Chapter 6
Laws, Contracts, and Lawyers

The first thing we do, let's kill all the lawyers.

Dick the Butcher in William Shakespeare's Henry VI

Don't Kill Your Lawyer

The well-known line about killing all the lawyers in Shakespeare's Henry VI is frequently misinterpreted as support for disdain of lawyers. In fact, however, when taken in the context of Henry VI, Shakespeare is actually demonstrating that without lawyers there would be no order and justice.

Shakespeare's nugget of wisdom also applies to starting and running an investment firm. Although you may feel like killing yourself at times, let alone your lawyer, while reviewing various drafts of agreements and contracts, a positive relationship with legal counsel will not only make your efforts in launching and managing an investment firm easier, but getting the proper legal framework in place early will allow for easier management of the firm during the various life events it may experience later.

Based on our own experience, partnering with quality legal counsel is invaluable. Given ever-increasing legal costs, fund founders may be tempted to spend a little less by relying on lawyers who are less experienced and/or established. We have found that any marginal savings to be gained by going cheaper are not worth the loss of expertise, practical advice, and relationships that respected fund lawyers have. Additionally, there is an implicit signalling effect when a fund associates itself with quality service providers that can create intangible value for the fund.

Although we recommend working with good lawyers to guide you through the legal aspects of starting a fund, it is important to have a grasp of the foundational components of the process yourself. This is important because even though your lawyer will give counsel, provide options, and help implement decisions, the fund founder must do the actual decision-making. This chapter highlights the core points a fund founder needs to understand to make those decisions.

In the first part of the chapter, we begin by describing the concept of legal entities relevant to fund management. The chapter then reviews the two components of a hedge fund described earlier in this book: the fund structure (i.e., trading and portfolios) and the firm (i.e., management of the non-portfolio aspects of a hedge fund or investment firm). Starting with the fund structure, we review its components and the important attributes and variations. For each important attribute and variation, we review the contractual documents that define the relationship between the relevant entities. We then do the same for the firm, reviewing its components and the contractual documents that define the relevant relationships among legal entities.

In the second part of the chapter, we review the three main structural design decisions that must be made regarding the legal structure of the fund as well as the firm in general. They are: (1) domicile selection; (2) legal form; and (3) regulatory status selection. To conclude we discuss complex tax structuring, in particular the questions of substance and control, and the tax treatment of fees. The purpose of this part is to make the would-be fund manager or the would-be investor knowledgeable in order to enable him or her to ask the right questions, recognize the important issues, and wisely and efficiently make use of various consulting resources and professional advisors.

Legal Basics for Funds

Concept of Legal Entities

A ‘legal entity’ is an individual or an organization which is legally permitted to enter into a binding contract, can be sued if it fails to meet its contractual obligations, and, for the purposes of our discussion, is able to hold investments in its own name. ‘Legal entity’ in our discussion will usually refer to a ‘juristic person’, which is an artificial entity such as a corporation, a legally established partnership, or a foundation that the law treats for some purposes as if it were a natural person. Thereby the law allows a group of natural persons (and/or other juristic persons) to act as if they were a single composite individual for certain purposes. In some jurisdictions an individual person may, by means of a juristic person, have a separate legal personality other than his own. For purposes of the present discussion, we will rarely deal with ‘individual persons’ except insofar as an appropriately qualified ‘high-net-worth individual’ and/or ‘experienced investor’ may be an investor in a hedge fund in his or her own name.

It is of relevant interest that some ‘juristic persons’ have a separate legal personality for the purpose of entering into contracts, being sued for failure to perform obligations, and holding investments but, for the purposes of taxation, may be ‘invisible’. The choice of a limited corporation or a partnership with limited liability is significantly driven by the nature and jurisdiction of the investor(s) or shareholder(s). Taxable investors (e.g., high-net-worth individuals or other ‘natural persons’) in some jurisdictions find it more tax efficient to invest in a limited partnership. Such a structure – the limited partnership – is generally not taxable in its own right. In accordance with the ‘look-through principle’, the revenues, expenses, assets, liabilities, gains, and losses of the partnership are allocated on a pro rata basis (in accordance with the partnership agreement) to the investors or shareholders(s) where, depending on the tax regime and status of the investor/shareholder, they are often consolidated for tax purposes with the other tax-relevant undertakings of the investor/shareholder. A non-taxable entity (e.g., pension fund), on the contrary, might find a limited corporation to be an entirely adequate and sometimes more satisfactory legal entity.

The Two Components of the Hedge Fund Business

The hedge fund business consists of two closely related and cooperating groups of entities that remain legally quite separate.

  • Fund. In essence, a special form of investment vehicle that undertakes no operative business activity.
  • Firm. Contains the entities that actually hold the intellectual capital and related infrastructure, whose function it is to develop the investment strategy and execute investment decisions.

Founding investor. Additionally, there is often a third legally separate entity – the founding investor – who may have significant power relative to the fund enterprise.

The Fund

The fund itself is normally established by act of law either as a limited corporation or as a partnership with limited liability. In the simplest of structures, the fund would consist of one legally established limited corporation or limited liability partnership. This legal entity may also be referred to as a ‘fund vehicle’, as the fund is in essence a particular form of ‘special purpose vehicle’ (SPV). An SPV exists in law to allow the creation of legal entities with a narrowly defined business purpose.

Generally, SPVs are established to allow multiple parties to invest in a common project, asset, or undertaking without the necessity of commingling the assets of the common undertaking with the unrelated assets of the project's manager and/or any of its investors. Furthermore, an SPV is designed such that bankruptcy of one of the investors or the manager does not result in a claim on the assets of the vehicle and, further, bankruptcy of the vehicle itself does not normally give rise to a claim against the manager or an investor. Thus, most SPVs are designed to be bankruptcy remote.

The fund – in essence, an SPV – differs from an operating entity in that the fund itself does not do anything. The fund undertakes no operative business activity. Instead, it ‘holds’ or ‘owns’ the investments that comprise the object of the fund. Investors own the investments through the acquisition of a direct or indirect stake in the fund. It is from profitable redemptions of those stakes, as well as from disbursements of dividends, if any, that investors achieve their return. Normally the fund doesn't have any employees of its own. It doesn't ‘contain’ or ‘include’ any capacity for investment decision-making or execution. The fund will:

  • hold the investment securities, assets, and related liabilities;
  • delegate to an investment manager (or if applicable, an investment advisor) investment decisions on behalf of the fund;
  • delegate to service providers, usually via the investment manager (or if applicable, an investment advisor) for the efficient administration of the relationships between the fund's investors and their investments.

Documentation: basic required documents

  • Business Registration Certificate
  • Articles of Association
  • Memorandum of Association
  • Regulatory Certification.

Attributes and Variations of the Fund Structure

We will now review important attributes and variations of the standard fund structure.

Founding Shareholder

A quick reading of the offering documents of many funds reveals three different kinds of shareholder: the fund or investment manager, ordinary investors, and a founding shareholder or shareholders. The so-called ‘founding shares’ often have substantial control but little economic investment value. A founding shareholder usually has, for example, the exclusive right to hire and fire directors of the fund, to modify the articles of association of the fund, to order a voluntary winding up of the fund, and in some cases to create new share classes of the fund.

The purpose of creating a founding shareholder class and assigning these shares to a particular entity or individual is for the fund manager to retain control of operational decisions (such as appointing directors).

