attested by the speed with which Guernsey has initiated or accelerated its own reviews and reforms of certain areas of its fund regulations.

2       The purpose of this article is to examine on a broad perspective some of the strengths and weaknesses of the funds regime in both islands, to review the initiatives and reforms that each island has introduced within the past eighteen months, and to offer some thoughts on dangers to which the current race for change may be exposing the island fund industries.  At the outset it may be helpful to provide some definition of what an investment fund is and to reflect briefly on two major forces, external to the islands, one economic and regulatory, which have shaped the fund industries that we currently have in the Channel Islands.

3       An investment fund is essentially a structure to facilitate the collective investment of capital by means of pooling of monies from two or more investors and the spreading of risk through the acquisition of a portfolio of investments with the objective of providing the participating investors with the benefit of the results of the management of the investment portfolio.  These key characteristics are to be found in both the Guernsey definition of a collective investment scheme and the Jersey definition of a collective investment fund.[1] Investment funds in the Channel Islands typically take the form of limited liability companies, unit trusts or limited partnerships.  In its origin the investment or mutual fund concept was developed in the United States in the 1930s to enable retail investors to benefit from professional investment management services and, through the economies of scale achieved through pooling of assets, to participate in securities markets that individually such investors did not have sufficient resources to access.  In recent decades the role of institutional investment into fund vehicles has grown dramatically with large sections of the global asset management industry servicing the investment needs of insurance companies, pension funds and investment banks.  It is this latter sector which has risen to prominence for the Channel Islands fund management industry for reasons explained below. 

4       The advent of the UCITS Directives[2] in Europe seeking to harmonise the establishment and marketing rules for investment funds aimed at retail investors across the EU and to provide for single passporting of funds established in one Member State into the market place in other Member States spelled the beginning of the end of retail funds business in the Channel Islands back in the 1980’s, and provided the foundation for first Luxembourg and more recently Dublin to emerge as pre-eminent investment fund centres within the EU.  Excluded from the scope of the UCITS legislation due to the constitutional relationship of the Channel Islands with the EU, the focus for fund management in the Channel Islands in the past decade has switched over to more specialised fund products and services targeted at sophisticated and institutional investors which fall outside the scope of the UCITS legislation and where for the time being there is regulatory and sometimes fiscal advantage in basing such vehicles in offshore locations. In such locations legal and regulatory regimes can be more favourable towards innovative fund structures and investment techniques. 

5       The emergence of new asset classes within the global asset management industry has also shaped the Channel Islands fund sector.  Both Jersey and Guernsey were well placed to capitalise on the growth of private equity business in the late 1990s, having enacted limited partnerships legislation[3] just in advance of this new type of investment activity becoming popular.  This must be one of the rare instances of the islands fortuitously having put legislation in place in advance of market demand.  Alternative investment strategies and the growth of hedge funds are the latest trends that the islands’ fund sectors are having to develop their experience in and reputation for.  But Jersey’s ability to capture more investment funds business has been handicapped by a number of features of the regulatory regime which date back to 1988.  Guernsey, by contrast, has been perceived in recent years by many introducers of business located outside the Channel Islands as a more user friendly jurisdiction for investment fund business.  Three key differences between Jersey and Guernsey can be identified as contributory reasons to Jersey’s recent doldrums in the funds arena and Guernsey’s preferred status.

6       The primary regulatory statutes for investment funds business in Jersey and Guernsey[4] adopt quite different approaches to the categorisation of funds and the level of regulatory supervision applied as a consequence of that categorisation.  In Jersey, the fundamental question which has to be answered when considering any fund proposal is whether the vehicle will fall to be regulated as a public fund or a non-public fund.  This issue turns on the question of the marketing and availability to investors of units, shares or other interests in the fund in question.  Under Jersey law any offering of collective investment fund securities to more than fifty prospective investors or any proposal to obtain a listing for collective investment fund securities within twelve months of the launch of the vehicle results in the fund being classified as a public collective investment fund.[5]  As a consequence, Jersey-based service providers to such a fund fall to be regulated by the Jersey Financial Services Commission under the Collective Investment Funds (Jersey) Law 1988 as amended (“the 1988 Law”) which is the principal regulatory statute in Jersey governing investment funds.  By contrast, funds which are offered on a restricted basis to not more than a maximum of fifty prospective investors who form an identifiable group and satisfy certain other criteria fall outside the scope of the 1988 Law and are subject to a lighter regulatory regime operated under the Control of Borrowing (Jersey) Order, 1958, as amended.

