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A practical approach to fund regulation in Bermuda

"One of the trends that we are seeing is the globalisation and institutionalisation of the hedge fund industry,’ says Jessel Mendes, a partner in Ernst & Young’s Bermuda hedge fund practic

"One of the trends that we are seeing is the globalisation and institutionalisation of the hedge fund industry,’ says Jessel Mendes, a partner in Ernst & Young’s Bermuda hedge fund practice. And as hedge funds have moved into the mainstream and are no longer viewed as niche products, and the larger investment groups are getting in on the act, the type of investors they attract has also changed. Increasingly, institutions are forming a larger proportion of the investor base of many hedge funds and their requirements, and those of their investment consultants, in terms of performance, the level of manager access and transparency and investor protection, are placing more and more demands on the hedge funds themselves.

In Bermuda, this trend towards an increasing number of institutional investors including a hedge fund element in their portfolios is viewed by many in the fund services arena as a positive one for the jurisdiction. ‘Given this trend, Bermuda holds a very favourable position,’ says Mendes. ‘Bermuda clients in the funds sector continue to be predominantly institutional, highly sophisticated investors who understand the hedge fund market and its associated risks,’ says Pat Phillip-Bassett, Assistant Director, Corporate Governance & Communications with the Bermuda Monetary Authority. ‘Bermuda has a strong reputation,’ says Chris Harkness, Managing Director of Bermuda-based fund administrator Swiss Fund Services. ‘It has been able to maintain a good balance of transparency while still maintaining market integrity and investor protection,’ he adds. ‘One of Bermuda’s strongest selling points is its highly respected regulatory body,’ Harkness comments. ‘The Bermuda Monetary Authority has a strong reputation both locally and overseas.’ The BMA’s approach to regulation takes into account the on the type of funds and investors that Bermuda attracts. ‘A very significant portion of our mutual fund sector comprises hedge funds of various kinds, including funds of hedge funds, with sophisticated investors that can reasonably be expected to make quite expert investment decisions. We also take this fact into account when applying on going regulatory oversight for those funds,’ comments Phillip-Bassett.

‘The authority’s approach to fund regulation continues to support Bermuda’s success as a quality fund domicile,’ says Phillip-Bassett. ‘We continue to apply a practical and effective risk-based approach to regulating funds, which includes hedge funds, and the primary focus in our approach remains on proper disclosure and market discipline.’ Given the sophisticated nature of the Bermuda market, the BMA is able to rely in large part on the tough initial vetting of the individuals and service providers, as well as their own detailed scrutiny of a fund’s prospectus and related material to ensure proper disclosure to investors. The authority operates by setting certain ‘triggers’ for exceptional matters to be reported to them. However, Phillip-Bassett points out that, if specific concerns arise at any time about the running of a particular fund, the BMA can intervene quickly to establish the facts and take such action that is deemed necessary. ‘Our approach is largely consistent with the report of the President’s Working Group Recommendations on Hedge Fund Regulation published late last year in the US, which cited no need at present for additional regulatory development in relation to hedge funds but rather a focus on proper disclosure, market discipline, ongoing vigilance of the regulator and having the power to intervene if there are issues with a fund,’ says Phillip-Bassett.

According to Phillip-Bassett, the implementation of the Investment Funds Act 2006, which repealed the previous (Collective Investment Schemes Classification) Regulations 1998, has been received positively by the market. A key component of the new legislation has been to introduce new classifications for funds that, Phillip-Bassett believes, better reflect the products sold in today’s marketplace. Authorised funds may be established as companies, unit trusts or for the first time as partnerships, which may now have legal personality separate from the individual partners if they elect to do so under the Partnership Amendment Act 2006. Companies may be established as segregated accounts and operate individual funds at a cell level. The Act also introduces a new provision confirming the segregation of assets in unit trust funds operating separate and distinct accounts.