Classes of Shares or Partnership Units

Even in the most simply structured funds, there are likely to be different types of investors with different expectations regarding the liquidity of their investment and appropriate fee structures to compensate the fund manager. Even in simple structures, one would expect to find that the shares held by the fund manager carried no fees but a long lock-up or redemption notice period. The shares of an ordinary investor, however, likely include a management fee (e.g., 2% per annum), a performance or incentive fee (e.g., 20% of profits), and redemption constraints such as redemption notices only being permitted on a quarterly basis.

These two different types of investor would normally be reflected in different share classes or different classes of partnership units. The constitutional and offering documents of the fund would recognize different terms and conditions as applying to these two different classes of investment participation (e.g., Class A – ordinary investors, Class B – fund manager shares). The investors in these various share classes hold shares in a commingled portfolio of assets and liabilities. In general, in this simplest of structures, shares held in either of these two classes would rank equally in case of the bankruptcy of the fund or its ‘winding up’ unless otherwise provided for in the constitutional documents of the fund (e.g., articles of incorporation or partnership agreement) and the offering documents of the fund.

Master–Feeder Fund Structures

The structure of a fund quite often consists of more than one legal entity, with a ‘master’ and ‘feeder’ fund approach. Occasionally, the unique requirements associated with different types of investor cannot be adequately met simply through the definition and issuance of different classes of fund shares or partnership units. There are numerous possible structural permutations reflecting the peculiar needs of specific investors. From a legal perspective, a feeder fund is a separate legal entity from the fund. Typically, a feeder fund will be 100% invested in shares of a specific class or classes of shares of the master fund. The feeder fund may not be of the same entity type as the master fund (e.g., limited corporation vs. limited partnership vs. unit trust) and it may not have the same domicile as the master fund (e.g., Delaware, USA vs. Cayman Islands).

The master–feeder fund structure allows the investment manager to manage money collectively for varying types of investor in different investment vehicles without having to allocate trades and while producing the same performance returns for the same strategies. This structure allows for the unified management of multiple pools of assets for investors in different taxable categories.

Feeder funds invest assets in a master fund that has the same investment strategy as the feeder fund. The master fund, often structured as a partnership, generally holds all investment securities, objects, or instruments.7 The master–feeder structure may include a US limited partnership or limited liability company for US investors and a foreign corporation for foreign investors and US tax-exempt investors. The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt investors, and offshore funds of funds.

Several examples should suffice to illustrate the types of challenge that may give rise to a master–feeder structure.

  1. Exchange listing. Certain types of investor are limited with regard to investing in shares that are not listed on a recognized exchange. Other investors particularly value the additional scrutiny and oversight associated with exchange-listed shares. The fund manager, however, may not want all share classes in the master fund to be subject to exchange rules. Exchange-listed shares usually have much more stringent regulations. For instance, regulations with regard to negotiating ‘side letter’ terms on fees and liquidity that differ from the offering documents will tend to be more restrictive for exchange-listed shares. As a result, the investment manager may want to create a feeder fund and list its shares on a recognized exchange.
  2. Regulatory restrictions. Marketing to certain types of investor in certain jurisdictions may incur regulatory obligations that the fund manager does not want to be applicable to the entire fund. For instance, current US regulations provide that no more than 25% of the assets of a fund may be attributable to Employee Retirement Income Security Act (ERISA)-regulated investors. An administrator especially attuned to the peculiarities of US securities and investment regulations can often best monitor relevant regulatory restrictions. Often a feeder fund designed specifically for different regulatory and tax categories of US investors would be created. Not only must a feeder fund in which US investors invest be ERISA-compliant, but there are often certain additional tax-reporting requirements that must be undertaken by the feeder fund.
  3. Tax-reporting jurisdictions. A widely marketed offshore fund might choose to channel all investments from a particular jurisdiction, such as the USA, through one or more feeder funds designed to meet the regulatory requirements of that jurisdiction concerning tax reporting. For example, as mentioned above, US-domiciled investments must be ERISA-compliant. Additionally, funds must provide information for the tax returns of each individual taxable investor in accordance with the rules of the US Internal Revenue Service (IRS). US citizens investing in offshore funds treated as corporations by the IRS, for example, require return information documents as they are subject to tax under the passive foreign investment company (PFIC) provisions of the IRS.8

Master–Feeder Fund Structure In Depth

As mentioned above, the structure of a fund quite often consists of more than one entity and is structured using a ‘master’ and ‘feeder’ fund approach. There are numerous possible structural permutations reflecting the peculiar needs of specific investors and/or the peculiar needs of specific investments. As a case study, let us consider a structure that is quite often seen in practice and is only moderately complex. It consists of the following entities: the master fund, an ‘onshore dollar feeder fund’, an ‘offshore dollar feeder fund’, and an ‘offshore euro feeder fund’.

The master fund in our example is incorporated as a ‘limited company’ in the Cayman Islands and has been registered with the Cayman Islands Monetary Authority (CIMA). It is a trading member of several commodity exchanges, maintains execution brokerage counterparty arrangements with numerous brokers, has several clearing broker bank relationships to clear its transactions through the various exchanges, and maintains direct trading counterparty relationships with several financial institutions and other market counterparties.

The master fund has no employees and no buildings but lots of contracts and a few bank accounts. The master fund has three statutory directors: one appointed from the fund services affiliate of its offshore counsel law firm, one appointed from the master fund's founding investor, and one completely independent director named because of her experience as a director of several other commodity hedge funds. The directors act together to oversee the master fund's activities and to guard the interest of investors. Two of the directors are Cayman Islands residents and one is a citizen and resident of another country. The master fund has three separate investment classes (other than that for the founding investor), each with different terms and each class aligned with a specific feeder fund. The master fund is a ‘US dollar-denominated fund’, meaning that its accounts are maintained in US dollars and its annual reports are prepared in US dollars. Nonetheless, the master fund maintains several bank accounts in different currencies.

The ‘onshore dollar feeder fund’ is organized as a limited partnership registered in Delaware, only accepts investments from onshore US-domiciled investors, and only accepts US dollars. It is organized as a limited partnership because US tax law makes that the most favourable fund structure for its taxable US investors. Investors acquire limited partnership units in the ‘onshore dollar feeder fund’. The ‘onshore dollar feeder fund’ is 100% invested in the master fund. The ‘onshore dollar feeder fund’ has one class of investors with regard to the investment terms offered (other than the founding investor). The terms of this single investor class mirror the terms of the relevant investor class in the master fund. The ‘onshore dollar feeder fund’ has a general partner responsible for its operation. The general partner is a Delaware limited corporation with three directors: a director appointed from the founding investor of the master fund, a director appointed from the corporate services division of the onshore law firm handling the master fund's business vis-à-vis this feeder fund in the USA, and a third director appointed for his knowledge of the fund business sector.

The ‘offshore dollar feeder fund’ is organized as a limited company registered in the Cayman Islands and only accepts investments from offshore US-dollar investors. These US-dollar investors may in fact include US-domiciled pension funds and other non-taxable entities which do not require the tax benefits associated with the limited partnership structure of the previously discussed ‘onshore dollar feeder fund’. The organization of this offshore feeder mirrors that of the onshore dollar feeder fund, and so it is also organized as a limited partnership. Investors acquire limited partnership units in the feeder fund that are 100% invested in the master fund. The terms of this single investor class mirror the terms of the relevant investor class in the master fund, and so on. However, the ‘offshore dollar feeder fund’ is aimed at offshore investors, and has the same three directors as the master fund.

The ‘offshore euro feeder fund’ is organized as a limited company registered in the Cayman Islands. It only accepts euro-denominated investments that are offshore to Europe. Again, it has the exact same three directors as the master fund, and the same single share class concept.