7       In Guernsey the initial regulatory categorisation of a fund proposal turns not on the question of the marketing and availability to investors of securities in the fund but the structural nature of the proposed vehicle.  In Guernsey the fundamental question is whether the proposed fund will be open-ended or closed-ended.[6]  If the fund is to operate as an open-ended structure then the fund and its service providers in Guernsey fall to be regulated under the Protection of Investors (Bailiwick of Guernsey) Law, 1987 as amended (“the POI Law”), which is the principal statute for the regulation of investment fund and investment business activities in Guernsey. Closed-ended funds fall to be regulated in Guernsey under a lighter regulatory regime operated under the Control of Borrowing (Bailiwick of Guernsey) Ordinance 1959 as amended.[7] The fact that Guernsey has historically afforded a lighter regulatory treatment to all closed-ended schemes goes some way to explaining the perception that has grown up amongst business introducers that Guernsey is an easier jurisdiction to deal with than Jersey.  Private equity schemes as a class tend to be structured as closed-ended limited partnerships; a number of early hedge fund products started off as closed-ended vehicles or converted into closed- structures; and investment trust companies are by definition closed-ended.  All of these types of fund have been growth areas in the funds market place in recent years.

8       The second major difference between the islands is the approach to the licensing of fund service providers.  Under the POI Law a generic licensing procedure applies enabling fund service providers to apply to be authorised to carry out licensed activities for collective investment schemes generally.[8]  While the identity of proposed service providers will be reviewed by the Guernsey Financial Services Commission as part of the authorisation procedure for a new Guernsey domiciled open-ended scheme, no further licensing of the service provider needs to be applied for where the service provider is being engaged within the scope of its existing licence.  In Jersey the licensing arrangements under the 1988 Law operate on a case by case basis and require each Jersey-based service provider (“functionary”) to a collective investment fund to apply for a regulatory permit each time it proposes to take on an appointment for a collective investment fund.[9]  Every permit which is issued has a series of regulatory conditions attached.  While many of these conditions are standard some will vary from permit to permit.  The result is that the experience of obtaining authorisation in Jersey and increasing one’s portfolio of business is often regarded by those undergoing the process as bureaucratic by reason of the need to make regulatory applications in connection with each new piece of business being taken on.  From a compliance perspective the burden is increased through the issue of multiple permits in the name of a single service provider with a strong likelihood that regulatory conditions attached may vary slightly between different permits.  This case by case approach to licensing adopted in the 1988 Law is out of step with the newer approach adopted by the Jersey Financial Services Commission in the regulation of non-pooled investment business and trust company business in Jersey where a generic licensing system applies under the Financial Services (Jersey) Law 1998 (“the 1998 Law”).  The stated intention of the Commission in Jersey is to move towards integrating the fund functionary licensing arrangements into the 1998 Law and moving towards a generic licensing approach similar to that which is operated in Guernsey.  Completion of this proposal will, however, require substantial amendments to both the 1988 Law and the 1998 Law and will take some time to achieve.

9       Thirdly, Jersey has historically attached great importance to the identity of the promoter of a collective investment fund which is to be set up in Jersey.  The promoter is the organisation which is the instigator or driving force behind the establishment of the scheme.  The approach of the Commission was enshrined in a promoter policy statement[10] which was framed in the late 1980s when the asset management world was dominated by large international asset management houses serving a predominantly retail investor client base.  The policy set out a very selective approach to the approval of organisations wishing to set up investment funds in Jersey and laid heavy emphasis on promoters being able to demonstrate that -

(i)      they had a track record and experience of operating funds in other regulated jurisdictions;

(ii)      they had an international (or at least national) reputation in their field;

(iii)     they had significant substance in terms of shareholder funds;

(iv)     they had  a spread of ultimate ownership of the promoting group which should not be under the control of a single or small number of persons.

