EUROPEAN UNION REGULATION AND THE USE OF UCITS FUNDS: AN EFFECTIVE MEANS OF INVESTOR PROTECTION OR A FALSE SENSE OF SECURITY? PHILIPPA-LUCY ROBERTSON AND DOMINIC LAWTON-SMITH OF JP FUND FOUNDATIONS ASSESS THE OPTIONS

1. featuring Admiral Administration // Appleby // Deloitte // Harneys //
Lockton // Maples Fund Services // Mourant Ozannes // ifina //
JP Fund Administration // Koger // Ogier // Solomon Harris // State Street //
UBS Global Asset Management - Fund Services // Walkers
Alternative Funds
The impact of upcoming regulation on the
offshore financial industry
Risk Management
Satisfying investor demands through careful
administrator, prime broker and custodian selection
Launches
The domicile of choice for managers looking
to establish new hedge funds
cayman 2011
WeekhFMS p e c i al r e po r t
DIstributed with HFMWeek

2. 30 HFMWEEK COM
C AY M A N 2 0 1 1
D
espite independent reports on the finan-
cial crisis, including the EU’s own De La-
rosiere Report, absolving hedge funds of
any blame in the recent financial crisis, the
European Commission has still pushed
through the Alternative Investment Fund
Managers (AIFM) Directive. The Directive includes mea-
sures to ensure that managers of alternative strategy funds
increase disclosure to investors. It also sets out new rules
on capital requirements and introduces a European ‘pass-
port’ system to enable firms to market to investors across
the continent.
One way in which fund managers have sought to im-
prove demand for their products
while keeping in step with the EU
is by launching Undertakings for
Collective Investment in Transfer-
able Securities (Ucits), which are
fast developing as a form of ‘regu-
latory wrapper’ for hedge funds as
they are intended to offer greater
transparency and are subject to
greater regulatory scrutiny. Given
the negative media and political
attention that surrounded hedge
funds following the financial crisis,
Ucits appear to some as being able
to offer a flexible alternative invest-
ment product, affording manag-
ers sufficient investment freedom
to pursue alternative investment
strategies while providing a variety
of safeguards to protect a wide range of investors.
UCITS FOR ALTERNATIVE INVESTMENT STRATEGIES
The degree of regulation that Ucits require should, how-
ever, be very carefully considered in terms of two key is-
sues. First, the Ucits structure is increasingly a means to
circumvent established regulation by enabling retail in-
vestors into complex strategies; such investors may not
have sufficient financial markets experience of the prod-
uct or the wealth to withstand potential losses. One can
only imagine the ways in which politicians will be able to
defame and damage the industry further when vulnerable
investors lose money in complex Ucits III & Ucits IV strat-
egies that may (even in a small minority of cases) not have
been appropriate in the first place. Second, Ucits struc-
tures require managers to make sacrifices, which can limit
the strategy and its returns, while concurrently increasing
the fund’s operating costs.
Clearly there are enormous commercial advantages to
the use of Ucits in the right context, but this must surely
be considered as being for a separate breed of investment
strategy.
As many people may be aware, the infamous Madoff
used Ucits as feeders, proving that no level of regulation is
‘fraud proof’. In at least one case, losses were compounded
by the appearance that the intended responsibilities of
the custodian were avoided by the
heavily regulated bank concerned.
There are many ways in which
investorprotectioncanbeachieved
beyond regulation through the
fund industry’s existing infrastruc-
ture. Using the Cayman Islands as
a case in point, the following will
indicate how better governance
and oversight is a realistic goal.
INVESTOR PROTECTION
BEYOND REGULATION
Despite reports to the contrary, the
CaymanIslandsMonetaryAuthor-
ity(CIMA)hasrecentlyconfirmed
that the Cayman fund industry
continues to flourish, growing by
approximately 95 funds per month, with de-registrations
remaining at a steady rate of around 5%, as has been typi-
cal over recent years. CIMA has also confirmed that a
mere four funds have explained their fund termination in
the Cayman Islands by a move to the EU.
The Cayman Islands is thriving, and is aware that the re-
ality of achieving increased investor protection is through
better oversight and better disclosure, in addition to spe-
cific built-in safeguards such as the employment of inde-
pendent directors and regulated fund administrators.
THE ROLE OF INDEPENDENT DIRECTORS
Investment funds structured as companies have directors
PROPERLY PAID, QUALIFIED
AND EMPOWERED
INDEPENDENT DIRECTORS
PROTECT INVESTORS’
INTERESTS
”
ALTERNATIVE INVESTMENT
FUNDS AND THE EU
EUROPEAN UNION REGULATION AND THE USE OF UCITS FUNDS: AN EFFECTIVE MEANS OF INVESTOR PROTECTION OR A FALSE SENSE OF
SECURITY? PHILIPPA-LUCY ROBERTSON AND DOMINIC LAWTON-SMITH OF JP FUND FOUNDATIONS ASSESS THE OPTIONS
Philippa-Lucy
Robertson graduated
with LLB (hons) and LLM
(distinction) in European
law She is associate director
at JP Fund Foundations
Ltd and focuses on legal
and compliance issues
associated with launching
hedge fund structures
Dominic Lawton-
Smith is a director of
JP Fund Foundations with
over 15 years’ experience
in banking and finance
Dominic’s background
combines trading and
wealth management with
postgraduate qualifications
in related international and
trust law

