LAWYERS TO THE FINANCIAL
SERVICES INDUSTRY
www.klng.com
Summer 2006
Take Stock
Blending FSA and SEC rules for
dual-regulated non-US advisers
The establishment of compliance
programmes and preparation of
compliance manuals for investment
advisers regulated by the Financial
Services Authority (FSA) and registered
with the U.S. Securities and Exchange
Commission (SEC) can give rise to a
number of challenges. Recognising and
addressing these challenges is an
important step towards creating a
compliance programme and manual that
is practical while remaining reflective of
all applicable regulatory requirements.
Some of the challenges are considered
below.
The Advisers Act
requirements as
applicable to non-US
investment advisers
The initial challenge for an SECregistered investment adviser whose
principal office and place of business are
located outside of the United States
(Non-U.S. RIAs) and whose clients
come from multiple jurisdictions is to
determine which rules would apply to
such adviser’s business. The U.S.
Investment Advisers Act of 1940 (the
Advisers Act) imposes various
requirements on investment advisers
registered with the SEC. In particular,
the Advisers Act makes it unlawful for
any SEC-registered investment adviser
to provide investment advice to any
client unless the registered investment
adviser adopts and implements written
policies and procedures reasonably
designed to prevent breaches of the
Advisers Act and the SEC's rules by the
registered investment adviser or any of
its supervised persons. The Advisers
Act requirements have to be
implemented in conjunction with any
local legal requirements applicable to
the Non-U.S. RIAs.
The SEC staff has over the years
provided guidance in a number of noaction letters to non-U.S. advisers who
wish to provide investment advice to
U.S. clients. In particular, the SEC staff
previously adopted a ‘conduct and
effects’ test to regulate the activity of
non-U.S. advisers. Under the conduct
test, conduct that takes place in the
United States, wholly or in substantial
part, would be sufficient to justify
application of the securities laws, even if
that conduct has no effect on United
States persons or markets. Under the
effects test, the securities laws would be
applied to conduct outside the territory
of the United States that has or is
intended to have substantial and
foreseeable effects within the United
States. Based on this approach, a NonU.S. RIA would generally be exempt
Welcome to the Summer Edition.
Many readers will have attended our
successful joint US/UK compliance
conference at London's Landmark
Hotel in January this year. The
conference showcased K&LNG's
financial services practice with over
150 lawyers working on transactional,
regulatory, compliance, enforcement
and litigation matters for financial
services institutions on both sides of
the Atlantic, and this edition of Take
Stock starts with an article penned by
members of the firm's London and
New York practices.
Contents
Blending FSA and SEC rules for
dual-regulated non-US advisers
1
European Commission feedback
on enhancements to the European
framework for UCITS funds
3
IOSCO consultation on hedge
fund regulation
4
MiFID - an update
5
Insider dealing - FSA methodology
as to how to measure it
6
FSA and SEC enter into new
Memorandum of Understanding
7
FSA and OFT to collaborate on
improving regulation
8
Who to contact
8
Take Stock
from the requirements of the Advisers
Act with respect to its non-U.S. clients
to the extent that any activity relating to
such clients does not take place in the
United States and has no intended
substantial effects within the United
States.
The SEC staff provided further
guidance and relief to Non-U.S. RIAs by
further refining its views as to what
constitutes a U.S. client. Non-U.S. RIAs
which do not have any direct U.S.
clients (being any U.S. client that
directly invests with a Non-U.S. RIA,
rather than through a non-U.S. fund) are
eligible to take advantage of the socalled SEC 'light' compliance regime.
These Non-U.S. RIAs are not required
to comply with various requirements
applicable to all other SEC-registered
investment advisers, but remain subject
to some of the more fundamental
requirements, such as the SEC
examination (See “SEC Light Regime”
overleaf).
Diverging rules
A Non-U.S. RIA that is subject to full
compliance with both SEC and FSA
requirements can look forward to a
number of other important challenges.
In particular, significant challenges arise
when the relevant U.S. and UK rules
diverge. While there do not seem to be
any directly contradictory U.S. and UK
requirements applicable to dualregulated investment advisers,
invariably either the UK or the U.S.
rules are more onerous on particular
issues. The result is that a Non-U.S.