Each of these feeder funds and the master fund require a number of operational oversight processes: ‘administration’ by an administrator, an auditor, etc. They also require regulatory registration in the Cayman Islands, except the ‘onshore dollar feeder fund’ which requires US registration.

Figure 6.1 visually lays out much of the structure discussed thus far in the chapter. Although not an exact replica of the case study immediately above, this figure gives a general sense of the relationship between the different legal entities.

image

Figure 6.1 Master–feeder diagram.

Source: Stable Asset Management.

Control Agreement for Master–Feeder Funds

Sometimes, in master–feeder fund structures, the relationship between the two entities will be defined by a ‘Control Agreement for Master–Feeder Funds’.

Side-Pocket Structures

Thus far our discussion of the fund structure has been limited to legal and regulatory facts that are primarily focused on the peculiarities of investors of different types, domiciles, and tax statuses. The fund structure, whether a simple standalone fund with various share classes or a master–feeder fund structure, defines the nature of the investment assets from the point of view of the investor. There are, however, other legal peculiarities of fund structures that have more to do with the specific strategies traded and the organization of the activities of the investment manager and its investment advisor and investment sub-advisor.

When all of the assets held by the fund's portfolio are traded in transparent and liquid markets such as some of the larger energy exchanges, it is likely that – from the legal and accounting perspective – all of the assets are commingled and held in the name of the single fund or master fund. Occasionally, however – either intentionally or as a result of changing market conditions – the fund will find that it owns investment assets that are infrequently traded, illiquid, or traded in markets lacking transparency and will find it difficult or impossible to value those assets for a significant period of time. Nonetheless, the portfolio manager may expect that the likely potential future value of the asset is significant enough to warrant holding those assets in the fund over a long period of time. It may be impossible to value the assets for many months until a certain future liquidity event. In general practice, such an asset is ‘ring-fenced’ or assigned to a ‘side-pocket’.

A new class of shares would normally be created exclusively to hold the investment in the side-pocket. Existing shareholders would redeem enough shares on a pro-rata basis to buy all of the shares in the new share class associated with the investment held ring-fenced in the side-pocket. These new side-pocket shares would normally have very specific terms describing the liquidity event (or events) that would lead to a valuation of the shares and the subsequent assessment of fees. At this point, investors could potentially redeem the shares held in the side-pocket. Normally neither management fees nor performance fees would be assessed and paid prior to the liquidity event, given that assessment of fees normally presumes the ability to value the assets. Unless the assets are to be valued based on original cost, the inability to value the assets is precisely the reason they were assigned to the side-pocket to begin with.

There are several important implications of creating a side-pocket. New investors in the fund purchase shares of the fund portfolio excluding the assets assigned to the side-pocket. Investors who were shareholders at the time assets were assigned to the side-pocket may have the right to redeem shares in the remainder of the fund; however, the redemption terms applicable to shares they hold in the share class associated with the side-pocket are likely to be much more restrictive.

A more serious matter is the legal segregation of the assets and liabilities of the side-pocket from the assets and liabilities of the remainder of the fund. If there is no formal process of legal segregation, and either the side-pocket or the fund portfolio became insolvent, the insolvent portion of the portfolio would normally have a claim on the assets of the legally undifferentiated solvent portion of the portfolio. This could lead to claims against the fund as well as its portfolio manager from investors in the share classes that owned the solvent portion of the portfolio. Thus, legal segregation is important.

The two most commonly used approaches to eliminate this cross-liability challenge are ring-fencing through contractual agreements and the creation of ‘segregated portfolio companies’. The first approach requires that each investor in the fund enters into a limited recourse agreement (i.e., a contract to limit their claims) with the fund. This means the investor acknowledging that they only have claim to the assets of the particular ‘side-pocket’ and no claim against any other assets of the fund. In most jurisdictions this contractual ring-fencing is widely used and has stood the test of insolvency cases, the exception being claims from non-contractual parties (such as tax claims from tax authorities such as the UK Inland Revenue).

The second approach is not contractual but statutory, which means it is not established through contract but according to existing laws. Creating ‘segregated portfolio companies’ is essentially to divide the fund into separate, statutorily defined ‘segregated portfolios’ (sometimes called ‘cells’). The statutory ring-fencing separates the assets to ensure there are no cross-portfolio claims. It is worth noting, however, that if insolvency is managed in a jurisdiction that does not recognize the laws on which the statutory segregation is based, then this method may not be effective.

To avoid the limitations of each approach, both approaches are sometimes used simultaneously to ensure no cross-liability risks exist between different portfolios within the fund. An example of illiquid assets that might be candidates for a ‘sub-fund’, ‘side-pocket’, or ‘segregated portfolio company’ treatment includes speculative and hard-to-value investments. Such assets would typically be found if a fund were investing in logistics assets such as transmission, transportation, or storage capacity. In circumstances where these capacities or assets are purchased in advance of their intended use and in the absence of active futures or forward markets for them, it may be necessary to wait months or years before actually realizing the value of investing in them.

While such investments may prove to be particularly valuable, they may be nearly impossible to value objectively until months or years after their acquisition. During this long period, the ownership of the commingled portfolio may change significantly. It therefore becomes an issue of fairness to ensure that the investors at the time of the acquisition of these assets remain exposed, in undiluted ratios, to the risks and potential returns of the investment. Additionally, this segregation can make borrowings in support of such an acquisition more feasible. A creditor may often feel more comfortable loaning money for an asset-based investment such as logistics capacity, while feeling quite uncomfortable being exposed to the overall risk of the fund portfolio.

The Firm

An investment firm consists of the entities that actually contain the intellectual capital and related infrastructure, whose function it is to develop the investment strategy, make investment decisions, execute those decisions, monitor risks associated with those investment decisions, etc. Even though the firm can outsource some of these activities, the firm is ultimately responsible for providing the essential investment-related intellectual capital. The following are the core entities that comprise an investment firm:

  • Investment manager. Responsible for managing the processes and activities necessary to enable the execution of the fund investment strategy. In some documents, the Investment Manager may be referred to as the Manager, and the Investment Advisor as the Investment Manager, this is especially prevalent in the United Kingdom when structures have onshore investment teams.
  • Investment advisor. Responsible for the tactical execution of the investment strategy.
  • Investment sub-advisor. Responsible for the execution of a particularly defined part of the investment strategy assigned (usually a single trader or small team of traders). An Investment Sub-Advisor may not always be necessary.

It is important to note that the existence and domicile of the investment manager, investment advisor, and any investment sub-advisor are driven by the realities of the intellectual capital that determines the investment strategy and their organizational infrastructure: who the investment managers are, who the traders are, where they work, and what tools they need to work with (computers, models, communications, IT, etc.).

The type of legal entity the investment manager, investment advisor, and any investment sub-advisor takes (such as limited company vs. limited partnership), and the nature of the contractual relationships they have to service providers, is driven by non-investment strategy-related aspects such as: investor marketing, liability shielding, tax structuring, regulatory compliance, and regime selection.

Investment Manager

The investment manager is the entity responsible for managing the processes and activities necessary to execute the fund investment strategy. It is the overarching entity that coordinates, organizes, and directs investment strategy.

The investment manager will often be organized as a limited partnership in the same domicile as the fund. A limited company is usually created to act as general partner. This limited company acting as general partner normally has one or more offshore independent directors. In addition, it may also have a director who, though not offshore, is either drawn from among the ranks of the team that founded the fund or is a well-trusted and close advisor. This investment manager, ‘Investment Manager LP’ and its general partner, ‘Investment Manager Ltd’ normally do not contain the intellectual capacity and related infrastructure to develop investment strategy, make investment decisions, etc.