3. hfmweek com 31
a d m i n i st r at i o n
to supervise business operations and ensure that the com-
pany’s corporate policies (and of course the respective leg-
islative provisions) are respected. Properly paid, qualified
and empowered independent directors who can devote
appropriate time to each of the companies for which they
are responsible protect investors’ interests.
Directors owe a fiduciary duty to investors, and in com-
mon law jurisdictions such as the Cayman Islands, fiducia-
ry duty is governed by the legal principle of equity. Equity
prevails over other areas of law to allow fairness in place
of the technical application of codes in situations where
the code’s creator would not have intended such an out-
come. Fiduciary duty exists in equity to protect investors
from the risk of the directors causing harm to either the
fund or its assets through fraud or mismanagement (see
also Rights in Property, below). Investors’ interests would
likely be better protected if a more literal and consistent
application of such fiduciary rules was enforced by the
courts, more in line with those of a trustee.
The Role of Independent, Properly
Regulated Fund Administrators
The appointment of an independent and properly regu-
lated fund administrator further mitigates risk of fraud and
mismanagement. A third-party administrator provides
the independent valuation of the shares and investor re-
porting key to investor protection. The administrator is
regarded as a fiduciary agent and must act in shareholders’
best interests.
Fund administration is unregulated in much of the EU
and in locations where fund administration is regulated
there are often limited capitalisation requirements (only
Ireland and Luxembourg within the EU have similar re-
quirements to the Cayman Islands).
Other points of independent oversight include parties
such as the deposit bank, custodian, auditor, prime broker,
and other brokers. In addition, the fund will likely appoint
an external law firm to provide legal services such as the
drafting and review of offering documents to ensure that
everything is sufficiently transparent to allow investors to
make their own, informed investment decision.
Rights in Property – the advantages of
Common Law Jurisdictions
As above, common law jurisdictions are governed by the
legal principles of equity and offer increased protection to
investors when compared to Napoleonic- or Germanic-
based legal systems. Where assets are lost as a result of a
breach in fiduciary duty, the principles of equity enable
the courts to grant powers to continue tracing and the
recovery of assets even where unmingled cash cannot be
identified. Trusts outside a code that recognises equity are
contract-based arrangements without such protections.
Thus where assets are still held, in whole or part, there is
far more chance of their recovery where the governing law
is that of a common law jurisdiction.
Managers should be aware that in non-common law
jurisdictions across the EU, including Luxembourg, Swit-
zerland or the Nordics, fund cash placed with banks be-
longs to the bank concerned, which in turn owes a debt
to the fund. Should the bank fail, other than a guaranteed
amount (a fairly standard CHF100,000 ($108,400) in
Switzerland, for example, and subject to certain condi-
tions), the fund would rank below employees and along-
side other creditors, including other banks and even the
utility companies providing services to the building. In
common law systems, the money remains the property of
the investor rather than the bank and so the investors (via
the fund) may often be better protected.
The Future
The knee-jerk political reaction of the EU to push the
AIFM Directive through last year may be regarded by
some as the EU reacting to protect investors from the
opaqueness of the fund industry. However, it may also be
legitimately described as misdirected. Whether the uto-
pian ideal of investor protection that the Directive seeks
will materialise in the reality of the funds industry remains
to be seen, though, as this article has illustrated, the extent
of its success will likely be limited in practice.
Increasing investor protection cannot be achieved
through regulation alone; regulators must understand
that investors need:
• fairness;
• transparency;
• effective, independent oversight;
• true accountability;
• security; and (as often seems forgotten by regula-
tors)
• to make a profit.
Whether planned AIFMD rules and Ucits IV (as used
by the hedge fund and private equity community) will
help or hinder in striking the right balance for the industry
will be for time to tell. It may require a level of efficiency
and agreement that has been absent so far. As a result of
international and industry pressure, the EU will recognise
the equivalency of other, high quality jurisdictions for the
purposes of the AIFM Directive. Given that protectionism
will not now be a feature of the Directive, there seems little
reason to domicile a fund in the EU if greater cost and in-
effective regulation are a factor. n
The co-authors can be reached at dls@jpfunds.com or plr@
jpfunds.com