Great expectations

While Dubai’s new Collective Investment Law sets a high standard for asset managers, there is a danger that bigger firms could benefit at the expense of smaller players, argue Roderick Palmer and Scott Gibson

The new Collective Investment Law (CIL), recently enacted in the Dubai International Finance Centre (DIFC), aims to provide the legislative framework to position the DIFC as a leading domicile for the establishment and management of investment funds.

In addition to the geographical benefits, firms operating in the DIFC are eligible for benefits such as a zero tax rate on profits, 100 per cent foreign ownership and no restrictions on foreign exchange or repatriation capital.

The fact that the DIFC is a zero-tax jurisdiction will naturally lead to a comparison with the offshore jurisdictions when considering the domicile for the establishment of funds. However, the DIFC’s aim is to provide higher levels of regulation.

Accordingly, the CIL is a prescriptive regime providing the DIFC with a high level of regulation, more in line with the regimes applicable to onshore jurisdictions than the minimal regulatory regimes of offshore jurisdictions which currently house most global funds.

The question for the asset management community is whether the benefits of market stability will generate enough demand to encourage fund managers to submit their businesses to the regulatory scrutiny and compliance requirements associated with relocating to the DIFC.

The authorisation process in Dubai
To understand the merits of the CIL, consideration must first be given to the concept of ‘authorisation’ – the prohibition which only permits ‘authorised firms’ to provide financial services in the DIFC.

An entity which wants to operate a collective investment fund in the DIFC (that is, assume responsibility under the fund’s constitution for the management of fund property) must first become authorised to provide five financial services: operating a collective investment fund, fund administration, asset management, arranging credit and deals in investment, and dealing as agent.

The authorisation process requires applicants to submit detailed information relating to personnel (including qualifications and experience), compliance, capital requirements, HR, and regulatory history. The DIFC uses this information to assess whether or not applicants are suitable to become authorised firms and carry on financial services within the DIFC.

The entry requirements set by the DIFC should ensure that the DIFC participants are of a high calibre. However, while the strict authorisation criteria may be easily met by institutional firms, they make it more difficult for the smaller, less established promoters and fund managers to set up in the DIFC. Bearing in mind that many of the key players in the global asset management community today had their start as one or two-man firms, this begs the question: has the DIFC set the entry benchmarks too high?

The five requirements
Of the five financial services a fund operator must be authorised to carry on, only the services of fund administration and managing assets may be delegated to other parties (for a particular fund) – and stringent delegation restrictions apply. The starting position – and most significant restriction – is that the operator of a DIFC fund must ensure the following activities are carried out within the DIFC: asset pricing and fund valuation; issuing and redeeming fund units; and record keeping and maintaining the unit holders register.

In essence, this means that a DIFC fund’s administrator needs to be located in the DIFC. At present, few fund administrators have established a presence in the DIFC.

To address this problem, the DIFC has granted short-term transitional relief to allow DIFC funds to be serviced by administrators located outside the DIFC, which are regulated and located in a ‘recognised jurisdiction’. The published list of recognised jurisdictions is limited and does not include key traditional fund jurisdictions such as the Cayman Islands, the British Virgin Islands or Bermuda. The length of the transitional period is also unknown.

Accordingly, promoters who have established relationships with administrators who choose not to establish a DIFC presence may be forced to decide between operating in the DIFC with a different administrator and carrying on business outside the DIFC with their administrator of choice.

Another requirement of the CIL regime is that an “eligible custodian” must hold legal title to fund property at all times. The eligible custodian must be a separate entity from the fund’s operator.

An eligible custodian may be a bank, a trustee, or an authorised firm (authorised to provide the financial service of ‘providing custody’) which satisfies certain eligibility criteria. A further restriction of the CIL is that a public fund must either be a partnership or a company; that is to say, it cannot be a trust.

Rules for specialist funds
One of the more striking features of the CIL is the provision of specific regulations for specialist types of funds. A private equity fund, for example, can only invest up to 25 per cent of the fund in one venture or undertaking, unless continued #+ continued the purpose of the fund is to invest in a single venture. It must also call a meeting of fund unit holders to elect three independent experts to sit on an investment committee.

Similar rules apply to property funds, which require that any property acquired by a fund must be valued by an independent valuer.

The independent valuer’s report must also state that if the property is acquired by the fund, it must be able be disposed of at that valuation within a reasonable period.

The property must then be acquired within a reasonable time from the date of the valuation and, in any event, not later than six months from the date of valuation and at a price no more than 5 per cent higher than the valuation price.

Comparable requirements are set out for hedge funds, fund of funds and Islamic funds. The CIL also goes on to detail specific requirements for the prospectuses of each of these specialised funds.

Such detailed regulatory measures are intended to provide a stable and controlled market for investors. However, from a promoter’s point of view, they represent significant restrictions and extra layers of regulation which do not exist in alternative zero tax jurisdictions.

Overlapping legislation
The specificity of the CIL leads to considerable overlap with other DIFC legislation. For example, in order to become an authorised firm within the DIFC, entities must show they have adequate controls and systems in place to ensure ongoing compliance with all relevant laws and regulations.

In addition to this, the CIL also requires that public funds establish and maintain specific ‘oversight arrangements’ to monitor compliance with respect to the law and the fund’s prospectus and constitution.

Permissible oversight arrangements for a corporate fund involve setting up a panel consisting of independent, non-executive members of the fund’s board (or an eligible custodian), and in the case of a partnership, a committee of at least two limited partners (or an eligible custodian).

The overlap is even more pronounced in the case of authorised firms which carry on Islamic financial business – carrying on one or more financial services in accordance with sharia either as an Islamic financial institution or by operating an ‘Islamic window’; that is, conducting Islamic financial business as part of a firm’s overall business.

All authorised firms that seek to carry on Islamic financial business must appoint a three-member sharia Supervisory Board to oversee its operations. In addition, at the fund level, the operator of any Islamic fund must also appoint a three-member sharia Supervisory Board (for that fund), which is independent of the operator. This overlap represents significant time and financial costs which may be difficult for smaller fund operators to justify.

Further CIL requirements
In addition to these key areas, there are also several other characteristics of the CIL which differentiate the DIFC funds’ regime from the traditional jurisdictions of choice for global funds. These include:
# an annual meeting of fund unit holders;
#a register of unit holders available for inspection by other unit holders;
#provision of annual and interim reports to unit holders; and
#a requirement that all applications for fund registration be accompanied by a sign-off from the fund’s legal advisers and that the fund’s constitution and prospectus comply with the relevant laws.

It is clear that in order to create a local funds market, it is important for the DFSA to establish an environment which provides investors and participants with confidence and stability.

It may take time for the global offshore funds community to adjust and re-structure to meet the high level of regulation created by the CIL and the complementing DIFC legislation in order to participate in this jurisdiction. n
Roderick Palmer is a partner and Scott Gibson is an associate at Walkers (Dubai)