In general, the investment manager and the entities that comprise it are established for tax efficiency, liability, and regulatory purposes. Nevertheless, they do perform an important management function by managing the processes and activities of the fund structure and the firm. Without this management the fund would not be able to function. Many would-be fund managers see the investment manager from purely a tax-efficiency and liability-shielding point of view. This is unwise. Most, if not all, tax authorities will quickly realize if an investment manager is not performing the roles it should be, and what kind of approach to the hedge fund business that fund employs: a fraudulent one.

The set of rules the US IRS uses to determine whether or not certain foreign funds are a US business is known as ‘The Ten Commandments’. This set of rules is used to determine which activities the investment manager must perform offshore if the fund wishes to be considered as under offshore jurisdiction. They include activities such as communication with shareholders and the general public, maintaining and auditing the books, or holding director and shareholder meetings. For the investment manager structure to be tax efficient by performing activities offshore, it is obvious that it must perform said activities offshore.

Investment Management Agreement

The fund delegates the responsibility for organizing and managing the processes that enable the execution of investment strategy decisions to the investment manager through the investment management agreement between the fund and the investment manager. The directors of the fund will, for liability reasons, be eager to demonstrate that they have delegated responsibility to the firm, however, this delegation of responsibility to the firm has tax and liability consequences. The investment manager will also be documented through the:

  • Registration Certificate
  • Articles of Association
  • Regulatory Certification (specific for each jurisdiction).

Investment Advisor

The investment advisor is a legal entity contracted to the investment manager to execute the investment strategy. Normally, the investment manager has delegated most or all investment decisions to the investment advisor. The investment advisor entity is normally domiciled in the same legal jurisdiction where the actual intellectual capital behind the fund is located and works on a day-to-day basis. The decision whether to establish the investment advisor as a limited company or a limited partnership (requiring a general partner) is primarily driven by tax concerns and the law of the respective jurisdiction.

The investment advisor can subcontract some (or all) of the investment activities to one or more investment sub-advisors. We discuss the investment sub-advisors below.

The Investment Advisory Agreement

An investment advisory agreement is contracted between the investment manager and the investment advisor. The investment advisor will also have the:

  • Registration Certificate
  • Articles of Association
  • Regulatory Certification (specific for each jurisdiction).

Investment Sub-Advisor

The investment sub-advisor is a legal entity designed to hold additional intellectual capital dedicated to the purpose of defining investment strategy. The investment advisor can subcontract some (or all) of the investment activities to one or more investment sub-advisor. This is often a structure used when there are actually several different discrete teams (with, perhaps, clearly identifiable trading responsibilities) or when discrete teams have different locations and local managements (and perhaps compensation structures).

The Investment Sub-Advisory Agreements

The investment sub-advisory agreement is contracted between the investment advisor and one or more investment sub-advisors. The investment sub-advisor will also have the:

  • Registration Certificate
  • Articles of Association
  • Regulatory Certification (by region).

Attributes and Variations of the Investment Management Enterprise

We will now review important attributes and variations of the standard investment management enterprise structure.

Governance Processes

Several governance processes might be used in the structuring of an investment firm. Governance processes are related to the activities to be performed within the firm, particularly those pertaining to the investment manager. Processes like regular board meetings with detailed minutes, regular strategy meetings with detailed minutes, compliance and performance meetings, etc. form a crucial part of the practical steps which need to be taken to ensure a robust governance structure for the firm and, by implication, for the fund.

Considerations on Contractual Documentation

Having reviewed the contractual documentation, there are some general considerations that are helpful to keep in mind while reviewing each of the contracts involved in setting up the fund structure and the firm structure. They are generic considerations that underline the most important aspects affected by the nature and terms of each contractual relationship. Each of the aforementioned contractual documents must be evaluated with the following aspects in mind.

  • Marketing: the nature of the contractual relationships will be important from a marketing perspective vis-à-vis not only investors but also service providers and other stakeholders as well. Each party will have preferences around who retains control for what functions, where each entity is domiciled, etc.
  • Liability transfers/retentions/indemnifications: the actual principals of the fund management business are likely to be interested in having as many layers of liability blockers as possible between them and their personal assets. On the contrary, service providers and directors are unlikely to want to ‘wear’ any risk for trading, risk management, and regulatory decisions they did not make.
  • Tax implications (especially related to control issues).
  • Consistency with the offering documents and the articles of association of the various entities involved.
  • Consistency with the regulatory status of the contracting entities.

Structural Design Decisions

We now review the three main structural design decisions that must usually be made regarding the legal structure of the fund as well as the firm in general. They are domicile selection, legal form selection, and regulatory status selection. To conclude, we discuss complex tax structuring, in particular the questions of substance and control, and the tax treatment of fees.

In general, there are three important decisions that must usually be made regarding the legal structure of the fund structure and the firm structure:

  1. Domicile selection
  2. Legal form selection
  3. Regulatory status selection.

These decisions are driven by three characteristics of the fund. (1) What is the investment strategy? (2) Where is the location from which investment strategy decisions will be made? In other words, into what commodities, through what instruments, through what platforms, and in what markets does the fund wish to invest, and where will the intellectual trading capital be located? (3) To a lesser degree, what type of investors will be targeted, and what are their nationalities and location of domicile?

The decision drivers associated with structural design decisions can be quite complex and often conflicting in practice. Optimizing among the various possible design combinations will be one of the most time-consuming and critical activities during the business planning phase. It is an exercise of trade-offs. This process is, of course, not entirely irreversible since it is often possible to restructure both the fund structure and the firm following launch. Post-launch restructuring, however, has considerable downsides:

  • it is usually much more expensive than taking the time to get it right the first time;
  • it often has tax consequences because it creates a taxable event;
  • it often requires the consent of investors, which gives the investors an opportunity and leverage to negotiate other unrelated matters.

Post-launch restructuring is incredibly time-consuming and tedious. It's like repairing a complex piece of moving machinery while it is operating, as opposed to building the machine correctly before operation begins. Virtually every counterparty of an entity being restructured must be involved in the restructuring process. This means director signatures, notarizations, apostilles, reruns of compliance and operational due diligence, etc.

A fund manager can expect to be involved with a variety of consultants during the structural design process: tax advisors, legal advisors, regulatory advisors, representatives of intended investors, and service providers. During this time it will become clear that not all investors and not all individuals involved in the firm necessarily have the same tax or regulatory interests. If a hedge fund includes traders or advisors in more than one country or state, it should not be surprising if they have very different needs with respect to tax structure. One should not rush this process; it will be iterative and take some time. The key objective should be to identify the necessary considerations and ensure that the original structural design process is adequately comprehensive with regard to the matters that it considers and addresses.

A hedge fund manager would be wrong to conclude that the matter is so complex that it is best left entirely to an international securities and tax law firm as selected by a prime broker. Many of the international firms subcontract – either out of necessity or convenience – portions of their work to local firms in offshore or other national jurisdictions. The layering of fees with bankers supervising lawyers supervising more lawyers and audit firms and tax advisors is a guaranteed way to spend a lot of money fast and to create an enduringly complex and expensive structure. A good legal structure for a hedge fund enterprise should not be delegated to lawyers and advisors, just like one should not delegate the legal structure for a complex commodity transaction.

The purpose of this section is to make the would-be fund manager or the would-be investor knowledgeable in order to enable him or her to ask the right questions, recognize important issues, and wisely and efficiently make use of various consulting resources and professional advisors.