RIA must either (1) apply the stricter
standard of the two to all of its clients, or
(2) treat U.S. and UK clients differently
because although FSA rules apply to all
clients, those of the SEC requirements
only generally have to be implemented
with regard to U.S. clients.
2
SUMMER 2006
Neither choice is entirely satisfactory.
Applying the more onerous standard to
all clients may impinge on the flexibility
of the adviser’s business operations and
may affect the adviser’s competitive
position vis-à-vis other managers that are
subject to the rules of only one
jurisdiction. The alternative, which
requires that a Non-U.S. RIA treat its
U.S. and UK clients differently, could
potentially be damaging from a
marketing perspective, may result in
clients questioning the adviser’s
loyalties and may be difficult to
implement in practice. For example,
U.S. rules generally require advisers to
disclose to their U.S. clients all conflicts
of interest to which they may be subject.
UK rules impose a duty on an adviser to
manage conflicts of interest fairly and
permit an adviser to select from a
number of possible approaches, only one
of which is disclosure to the client.
Recordkeeping
requirements
Differences in
terminology
Personal transaction
reporting
A firm's policies, procedures and
compliance manual should be clearly
understandable to its employees. Given
the different U.S. and UK usages of our
shared language, the wording of typical
U.S. compliance policies and procedures
need to be reviewed in the UK to
ensure that U.S. usages do not cloud
meanings for UK staff. As an example,
in the U.S. the use of the word 'solicitor'
has a specific meaning under the SEC
rules (a person who refers clients to an
investment adviser) whereas in the UK
the word is almost exclusively associated
with the legal profession. Similarly,
certain other U.S. legal and business
concepts would be confusing for a UK
employee. Compliance policies,
procedures and manuals should be
designed to make sure that U.S. legal
requirements are clearly explained to
UK users.
One important area where there are
marked differences between U.S. and
UK rules is with regard to personal
account dealing. UK rules require
advisers to have written procedures in
place for the approval, reporting and
monitoring of personal account dealings
by staff. Generally this equates to staff
members being required to seek the
consent of the firm's compliance officer
and a record being made with respect to
every transaction prior to such
transaction’s execution. The U.S. rules
also call for written procedures requiring
any person who is an 'access person' (a
defined term discussed below) to make
reports on commencing employment,
and then quarterly and annually
regarding all transactions in any
securities in which they or any of their
family members have beneficial
ownership. Unlike the UK rules, the
It may be difficult to develop a single
integrated recordkeeping programme
that satisfies both U.S. and UK
standards. In particular, depending on
whether an investment adviser is
subject to a 'light' SEC regime
(discussed below), it may be able to
keep different sets of records for its U.S.
and non-U.S. clients and, therefore
advisers should consider adopting
different recordkeeping rules for each
category of clients. Advisers should be
mindful of differences in specific
recordkeeping requirements. For
example, under FSA rules, copies of all
financial promotions and supporting
documentation are required to be
retained for a minimum of three years;
while under the SEC rules, similar, yet
not identical types of documents must
be maintained for five years.
www.klng.com
U.S. rules do not expressly require a preapproval of each transaction, except for
certain limited circumstances. In fact,
however, in order to assure compliance
by staff as well as advisers, it is a U.S.
industry best practice to require prior
authorisation.
Identifying persons subject to personal
transaction reporting can also be a
difficult challenge for Non-U.S. RIAs.
In addition to the difference between
UK and U.S. laws, advisers to U.S.
registered investment companies must
comply with the stricter code of ethics
requirements of the Investment
Company Act of 1940 (1940 Act). For
example, the Advisers Act defines
access person to only include employees
and other “supervised persons” of an
adviser. While the Advisers Act
definition includes any common
employees or officers that an adviser
shares with an affiliate, it does not
generally apply to officers and
employees of affiliates. However, the
1940 Act is broader in that it includes
any employee of a company “in a
control relationship” with the adviser
who “in connection with his or her
regular functions or duties” has access to
confidential information on fund
holdings or transactions.