10     Guernsey also operates a policy of selectivity in relation to the promoters or sponsors of schemes seeking to establish in the sister island, but the Commission in Guernsey has in practice tended to operate their policy in a more flexible and commercially pragmatic manner with the consequence that over the years certain fund promoters who have been rebuffed in Jersey have been welcomed in Guernsey.  The difference of approach was exacerbated by the changing nature of the global asset management industry where the trend has been towards the emergence and development of new investment techniques and alternative investment strategies.  These advances have in large part been pioneered by small specialist asset management businesses many of which are spin-out operations from large investment banks and institutional asset managers.  These specialist asset management businesses often do not meet the benchmarks set by the Jersey promoter policy; they tend to be in close ownership amongst a small number of individuals (although there will often be minority institutional stakeholders as well);  they do not have significant substance in terms of shareholder funds; at inception they do not have an international profile and while their principals and officers may collectively have many years of relevant experience, the business entity itself may well have little or no track record of operating funds in other regulated jurisdictions.  The cumulative effect of all these differences of approach between the islands was to engender a view abroad that Jersey was either at worst closed to business from the new alternative investment managers, or at best was not as welcoming as Guernsey. 

11     In February 2004 Jersey responded by announcing the introduction of the Expert Fund concept in Jersey which heralded a new approach to the authorisation of collective investment funds which were to be offered exclusively to expert investors.[11]  In reality this was not a new type of fund vehicle but merely a means of obtaining fast-track approval for the issue of permits under the 1988 Law for collective investment funds which met the requirements set for Expert Fund status.  One of the key features of this new status was to shift the focus away from the old promoter policy and establish a new set of benchmarks centred on the more familiar regulatory concept of fit and proper person status, which were to be used to vet the investment manager or investment advisory company proposed to be engaged for an Expert Fund.  The new approach emphasised the need for full disclosure to investors of risks inherent in the investment proposal and an acknowledgement by subscribing investors that they had the necessary status to qualify for participation in the scheme and were aware of the risks involved.  The new policy dropped the requirement for open-ended corporate funds to have a Jersey-based management company provided that there was an island-based administrator appointed, thereby simplifying functionary arrangements and conforming with the movement towards third-party administration of fund structures.  Also, in an attempt to make the island more attractive to hedge fund operators, the policy set out a new standard that corporate hedge funds need not appoint an island-based custodian provided they appointed an off-island prime broker.[12]  Compliance with the requirements of the Expert Fund Guide by a proposed fund is to be certified by the fund and a Jersey-based functionary of the scheme, and the Commission in Jersey set itself a service charter of issuing regulatory permits within three business days of completed applications being submitted.  All of this was achieved without any changes to legislation and it points to one of the advantages of the Jersey system; that it operates largely on the back of policy and practice statements and is not encumbered with large amounts of subordinate legislation below the level of the 1988 Law which might have frustrated the speedy introduction of these reforms through the need to alter legislative rules. 

12     The advent of the Jersey Expert Fund policy was a cause for concern in Guernsey.  At the close of 2003 the Guernsey Financial Services Commission had been consulting with the Guernsey fund industry on changes to facilitate the use of Guernsey domiciled funds for hedge fund business.[13]  A number of legal and structural difficulties had been identified arising from the fact that, by contrast with Jersey, the Guernsey funds regime is more prescriptive and has a greater amount of subordinate legislation in place which restricts the ability to exercise regulatory discretion in the approval process for new fund structures.  In particular, the following problems existed.  It is a feature of the POI Law that open-ended funds must have a custodian whose function is to control the assets of the fund and hold them on trust.  It was difficult in the light of this requirement to accommodate the concept of the prime broker which will typically be a creditor of the fund and hold all or substantial portions of the fund assets as collateral which may or may not be segregated from proprietary assets of the prime broker.  Furthermore, client money rules in Guernsey enshrined in subordinate legislation to the POI Law meant that subscription monies must remain segregated in clients’ accounts until fund valuation procedures were completed.  This was an obstacle to Guernsey open-ended hedge funds issuing securities to investors based on estimated fund valuations which is quite a common occurrence in the hedge funds sector.