The domicile selection, legal form selection, and regulatory status selection decisions will be treated as if they were a sequential process. Furthermore, these matters shall be treated as if the fund structure and the firm structure can be considered separately or in isolation. In reality, however, both decisions must be made simultaneously for both the fund structure and the firm structure. Like most complex business structuring decisions, it will be an optimization process with multiple variables to be traded off against each other.

Domicile Selection

When we speak of domicile in this section, we refer to legal domicile. A corporation or a partnership has a legal domicile within a specific legal jurisdiction and is subject to the laws of that jurisdiction. In most cases, the jurisdiction has a public agency that is responsible for registering corporations and partnerships as well as handling the administrative law aspects governing their creation, existence, modification, termination, sale, transfer, and insolvency.

Legal domiciles tend to be very specific because the governing laws and administering agencies tend to be very geographically specific. It would not be enough, for instance, to say that a legal entity is domiciled in the USA or in Switzerland. It is also necessary to identify the state or canton, as the case may be to know the correct legal domicile. There is, for instance, within the USA considerable difference from state to state in terms of corporate law. While the differences are not as great among the cantons of Switzerland as the states of the United States, they are still relevant.

Legal domicile is not automatically the same as tax domicile or ‘residence’. While it is virtually automatic that, for instance, the Cayman Islands would consider a Cayman Islands legally domiciled fund to also be tax domiciled in the Cayman Islands (and thus not subject to any tax), it would be relatively easy through poor structural planning for the Swiss tax authorities or the US tax authorities to determine that the Cayman Islands legally domiciled fund was a Swiss or US fund for purposes of taxation.

This imputed tax distinction falls under various tax doctrines including, for instance, that of ‘permanent presence’. Once again, when we refer to domicile in this section, we refer to the legal jurisdiction that has registered the fund. We are not referring to ‘choice of laws’.

For example, in the contracts prescribing the delivery of services between two Cayman Islands entities, the contracting counterparties occasionally agree that the contract will be interpreted and governed under the laws of, for instance, the State of New York. Occasionally, even a non-Cayman Island jurisdiction will be chosen for settling of disputes – such as by arbitration. Once again, this is a separate matter from the legal domicile of a legal entity. This ‘choice of laws’ or ‘jurisdiction for settlement of disputes’ is an important legal matter but is beyond the scope of this book and, in any case, is not essential material to be mastered by hedge fund managers or investors.

The following are the principal drivers that substantially impact domicile selection.

Regulatory Environment and Framework

  • Stability and predictability. Is the regulatory system and its related institutions widely understood and stable? All hedge fund-related regulation is constantly under review but it is important for investors and investment managers alike to be able to trust that the general system which they are adopting is relatively predictable, transparent, consistently enforced, and not subject to ‘behind the scenes’ influence on the part of counterparties or interests groups which could be detrimental to the investor or the fund manager.
  • Degree of regulation, the balance of ‘loose’ and ‘tight’. Investors and fund managers will want a system that they can trust as being fair and consistently applied. They will, however, not want an exhaustive (and exhausting) system of regulation that leads to substantial investment of time, substantial legal and regulatory compliance costs, and a substantial potential for accidentally violating a regulation with resulting serious consequences.
  • Pivotal industry player power. Which interests are the principal drivers of change in the regulatory regime and which interested parties are routinely involved and consulted prior to changing the regulatory system? In some jurisdictions, such as Germany, the pressure for change in the regulation of hedge funds seems to come primarily from political forces that are not typically friendly to the deployment of any form of speculative capital or the earning of money from speculative market behaviour. Fund managers and investors are occasionally included in discussions about regulatory strategy, but do not appear to be either the driving or a significant mitigating force in determining final decisions on regulation. In a fluid regulatory environment one could reasonably predict that the regime will change in ways unfriendly to both fund managers and investors.
  • National bias. The variety of regulation available to a hedge fund often depends on whether investors will be local or foreign. Most offshore domiciles have very different regulations for funds that allow local individuals to invest. As long as investors are foreign individuals or firms, a more friendly regulation regime tends to be available.
  • Applicability of law. As mentioned above with regard to taxes, there are many ways that a fund or fund manager domiciled in one jurisdiction can accidentally be interpreted by a regulator in another jurisdiction to be subject to the regulations of that jurisdiction they are not domiciled in. In the USA, Switzerland, and even the UK, failure to pay careful attention to the local regulations – especially as concerns the marketing of the fund to investors and the acceptance of investments – can result in being accidentally interpreted as being subject to that local regulatory regime (along with its rules, registration, and reporting requirements).

Taxes

  • Degree of tax neutrality. In most cases, the ideal domicile for a hedge fund entity is one that is ‘tax neutral’. In other words, the tax implications of the investment should be primarily driven by the tax positions of the investors themselves rather than by the domicile of the fund. The Cayman Islands, for instance, along with most other offshore domiciles, ensure ‘tax-free operations’ for investment vehicles that are essentially handling offshore business (rather than local Cayman Islands activities). The Cayman Islands even goes as far as to provide a government certification ensuring that any change in tax law that would result in the fund or fund manager being liable to taxation would not be applied for 20 years – essentially ensuring permanent non-taxable status.
  • Hidden taxes. It is important to look for ‘hidden taxes’. Besides taxes on the profits of the fund or on dividends – both types of tax that are frequently non-existent in offshore domiciles – it is important to look for various types of so-called ‘stamp taxes’. Even in most ‘tax-efficient’ regimes such as the Cayman Islands and Switzerland, there can be taxes or tax-like fees on such transactions as authorization of new shares in the fund or the firm. In the case of Switzerland, for example, a stamp tax is due on certain types of investment transaction.
  • Trade-off in tax interests between investors and the investment management enterprise. Domicile issues must always be considered when balancing the tax interests of the investors and the firm. There are domicile combinations that do not work well together. For example, it may be the case that for a certain fund it is easier to structure a fund with a Cayman Islands domicile for US investors and a fund with Guernsey or Luxembourg domicile for EU investors.

  • Trade-off in tax interests between the firm and the fund. It is often easier to consider the tax implications of the domicile of the fund rather than the implications of the domicile of the firm. If the fund is offshore, it is unlikely that the actual intellectual capital activity of the firm will physically take place on the soil of the legal territory of that domicile. For example, an investment manager that is physically located in London, New York, Zurich, or Frankfurt will have a difficult time claiming, for instance, that it should be considered Cayman Islands resident for tax purposes. All tax authorities, almost without exception, will look to determine where the ‘control’ lies. Control lies wherever the actual individuals making the decisions are resident. Tax authorities will suspect that an investment manager located in the Cayman Islands or other offshore regime is a ‘shell company’ with no ‘tax substance’. This is particularly true when there is no effective tax treaty between the regime that is the domicile of the investment manager and the jurisdiction in which the intellectual capital is actually located and working.

    Many of the legal entities, including, for instance, the ‘founding investor’ attempt to solve challenges posed by competing tax regimes and their sensitivities. The area concerning the taxation of an investment manager's other firm components and individual fund managers is currently fluid. Even very stable tax and regulatory jurisdictions such as the UK are paying careful attention to the taxability of offshore revenues and attributable capital gains. Later in this chapter we discuss some of the tools of tax structuring which are often employed to address tax-related challenges.