SEC-light regime
As discussed above, Non-U.S. RIAs with
no direct U.S. clients are not required to
comply with various requirements
applicable to all other SEC-registered
investment advisers and, therefore, only
need to incorporate a few, if any,
applicable U.S. regulatory requirements
into their compliance manuals.
Investment advisers subject to a ‘light’
regime are not, for example, required to
designate a ‘chief compliance officer’ for
U.S. purposes, need not have a 'code of
ethics' and are not subject to various
other requirements under the U.S.
Investment Advisers Act of 1940.
Nonetheless, light regime RIAs may
otherwise become subject to U.S.
regulatory requirements often by virtue
of their acting as advisors to non-U.S.
funds that offer their shares to U.S.
investors and trade in U.S. markets
(such as the Gramm-Leach-Bliley Act,
the Securities Act of 1933, the Securities
Exchange Act of 1934 and the Insider
Trading and Securities Fraud
Enforcement Act of 1998). In such
cases, advisers should address the
requirements of those U.S. statutes in
their compliance manuals.
by Kay Gordon, New York. tel: +001 212 536 4038. Email: kgordon@klng.com
and Philip Morgan and Neil Robson, London. (Details on page 8)
UCITS - Feedback statement on enhancing the European
framework
On 13 February 2006 the European
Commission published a feedback
statement setting out a summary of the
responses received in connection with
its 14 July 2005 green paper entitled
"Enhancing the European Framework
for Investment Funds" which asked the
question - how well is the UCITS
framework meeting its objectives? The
responses summarised in the feedback
statement identify ways in which the
European fund industry can be
developed by building upon the existing
UCITS legislation.
The current position
At present the UCITS directives protect
investors through strict investment
limits, capital requirements, and
disclosure requirements, and also
require that asset safekeeping and fund
oversight must be provided by a
depositary independent of the fund
manager. Each EU country regulates
UCITS within its own territory, but
once authorised a UCITS fund can
'passport' across EU borders and can be
offered to retail investors across the EU.
options suggested in the green paper for
expanding the market freedoms
available to fund managers, as discussed
below. There was also some support for
a move towards principles-based (as
opposed to rules-based) regulation.
Some of the themes within the feedback
were:
n
The feedback responses
- suggestions
There were 121 responses in total, with
the majority from the UK, France and
Germany. Overall the feedback
responses give strong support for the
Commission's efforts to improve
implementation of the existing UCITS
Directives, and also for some of the
concerns regarding the existing
regime's requirement that UCITS
funds must provide the customer
with a simplified prospectus. In the
feedback responses there was support
for EU-wide harmonisation of the
content and format of the simplified
prospectus. Some respondents
advocated a more highly simplified
document which is easier for
SUMMER 2006
3
Take Stock
customers to understand and which
would contain only basic information
to ensure transparency and
comparability.
n
n
widespread concern that regulatory
fragmentation within the 25 EU
countries is holding back
development of the alternative
investment fund sector (which
includes hedge funds and private
equity funds), and support for a
common approach to 'private
placement' and a common
understanding of the term 'qualified
investor' as part of the solution to
this problem.
from almost two thirds of
respondents there was support for
the development of a 'passport' for
UCITS managers in one EU country
to enable them to manage the assets
of a UCITS fund in another EU
country on the basis of the manager's
home-state authorisation. The
Commission will have to consider
how to ensure regulatory certainty if
this suggestion is to be developed
further. Some respondents have
proposed that management company
rules (including operating rules and
risk management standards) will
have to be harmonised, and there
will also have to be enhanced cooperation between regulators.
n
from sixty percent of respondents
there was support for cross-border
pooling of UCITS funds, allowing
funds to remain legally separate
whilst allowing them to be
collectively managed. Of the options
proposed by the Commission in its
green paper most respondents
favoured the master-feeder structure
where the assets of pooled UCITS
funds are fed into a master fund. It is
hoped that allowing UCITS to be
pooled in this way will provide
greater flexibility and cost
reductions.