13     Faced with the introduction of the concept of Expert Funds in Jersey at the start of February 2004, Guernsey moved swiftly and on 23rd February 2004 announced that it would be prepared to accept requests for rule waivers in relation to those Guernsey provisions which were problematic to the growth of Guernsey domiciled open-ended hedge funds.[14]

14     Jersey in the meantime was preparing its next initiative which was launched in June 2004 in the form of a further policy statement called the Non-Domiciled Fund Guide.  The objective of this Guide is to encourage the use of Jersey as a location for providing support services to investment funds established in other jurisdictions by streamlining the process for obtaining permits for Jersey-based functionaries appointed by foreign funds.  There is a well established practice in the offshore hedge fund market place for hedge funds to be domiciled in the Cayman Islands and, where administration is to be located in a European time zone, for a hedge fund administrator in Dublin to be appointed.  Recognising that the Channel Islands cannot realistically expect to break in the short term the near monopoly of the Cayman Islands for the incorporation of hedge funds, the Non-Domiciled Fund Guide seeks to enable Jersey-based fund administrators, distributors and investment managers to tender for the business of servicing foreign hedge funds with the advantage of a fast-track regulatory approval process in Jersey.

15     Guernsey already had a more developed approach to encouraging third-party fund administration in the form of the Licensees (Conduct of Business and Notification) (Non-Guernsey Schemes) Rules 1994 (“the 1994 Rules”).  This enables Guernsey-based management companies, fund administrators and custodians which are already licensed under the POI Law to provide services to non-Guernsey open-ended funds where those non-Guernsey funds do not require to be licensed under the POI Law.  Specific approval from the Guernsey Financial Services Commission is required for a local licensee to take up an appointment in connection with a foreign open-ended fund, and a notification system exists under the 1994 Rules for this purpose. 

16     The Non-Domiciled Fund Guide can be viewed as introducing a framework in Jersey for regulatory approvals in connection with foreign funds which parallels in many ways the 1994 Rules in Guernsey.  There are two significant differences however between the islands in this context.  The Jersey policy applies to both open-ended and closed-ended funds, a point which harks back to the fundamental tenet of the Jersey regulatory regime which ignores the structural characteristics of a fund and focuses on distinguishing between public funds and non-public funds, whereas in Guernsey the 1994 Rules only apply to foreign open-ended funds. There are no regulatory controls in Guernsey under the 1994 Rules on the taking up of servicing roles in connection with foreign closed-ended funds.[15]  The fact that Guernsey does not regulate the closed-ended sector under the POI Law and the ability of Guernsey fund administrators to take on business for foreign closed-ended funds with, in some circumstances, no need to apply for any regulatory consents, is regarded with some envy by the Jersey funds community.  On the other hand, investor sentiment is arguably turning in favour of seeking to invest through funds and service providers which are subject to an appropriate level of regulatory supervision in jurisdictions which enforce good corporate governance standards and where the regulator has responsibility and a full range of intervention and inspection powers across the whole gamut of fund vehicles.  While Guernsey service providers to foreign closed-ended funds will, for the most part, tend to be licensed under the POI Law in connection with Guernsey-domiciled fund business which they are also servicing, the Commission in Guernsey does not appear to have the same degree of regulatory oversight and intervention powers which the Jersey Commission has under the 1988 Law in respect of all foreign public funds which are serviced out of Jersey. 

17     Another perceived advantage for Jersey arising from the Non-Domiciled Fund Guide is the speed of turnaround for regulatory applications which mirrored the service charter provided by the Commission in connection with the Expert Fund Guide to issue regulatory permits within a matter of a few business days of submission of completed applications.  The speed of processing in Jersey was again viewed with concern in the sister island where initial regulatory status checks by the Guernsey Financial Services Commission can take considerable periods of time to be completed, depending upon the geographic location and status of fund sponsors and principals to Guernsey fund proposals.