Customer Friendliness

  • Administrative complexity. How easy and expensive is it to deal with the various administrative agencies in the candidate domicile? What hidden costs are there, such as excessive local counsel or notarial actions associated with transactions with the administrative agencies? The most efficient offshore domiciles have extensively automated the standard processes of registering a new company or partnership, changing its name, recording its incumbent directors, filing its regulatory documents, etc. In regimes of high customer friendliness, local law firms may be connected directly via computer to the required agencies with the result that companies and partnerships can be created and registered almost in real time, offering memoranda can be filed automatically and immediately, fees nearly instantly transferred, etc. Key questions helpful to determine administrative complexity include: How quickly and inexpensively may an entity be created, renamed, or changed? How quickly and inexpensively can its articles of association or incorporation or other governance documents be changed? How quickly and inexpensively may directors be legally appointed and/or removed? How quickly and inexpensively may required regulatory documents be filed? How time-consuming will it be to complete the regulatory documents?
  • Ease and cost of maintenance. In addition to the complexity and cost involved in certain actions, one must also consider how complex and costly the ongoing maintenance of the structure is after set-up. For example, what are the requirements and costs of annual registration? What are the requirements for annual shareholders and periodic directors' meetings? What are the requirements for filing of audited or unaudited annual reports? What are the costs, speed, and ease of obtaining frequently required documents such as official lists of directors as recorded with the corporate registry, certificates of good standing, certified copies of articles or certificates of incorporation, etc.?
Case Study: Customer Friendliness

In the Cayman Islands, a complete firm structure could easily be registered, populated by legally appointed directors, and approved for required regulatory filings and exemptions within one week. That includes signing the investment management agreement and other contracts among the newly created entities. This assumes, of course, that the investment manager already has a relationship with local counsel and that the local counsel already maintains anti-money-laundering and ‘know your customer’ (KYC) compliance documentation on the relevant parties including the investment manager and the founding investor (if there is to be one). The Cayman Islands work diligently to ensure that they are the most efficient place in the world to domicile a hedge fund. There are of course some challenges, such as the time difference, that need to be considered.

Brand

  • Domicile brand. Countries have brands. For example, countries like Macau and Cyprus undoubtedly offer tax advantages and easy regulatory environments for a fund. Many international investors, however, would feel uncomfortable investing in a fund that was domiciled in Macau or Cyprus. Their instinctive discomfort is associated with the brand of that domicile. The brand of Cyprus as a domicile, whether justly or unjustly, is often associated with money laundering, non-transparent activities, and even criminal activities. At the opposite end of the spectrum, places like Jersey or the Cayman Islands work hard to defend their reputable brand as a domicile for funds.

    Therefore, it is crucial to know what brand value each potential domicile has in the eyes of the target investors of a fund. If investors trust the particular regulatory and legal regime of a domicile, they will feel more comfortable with the fund being domiciled there. They will see integrity, transparency, and fairness in brands they trust. Additionally, they will be more familiar with the domicile characteristics, such as their tax regime. Not only do the investors have an interest in the domicile and its reputation or brand. Many service providers are particularly concerned with the integrity and the quality of anti-money-laundering, KYC, and other anti-fraud measures. Last, but not least, fund managers must also realize that a domicile brand will be a proxy for its regulatory and legal dependability.

    Offshore, tax-neutral domiciles have to work constantly in order to maintain and defend their brands. A handful of high-profile cases of tax fraud or laundering of tainted money can do a great deal of damage to the brand of a jurisdiction. As a result of the increasing competition between jurisdictions to attract more hedge fund and other investment fund clients, many of the offshore jurisdictions have greatly tightened their due diligence and KYC requirements. Of course, any jurisdiction that is tax neutral is wide open to tax abuse and avoidance. Many of these offshore jurisdictions are increasingly tightening their regulations to ensure that business undertakings have real business substance rather than only the avoidance of taxes. As a consequence, managers setting up offshore funds will often find that honest and respected directors become nervous or uncomfortable around too much emphasis on tax efficiency.

Availability of Knowledgeable Service Providers

  • Local bias. Many jurisdictions insist on requiring that certain types of service provider be locally approved. They include:
    • Registered office services
    • Directors
    • Administrators

    • Auditors.

      Not only do these measures help them protect their brand against the presence of substandard service providers, they also ensure that a thriving local industry is created within the boundaries of the jurisdiction.

  • Service provider regulation. Strict requirements concerning the regulation of service providers are a sign of jurisdiction stability and dependability. Rarely will a fund manager or investor actually physically visit the offshore jurisdiction with any regularity. For this reason, service provider regulation ensures the availability of highly qualified service providers. Some respected jurisdictions will permit non-local administration or audits but require a locally licensed service provider to be officially responsible for providing the service.

Legal Environment

Public Listing Requirements

  • Public listing motivations. There are a variety of reasons why a fund would consider public listing. Rarely is it to facilitate true liquid public trading of the shares of the hedge fund. More commonly it is motivated by the following reasons:
    • To allow investments by entities that are restricted to investing only in listed securities.
    • To give certain investors the comfort of believing that the listing exchange or agency provides an additional level of regulatory oversight which helps ensure the fair and transparent treatment of the investor.
    • Tax structuring.
  • Domicile vs. public listing jurisdiction. It is not necessarily required that a fund be domiciled in the same jurisdiction in which it is listed or vice versa. For instance, there is no reason why a Cayman Islands-domiciled fund cannot be listed on the Channel Islands Stock Exchange or the Dublin Stock Exchange. If it is envisioned that a listing may be required at a future point in time, it is important that a fund ensures the likely listing exchanges would be willing to recognize a fund domiciled in an otherwise proposed jurisdiction. In general, a well-regulated, transparent, and fair domicile jurisdiction with a good reputation is likely to be acceptable as the domicile of a fund to be listed on major exchanges.
  • Exchange characteristics. Fund managers must review the characteristics of available exchanges from a legal point of view since not all exchanges are ‘approved’ or ‘recognized exchanges’. Additionally, it is not always necessary for a listing to be on a ‘recognized exchange’. It is important to review the level and source of ‘recognition’ that an exchange has before determining that it is indeed sufficiently and appropriately ‘recognized’. Additionally, some exchanges will only list legal entities incorporated in their own jurisdiction. Others will only list corporations and not limited partnerships.
  • Speed, cost, and complexity of listing. The speed, cost, and complexity of listing vary dramatically from exchange to exchange. The Caymans Stock Exchange and Channel Islands Stock Exchange claim to be able to manage a listing within three to six weeks of application, assuming all is in order. Practically speaking, it is reasonable to expect the entire process to take under eight weeks. Dublin, for example, is more likely to take six months or more. AIM, a sub-market of the London Stock Exchange, and some other exchanges can be considerably more time-consuming and complex.
    • Listing fees can be considerable, including those for a local jurisdiction ‘sponsor’. These should be carefully compared.
    • A listing in the same jurisdiction as the normal offshore counsel and service providers is likely to increase speed and reduce cost by reducing the number of layers of service providers (e.g., Cayman Islands counsel and Guernsey counsel, Cayman Islands auditors and Guernsey auditors).

Legal Form Selection

The second structural design decision is that of the legal form of the fund and its firm. It is worth emphasizing that the legal structures that compose a hedge fund business collectively include elements of corporate law, contract law, and securities law. For instance, a fund will prepare an Information Memorandum, which is substantially a securities law compliance document complete with warnings and restrictions but also has many characteristics of contract law. In it, the fund – and by implication the firm as its contracted service provider – commits to certain guidelines such as the investment restrictions and risk parameters. Intentional violations of those commitments can have implications in securities law but can also lead to liabilities for breach of the contractual terms that govern investments. Legal form is therefore also of critical importance, and relevant in terms of the legal system as a whole, not only securities law. This may cover aspects such as the role of arbitration in courts or the role of common vs. case law with respect to disputes.