New legislation
Exactly how the responses from the
green paper consultation will be
reflected in new legislation remains to
be seen. The way forward for UCITS
will become clearer in Autumn 2006
with the Commission's publication of a
white paper.
IOSCO consultation on hedge fund regulation
In March 2006 the International
Organization of Securities
Commissions (IOSCO) published a
consultation report on the regulatory
environment for hedge funds updating
a report produced in 2003. IOSCO's
standing committee (SC) was
instructed to map the different
approaches taken in each of its member
jurisdictions to take account of any
reforms in hedge fund regulation or in
the concept of retail clients as related to
hedge funds.
Defining 'hedge funds'
None of the IOSCO SC member
countries' regulators has yet adopted a
formal, legal definition of the term
'hedge fund'; however, it is accepted
amongst most IOSCO jurisdictions that
a hedge fund is a collective investment
scheme which has a flexible investment
strategy, and in addition to buying
assets in the hope that their value may
4
SUMMER 2006
rise they may also use short-selling
strategies that rely on an asset
decreasing in value. Whilst traditionally
characterised by high borrowing levels,
some hedge funds have diversified their
investment strategies to include other
strategies that do not focus upon
strategies using leverage or borrowing.
IOSCO notes that this seems to be
making it harder to achieve a successful,
or any, definition of 'hedge fund'.
Regulation and
marketing differences
IOSCO notes that hedge fund advisers
are regulated in most member
jurisdictions, although some
jurisdictions regulate both the fund and
the adviser, and other jurisdictions
regulate only the adviser. There are also
differences in marketing regulations
applicable in different jurisdictions,
although in practice few jurisdictions
report any significant levels of sales of
hedge funds to retail customers. Some
regulators anticipate that this is
changing (indeed, in the UK the FSA
issued a preliminary consultation paper
which raised this issue during 2005, and
a further consultation will take place
later this year or early next year. At the
present time only Ireland, Switzerland,
Australia and Hong Kong expressly
permit participation by retail clients in
hedge funds, although IOSCO notes
that this list is likely to increase.
A final report will be produced later this
year to determine whether IOSCO
should carry out further work on hedge
funds. It seems likely from the report
that IOSCO will consult further on
permitted investment strategies for
retail collective investment schemes,
registered fund of funds and on
valuation and risk rating.
www.klng.com
MiFID - an update
Due imminently
European Parliament should have assessed the Committee of European Securities Regulators
(CESR) 'Level 2' guidance and issued a parliamentary opinion accepting the guidance.
By end of Q2 2006
FSA Consultation Paper anticipated on systems and controls (establishing a common platform
under both MiFID and the Capital Requirements Directive).
In June 2006
The European Securities Commission (ESC) votes on CESR's final Level 2 guidance.
In July 2006
European Commission expected to adopt CESR's Level 2 guidance (in form endorsed by
Parliament and the ESC).
By end of Q3 2006
FSA Consultation Paper on MiFID provisions on market transparency, transaction reporting,
authorisation and permissions, and enforcement and co-operation.
By end of December 2006
FSA Consultation Paper on changes to conduct of business rules covering those changes
anticipated as a result of MiFID provisions and covering impacts on business outside the
scope of MiFID.
By end of December 2006
FSA Consultation Paper on MiFID provisions on marketing communications, as part of the
wider FSA financial promotions review.
By 31 January 2007
EU countries are required to have all their MiFID implementing measures in place.
On 1 November 2007
MiFID comes into effect across all 25 countries of the EU.
On 10 March 2006, the Council of the
European Union announced that it had
adopted a directive to extend the
deadlines for the transposition and
implementation of the Markets in
Financial Instruments Directive
(MiFID) into EU countries' national
law by nine months.
One week later the FSA published
preliminary draft guidance on the
interaction between MiFID and the
Capital Requirements Directive
(CRD). The guidance is broadly
tailored so as to apply to different types
of firms with different types of
permissions such as credit institutions,
UCITS management companies,
investment services firms etc. It also
contains guidance on issues including
the scope of the CRD and the
categories of firms for the purposes of
the FSA's base capital resources
requirements. Most usefully it also
includes 'permission maps' which
indicate which FSA-regulated activities
and specified investments correspond
to MiFID investment services,
activities and financial instruments.