The legislation defines three fund classifications. The classification of administered funds – a concept that is wholly new to Bermuda – has been introduced to streamline the regulation of funds that have a Bermuda-licensed fund administrator. Administered funds must be administered by a fund administrator licensed in Bermuda, and be either listed on a recognised stock exchange or have a minimum investment of $50,000. Institutional funds are administered by a fund administrator licensed in Bermuda, and are either listed on a recognised stock exchange or have a minimum investment of $100,000. The final classification is standard funds, which includes any fund that does not fall into any other class of fund.

The legislation has also introduced enhanced powers for the BMA for the regulation of the funds industry. It is now the BMA, rather than the Minister of Finance, that has the power to create, modify or waive rules to be followed by authorised funds. The Authority may investigate suspected cases of funds conducting business without authorisation or operations providing fund administration services without a licence. ‘Refined powers under the Act have allowed us to drive forward our risk-based approach by carefully differentiating the obligations on retail and wholesale funds,’ says Phillip-Bassett. ‘Industry consultation was an important part of the development of this new legislation and it has been generally well received by the market. We believe that, as the Authority continues to enhance Bermuda’s regulatory framework for financial services, the enhanced supervisory regime for investment funds and administrators underpinned by this new legislation will provide Bermuda with a secure framework for the further development of the fund industry,’ he adds.

The final component of the Investment Funds Act 2006 was the introduction of a new licensing regime for fund administrators in Bermuda. Fund administrators have a period of one year from the date on which the Act comes into force within which to obtain a licence from the BMA, and the Act makes it an offence to carry on the business of fund administration in Bermuda without a licence. The Act introduces a list of minimum criteria for licensing which must be fulfilled both at the application stage and on an ongoing basis and the Authority may revoke a fund administrator’s licence if it considers that the minimum criteria have not been fulfilled, if the company has not complied with any provision of the Act or has provided the Authority with false, misleading or inaccurate information. As with funds, fund administrators and any affected officers and controllers may appeal a decision of the Authority to the appeals tribunal. The BMA is currently developing codes of conduct dealing with the duties, requirements and standards that fund administrators should adhere to. Phillip-Bassett says that the Authority has already received, and is in the process of assessing, license applications from fund administrators.

The fact that Bermuda’s fund administrators now have to be licensed by the BMA and comply with the standards set down by the Authority are certainly not dissuading administrators from starting up on the island. Bermuda is seeing increasing numbers of niche administrators setting up there and Bermuda can boast a wealth of global administrators and fund service providers. ‘We are seeing many new administrators setting up here and expanding globally,’ says Mendes.

The increase in numbers of fund administrators globally is another product of the institutionalisation of the funds industry. ‘We used to see more hedge fund managers doing in-house administration of their funds,’ says Harkness, ‘yet due to heightened scrutiny and increased institutional demand, fund managers look to third party administration extras a means by which to enhance the overall level of investor comfort.’ Increasingly, also, Harkness believes that mangers are willing to pay for quality when it comes to choosing an administrator and this is another area where Bermuda gains a significant advantage over other jurisdictions. ‘In addition to the nearly 70 fund administrators currently operating from within its jurisdiction, Bermuda is home to many of the leading offshore law firms and all of the large audit firms. Thus, offshore service providers are able to build close ties and strong working relationships by leveraging Bermuda’s diverse financial landscape,’ Harkness says. Mendes is in agreement. "I think we are known globally for being a quality jurisdiction with effective regulation, sound infrastructure, talent and an excellent track record for attracting and retaining business,’ he comments. "When it comes to hedge fund incorporations, we are not seeing the quantity some of the other jurisdictions may be experiencing, but we are noting the big institutional type managers setting up funds in Bermuda, hopefully a direct result of our reputation," says Chris Gauk, a partner in Ernst & Young’s Bermuda hedge fund practice. In Mendes’ opinion, Bermuda is well placed to capitalise on the future growth of the hedge fund industry.

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