  • Stability and transparency. Hedge fund-related law is constantly evolving. In certain jurisdictions, however, there is already a very well-developed body of law and regulatory policy. Professional investment associations such as the Alternative Investment Management Association (AIMA), as well as local service providers, can share insights into how the local law has evolved and will continue to evolve relative to hedge funds. It is crucial to be convinced of the future stability and transparency of the legal environment of a jurisdiction.
  • Legal friendliness to hedge funds. Some jurisdictions intentionally attempt to attract hedge fund businesses. They compete with other jurisdictions to have the most developed legal framework, the best customer service-oriented administrative offices, etc. Some time spent on the phone talking with potential offshore counsel and other service providers will give you a fairly good impression as to whether the institutions of the jurisdiction – more than just its laws and agencies – are culturally friendly to the fund management business.
  • Legal system: UK common law vs. continental civil law. Nearly every place on the globe that was once ruled by Great Britain continues to operate under a UK common law regime (including the USA (except Louisiana), Cayman Islands, British Virgin Islands, Singapore, Bahamas, etc.). Those operating with legal systems based on British common law traditions have the advantage that many lawyers throughout the world – not only in that jurisdiction – will feel comfortable understanding contracts and other legal structures designed for that jurisdiction. There is a vast difference in the structure and assumptions behind continental civil law as opposed to a common law environment. Most hedge funds in the world, as well as their fund managers, are domiciled in common law jurisdictions.

Ease of Structure Change

  • Cooperation with structures in other jurisdictions. If the fund is successful, it will inevitably be necessary to evolve the structure of the fund and its related entities. If the primary domicile of the fund is widely respected and accepted, it is more likely possible to add new related structures (e.g., segregated funds or feeder funds) without the original domicile becoming a fatal flaw of the structure.

Regulatory Status Selection

The third structural design decision is that of the regulatory status of the fund and its firm. Regulation in different jurisdictions tends to be focused on one or more of the following:

  • The fund itself – its transparency, trading, what it trades in, how it is valued, etc.
  • The marketing process – to whom the fund can be marketed, by whom, where, and how?
  • The investing process – who does the investing or trading. Do they have adequate experience? Do they understand ethical principles regarding ‘late trading’, ‘market manipulation’, and other issues necessary to maintain high ethical standards? Do they understand and employ risk-management processes? Do they have the infrastructure necessary for the investment activities anticipated by the fund and do they have enough capital to survive while trading the fund?

Often, the fund itself and the parties responsible for marketing can escape regulations merely based on the type of entities to which they market the fund (e.g., very high-net-worth experienced investors, professional investment groups, corporate treasuries, etc.). Not all jurisdictions require that the firm and/or investment advisor and/or investment sub-advisor be regulated. Different commodity trading platforms in different jurisdictions may have different rules in this regard.

Case Study: Complex Tax Structuring

We conclude this chapter with a case study-type discussion on complex tax structuring, to illustrate the tax considerations implicit in legal entity design for a hedge fund business. We cover the particular tax questions of substance and control as well as the tax treatment of fees.

Tax Structuring: The Example Fund

To more easily tackle the question of complex tax structuring, we shall discuss the tax-optimal structure for a fund of the following characteristics.

  • Domiciled in the Cayman Islands.
  • Most investors are fund-of-funds and family offices based in Europe.
  • Some US investors.
  • Investment manager: desire to establish in Cayman Islands for tax purposes.
  • Investment advisor: services including some trading in Switzerland.
  • Investment sub-advisor: trading activities within the EU, such as London.

Substance and Control

The challenge of the investment manager is that it is essentially a shell company in its chosen jurisdiction (in this example, the Cayman Islands). When tax authorities assess the tax liability of a fund structure and its corresponding firm structure, they look to two key factors: substance and control.

Substance

The investment manager is eager to demonstrate that it actually has significant substance in the Cayman Islands. Substance is taken to mean that real, substantive things happen there, that key decisions are made there. Increasingly, tax authorities look for evidence such as employment agreements and office rental agreements. Furthermore, authorities will expect an address, telephone number, and e-mail address which are not at the offshore counsel office or some other registered office services company. A PO Box address c/o a law office with a telephone number answered by the registered office division of a law office is most persuasive against there being any real substance in the offshore domicile.

A common effort to resolve this will be for the Swiss and EU-based traders founding the firm to attempt to locate a service provider that offers a ‘substance package’. Such service providers are understandably sensitive about saying that they are offering ‘substance packages’ inasmuch, as the clear purpose is to circumvent the tax regulations of other jurisdictions.

Usually, a substance package will include one or more employee contracts, an office rental contract, and other similar services. The service provider will actually provide employees under these contracts to answer the telephone, reconcile invoices, prepare financial statements, and a variety of other administrative functions. Were an investigator or a financial auditor to drop by for a visit, they would find an office with a computer, the name of the company on the door, and a secretary. Failure to make the effort to demonstrate substance in the offshore jurisdiction ensures rejection when a fund applies for offshore tax status. Making the effort, however, does not ensure success. We advise truly investing in creating operations offshore if this is of importance to the would-be manager and we encourage investors to properly due diligence the tax aggressiveness of the manager. The former is the only real way to achieve this goal.

Some jurisdictions, such as Switzerland, are willing to evaluate the evidence on substance and business functioning. They will structure and issue a ‘tax ruling’ applicable for some years into the future, thereby securing greater certainty of the effectiveness of the substance package. The USA is uncharacteristically clear about its standards for offshore substance.

Funds also endeavour to have offshore directors or other employees who will ‘review’ and sign documents such as trading strategies, nominations, and brokers' directives. The would-be fund managers should be aware that it is difficult to find honest service providers willing to provide such services. Unless the service provider actually has some knowledge of the underlying commercial business, the process of ‘pretending’ to be the ‘deciding, controlling, or authorizing’ party is blatantly untruthful. Offshore service providers may have little to no risk of penalty from the far-distant tax authority in the remote case of being caught in this little game.

Let us consider the disaster scenario. Were the fund to become insolvent or otherwise ‘blow up’, the signature on the trades will be the unknowledgeable offshore employee, contractor, or director. A wise director will ask himself how it will sound when he must testify: ‘No, I really have no clue about these transactions, I only signed off on them to facilitate a tax fraud.’ Meanwhile, now that things have gone pear-shaped for the fund, the fund managers will likely claim that they did not have control over the trades that caused the debacle, and that the control was offshore, with those who signed the strategy off.

Control

This worst-case scenario illustrates the most difficult test to satisfy: the control test. Mainland tax authorities (where managers usually operate) will attempt to claim that the investment advisor, through the investment manager, is actually in control of the fund by virtue of his power over the levers of control of the fund. This could result in the determination that the fund itself was subject to taxation in the mainland jurisdiction. Furthermore, the mainland tax authority would argue that the offshore investment manager is either a shell company or at best a ‘dependent agent’. In other words, for the mainland tax authority, the brains are really not offshore – they are in the higher-taxed mainland jurisdiction.

In this case, the ruling would be that little of the fund income should be attributable to the offshore jurisdiction. Given that the investment manager will be the recipient of both management fees and performance fees, and that either it or its ultimate shareholders are likely to have a substantial investment of their own money in the fund, the tax status of these offshore structures has significant consequences. Additionally, if the offshore fund is determined to be subject to mainland tax rules, value added tax may be imputed and collected for the ‘service’ provided by the investment manager to the fund, which is represented by the management fees and performance fees. That means adding an additional 5% to 20% in taxes on top of the fees. Last but not least, the taxes on redemption of shares from a profitable fund will also be significant.