The FSA states that it wants firms to
begin the process of thinking about the
kinds of issues that may be relevant to
their business after the implementation
of MiFID in the UK. A revised version
will be included in an FSA consultation
paper on systems and controls, which is
scheduled for publication by the end of
the second quarter of 2006.
The updated timetable of events for
the implementation of MiFID in the
UK is set out above.
SUMMER 2006
5
Take Stock
Insider dealing - FSA methodology as to how to
measure it
On 17 March 2006, the Financial
Services Authority ("FSA") published
an occasional paper on 'market
cleanliness' which outlines a
methodology for measuring the insider
dealing aspect of market abuse in the
UK. The methodology looks at the
extent to which share prices move
ahead of regulatory announcements.
FSA occasional papers are not official
FSA guidance; they are published so
that the FSA can promote debate on
financial services issues amongst
academics, practitioners and policymakers. The paper, written by two
members of the FSA's Economics of
Financial Regulation Department
examines two types of announcements
to assess the statistics regarding insider
dealing:
securities fraud. Whilst it is not direct
proof, the US courts deem such
abnormal price movements to be
highly indicative, and the authors of
the paper believe that the same
conclusions should be able to be drawn
from UK data.
n
announcements relating to the
trading performance of FTSE 350
listed companies; and
n
announcements relating to takeover
bids.
The analysis of takeover
announcements included 2004, when
five misuses of information cases were
completed. In relation to these
announcements, the analysis found
some evidence of a deterioration in
market cleanliness.
Announcements that led to large or
abnormal share price movements
(assessed as a move of 10% or more)
were then analysed, as these were
deemed most likely to contain
information of use to an insider.
Statistical evidence detailing abnormal
returns of this type are used by the
Securities and Exchange Commission
in the US when it seeks to prove in the
US courts that a firm has committed
6
SUMMER 2006
The analysis of the FTSE 350
announcements covered 1998 to 2003 both before the Financial Services and
Markets Act 2000 (FSMA) came into
effect, and later, when FSMA was in
force. At this time the FSA had not yet
taken any enforcement action against
market abuse (the first action was in
2004). The analysis found that there
was no change in the level of market
cleanliness in relation to these
announcements.
Although principally an academic
paper, the FSA believes that the
methodology will enable it to measure
its success in tackling the insider
dealing aspect of market abuse, and
intends to repeat the analysis later this
year. Interested parties are invited to
provide the FSA with feedback on the
methodology and the results.
www.klng.com
FSA and SEC enter into new Memorandum of
Understanding
In March 2006 the FSA and the SEC
entered into a new Memorandum of
Understanding (MoU) in connection
with the exchange of information
regarding the oversight of financial
services firms conducting business in
both the UK and in the U.S.
Background
Many agreements have been entered
into between financial regulators since
the early 1990s. In 1995 the SEC and
the Investment Management
Regulatory Organisation entered into a
Declaration of Cooperation for the
Supervision of Cross-Border
Investment Management Activity,
which developed the concepts of
information sharing between regulatory
authorities in the UK and the U.S. and
the procedure for the on-site inspection
of regulated firms. This 1995
Declaration is superseded by the
March 2006 MoU. Information
exchange for the purposes of
enforcement investigations is, however,
still subject to the 1991 MoU and the
IOSCO Multilateral Memorandum of
Understanding concerning
Consultation and Co-operation and the
Exchange of Information.
FSA and SEC intentions
The FSA and the SEC state in the
MoU that they intend to (1) achieve cooperation primarily though ongoing
informal oral consultations
supplemented by more in-depth ad-hoc
co-operation, (2) periodically review
the functioning and effectiveness of
cooperation arrangements, (3) inform
each other in advance of pending
regulatory changes and material events
that could affect each other's markets
or the stability of firms, (4) provide
each other with the fullest cooperation
in assisting with the oversight of a firm
by providing firm specific information
on written request, and (5) further
assist each other by each regulator
allowing the other to make on-site
visits to firms in the first regulator's
jurisdiction which are regulated by
either or both regulators. In the case of
firms regulated only by the FSA,
however, the MoU only permits SEC
visits where the firm's global
headquarters is in the United States,
and vice versa.