18     In October 2004 Guernsey responded with a consultation paper[16] seeking to establish a streamlined fund approval regime in connection with both open-ended and closed-ended funds which are aimed at professional, experienced or knowledgeable investors.  The main thrust of the proposal is that the Commission would grant the required fund approvals within three working days provided an appropriately licensed Guernsey entity certifies to the Commission (1) that they have conducted due diligence on the promoter and associated parties and found them to be fit and proper;  (2) that the fund will be restricted to professional, experienced and knowledgeable investors;  and (3) they are satisfied about the fund’s economic rationale and that any risks associated with the fund are clearly disclosed to investors.

19     These proposals have a very strong resemblance to the key criteria set out under the Jersey Expert Fund regime and we can conclude that once the anticipated changes in Guernsey are formally introduced the major differences between the regulatory regimes in the two islands will have been largely eliminated.  The regimes will now operate largely to the same effect with both islands offering the same sort of approach to regulatory approval for funds aimed at sophisticated or professional investors which will be delivered on a fast-track time scale.   This will enable the Channel Islands as a whole to compete more effectively for increased volumes of investment fund business from the rest of the world and at the same time stimulate continuing competition between the Channel Islands for this business.

20     But there are dangers that the effective deregulation of the funds approval processes in both islands has opened up both for the regulatory authorities and investors.  The regulators need to continue to defend the reputation of the islands as first division finance centres and ensure that the well established track record of the islands for quality both in terms of transactions and participators is maintained.  The self-certification process which is to be made available in both islands for funds targeted at sophisticated investors introduces a tension by allowing service providers to build their portfolios of business more quickly than ever before; it will relieve the regulators from undertaking initial vetting and scrutiny of fund proposals in reliance upon regulated service providers within their jurisdiction evaluating the quality of the business and the counterparties they are to engage with and certifying the outcome to the regulator.  The Commissions in both islands have an increased need to ensure that business take-on procedures and general conduct of business standards amongst service providers are not diluted as they begin to exploit the greater flexibility and speed of the new approval processes.

21     The dangers were recognised by the Commission in Guernsey which in its October 2004 consultation document included the following statement of intent -

“The Commission would continue to discharge its regulatory role under the new regime.  The requirements of the IOSCO[17] Objectives and Principles of Securities Regulation would be met in particular through enhancing the ongoing monitoring of those local POI licensees providing the certification referred to in [preceding paragraphs of the consultation document].  Investment Business Division staff would include assessment of licensees’ application due diligence as part of their post-facto monitoring of licensees.  If the Commission were to find that warranties provided were defective, or misleading, the Commission would take action against the licensee, and in appropriate cases would exclude that licensee from future participation in the self-certification programme.”

22     Guernsey has also moved to reinforce the importance of maintaining high standards of corporate governance by issuing a document entitled Guidance on Corporate Governance in the Finance Sector in Guernsey on 10th December 2004.  This contains broad exhortations to adopt effective corporate governance and risk management procedures, and it explicitly refers to its application to service providers licensed under the POI Law.

23     In Jersey similar moves are afoot to strengthen the regulatory accountability of Jersey-based functionaries appointed to collective investment funds.  The Commission in Jersey is in the process of finalising a Code of Practice to be promulgated under the 1988 Law which will establish general conduct of business rules and best practice standards for these functionaries.  Deviation from the standards set out in the Code of Practice may be taken into account by the Commission in assessing the continued fit and proper status of fund functionaries.

24     It is to be assumed that the Commissions in both islands will also regard the availability to them of a full range of statutory intervention powers as a necessary and complementary feature to the good governance environment that they are busy promoting to regulated entities.  Legislative revision of the 1988 Law is in prospect in Jersey and it will be interesting to see whether further primary powers for the regulator in Guernsey come about in the near future including express investigation and intervention provisions in relation to closed-ended schemes generally.

Simon Howard is an advocate of the Royal Court of Jersey and a consultant to Bailhache Labesse PO Box 207 13-14 Esplanade St Helier Jersey JE1 1BD.

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