A variety of measures are commonly used to try to demonstrate that in addition to the ‘offshore substance’, control is actually: (a) offshore and (b) does not lie with the investment manager. The intent is to position the investment manager as just another service provider to the fund. Always keep in mind that legal structures put into place in order to create appearances remain nonetheless legal structures. This means that a legal structure designed to deflect liability to someone else or to give the illusion that another party has control is likely to actually transfer some liability and control to that entity. To shift the appearance of control implies effectively shifting it. Otherwise, this would be unethical.

We have briefly discussed the role of the founding investor previously. The founding investor's role is particularly relevant when thinking about tax structuring. The founding investor typically buys a few initial shares that do not earn dividends and have no redemption value; however, these shares do have voting rights. These rights usually include: appointment and termination of directors of the fund, changing the articles of association of the fund entity, and winding up the fund. Any effort on the part of the investment manager to create a hidden legal structure that actually gives it control of the ‘founding investor’ entity will inevitably require fraud or perjury to keep it hidden, and the relationship will ultimately become clear. This approach is not only unethical but illegal. Real control of these critical rights is actually transferred to the founding investor, who must indeed be a trusted party. The founding investor will typically be powerful enough to ultimately dismiss the investment manager. Remember, the legal appearance of transferring control does indeed transfer control.

The investment manager should ensure that there are regular board and committee meetings of the fund and the offshore investment manager to review strategy, review performance, approve actions, and discuss future plans. The documentation should build the case that the investment manager is a very important service provider that does not have final control.

Most large or highly profitable investment management groups will be audited in conjunction with their own tax preparation. Doing so will help demonstrate transparency and assist in due diligence conducted by potential investors or regulatory authorities. Auditors of the firm structure are likely to carefully apply these tests of substance and control to determine whether, and in which way, the offshore structure including possibly the fund itself may need to be consolidated into the financials of the firm.

This can have two important consequences: tax authorities receiving copies of the audited financial returns are likely to give significant weight to a determination of a financial auditor that the offshore firm structure is actually a dependent agent and that the fund should be fully consolidated. Further, regulatory bodies may similarly give considerable weight to such an audit determination. This could result in seriously adverse tax consequences for both the firm and the investors. Additionally, it could result in a determination that the offshore fund should additionally be regulated in accordance with the onshore regulations of a particular jurisdiction.

Tax Treatment of the Performance Fee

One additional matter of tax structuring that is of great consequence is the treatment of the performance fee. Depending on the jurisdiction of the fund manager and traders behind the investment manager, the performance fee should be positioned as ‘carried interest’. In this way, it would be subject to capital gains tax, which is usually much lower than ordinary income tax. Alternatively, a significant portion of the ordinary income arising from the fees should be attributed to actual intellectual services performed in the offshore jurisdiction.

To illustrate this issue, imagine a US fund manager and a UK-based Spanish trader. A US citizen is taxable on worldwide income and is therefore more likely to attempt to get classification as ‘carried interest’ subject to capital gains tax. On the contrary, a Spanish trader based in London is likely to claim that a substantial portion of the management and performance fees earned are actually attributable to the valuable service provided by the offshore investment manager entity and therefore should be taxed in the (low-tax or no-tax) offshore jurisdiction. Increasingly, onshore tax and revenue authorities are focusing on this ‘foregone’ tax revenue. In virtually every mainland jurisdiction, it will get more difficult – not easier – to effectively control an offshore structure and attempt to impute income to the offshore structure, thereby avoiding onshore taxes.

A special note: more than one fund manager has invested enormous amounts of time and money in designing a tax structure which will have ongoing requirements for substance packages, travelling to the offshore jurisdiction for meetings, etc. This is time and money invested in creating documentable evidence of offshore substance and control for the purpose of avoiding taxes. However, these taxes might not have been abusively unreasonable to begin with. It is always much easier to optimize the structure within the law and then pay the taxes due. It is very difficult and of questionable ethics to ‘give appearances’. One must then walk the thin line that divides tax efficiency from tax fraud. Honest service providers and reputable jurisdictions understand the importance of tax efficiency but are equally eager to avoid being associated with tax fraud.

Investors should be wary of investing in structures that appear to have been too aggressively structured from a tax perspective. In addition to potentially unseen risks to the investors themselves, the investor should not ignore the added operating costs associated with complex tax structuring. Nor should the investor ignore the potential risk of an investment manager becoming distracted from investing assets due to misguided focus on tax structuring. In the worst-case scenario, the distraction could be fuelled by a need to respond to tax authorities on serious tax-evasion charges. A jailed, distracted, or bankrupt investment manager is a risk to be avoided.

More Contracts

Besides the fund formation documents and PPM (Exhibit B), a start-up hedge fund will need to sign a number of contracts with various service providers including its prime broker(s) and other trading counterparties it may trade OTC derivatives with. Though the suite of contracts that a prime broker will require to on-board a new fund will depend on investment strategy, at a minimum a prime broker will likely require a Prime Brokerage Agreement, an ISDA9 Master Agreement, and other additional documentation, particularly if OTC derivatives are part of the fund's investment strategy. Additionally, a fund may desire to trade OTC derivatives with other counterparties besides its prime broker, which will require signing additional ISDA Master Agreements, Credit Support Annexes, and other OTC derivatives relates agreements with each of those counterparties.

We highly recommend that a lawyer with experience looking at such contracts assist any hedge fund with reviewing these types of contracts. Like many legal agreements, no one really looks at them when things are going well; however, it is when things are not going well that the provision in such agreement can become critical. The fallout from Lehman Brothers bankruptcy during the GFC is a recent, high-profile example of the importance of understanding the mechanisms embedded within such documentation. Though not comprehensive by any means (and please consult with your legal counsel) some key areas, inter alia, to consider when negotiating an ISDA Master Agreement are: cross-default provisions, net asset value triggers, events of default/termination events and how they will be treated if they occur, taxation issues, collateral terms, and ensuring consistency between the ISDA Master Agreement and other agreements the fund may have signed.

Be Nice To Your Lawyer

An investment of time and strategic thinking at the beginning of the journey will minimize legal and tax issues down the road. The legal and tax issues that need to be addressed for new hedge funds are not cookie-cutter but very specific to a fund's particular investment strategy, the jurisdictions it operates in geographically, and the nationalities of its employees. All of the above needs to be considered within the context of ever-evolving bodies of law and regulatory requirements, further adding to the complexity.

The information in this chapter is designed to provide a broad framework to help fund founders think about key legal issues as they engage legal counsel, accountants, and regulators in establishing a successful new fund. Lastly, we also encourage you to channel your inner Shakespeare and be sure to partner with quality legal counsel that can help you navigate the legal process of forming and managing a fund.

Bibliography

Law firms and other professional service firms active in the investment management and investment funds space regularly disseminate updates on new laws and regulations. These updates are a good way to stay abreast of changes. Additionally, regulators such as the US SEC offer updates via e-mail subscription for free.

  1. Carreno, F., McGrade, L., and Page, A.N. (2012) Hedge Funds: A Practical Global Handbook to the Law and Regulation. Globe Law & Business: London.
  2. Morgan Lewis & Bockius LLP (2012) Hedge Fund Deskbook: Legal and Practical Guidance for the Dodd–Frank New Era. Thomson Reuters: New York.
  3. Nowak, G. (2009) Hedge Fund Agreement Line by Line: A User's Guide to LLC Operating Contracts. Thomson Reuters: New York.
  4. Shartsis Friese LLP (2006) U.S. Regulation of Hedge Funds. American Bar Association: Chicago, IL.
  5. Zetzsche, D. (2012) The Alternative Investment Fund Managers Directive: European Regulation of Investment Funds. Kluwer Law International: Dordrecht.

 

 

 

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