Written requests for
information
Either regulator may ask to see
information on documents held by the
other including information relevant to
the financial and operational conditions
of a firm and any relevant regulatory
information, and both the FSA and
SEC have agreed that they intend to be
co-operative in these situations.
Copies of regulatory reports, filings and
other information may sometimes be
provided but the onus is on the
requesting regulator to show why direct
access is required to information in this
form.
Either regulator may use non-public
information obtained solely for (a)
conducting oversight of firms, as well as
(b) seeking to ensure compliance with
the regulator's domestic laws or
regulations.
Before using any non-public
information provided to either regulator
under the MoU for any purpose other
than those set out in (a) or (b) (for
example, for enforcement proceedings)
the regulator making the request must
first inform the other regulator of the
intended use of the information. The
request may be denied if either
regulator believes that the intended
use goes beyond the remit of the MoU.
In addition, where a firm is regulated
by both the FSA and the SEC and
where that firm conducts investment
management activities (including
investment advisers, investment fund
managers, fund administrators, fund
trustees, investment companies and
investment funds), the regulators have
agreed that they will provide to each
other, on a routine basis and without
advance request, copies of any
inspection reports produced.
All information shared between the
FSA and SEC, the existence of the
requests made, the contents of those
requests and other matters arising as a
result are confidential.
In the climate of greater cooperation in
the regulation of financial services,
firms that have operations in both the
UK and the U.S. may find it more and
more difficult to insulate a compliance
breach occurring on one side of the
Atlantic from their operations on the
other. Any response to the discovery of
a compliance breach must take into
consideration the regulatory
consequences in both jurisdictions
since it is possible that information
regarding the breach may be passed
between the FSA and SEC.
SUMMER 2006
7
Take
StockChecks
Travellers’
FSA and OFT to collaborate on
improving regulation
Forthcoming
Seminars
In March 2006 the FSA and the Office
of Fair Trading (OFT) announced that
they will produce an action plan in the
second quarter of 2006 to set out how
they believe they can reduce the
administrative burdens on firms and
deliver benefits to consumers and firms
by:
n
Breakfast Briefing “Mergers &
Acquisitions in the Investment
Management Industry”.
n
working together on consumer
education; and
working together more effectively,
e.g. improved collaboration on
matters of mutual interest such as
the sale of payment protection
insurance;
n
completing a feasibility study to
consider greater cooperation
between the FSA's consumer contact
centre and the OFT's consumer
direct service.
n
n
completing a feasibility study (by
September 2006) on ways to reduce
the administration burden on firms
either seeking authorisation from, or
regulated by, both organisations;
collaborating more closely on
enforcement of rules on advertising
and other matters, and on guidance
to business, e.g. the FSA intends to
amend its financial promotion rules
so that advertisements subject to
dual regulation need contain only
one risk warning;
Topics to be discussed:
n Key Trends Driving the Merger
Wave;
n Innovative Structures in Recent
Transactions;
n Challenges: Client and Employee
Retention; and
n Structuring Options and Related Tax
Structuring Issues; and Regulatory
Issues.
For further details please contact:
Jennifer Garrett (New York) on +1 212
536 3963 or jgarrett@klng.com
Kathie Lowe (London) on +44 20 7360
8248 or klowe@klng.com
Kirkpatrick & Lockhart
Who to Contact
Nicholson Graham LLP
For further information contact the following
Philip Morgan
Neil Robson
Tuesday 6 June - K&LNG New York
Wednesday 21 June - London
London Chamber of Commerce &
Industry, 33 Queen Street, London,
EC4R 1AP.
+44 (0)20 7360 8123
+44 (0)20 7360 8130
pmorgan@klng.com
nrobson@klng.com
110 Cannon Street
London EC4N 6AR
www.klng.com
T: +44 (0)20 7648 9000
F: +44 (0)20 7648 9001
Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle
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SUMMER 2006
© 2006 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP. ALL RIGHTS RESERVED.