Hedge funds will need the assistance of an attorney to write a fund’s offering memo or mandate and attend to other legal matters such as the legal structure of the hedge fund, compliance with statutory regulations, and the documentation needed when starting a hedge fund. The advent of legal assistance helps hedge funds avoid pitfalls and build relationships.
The term “offering memo or mandate” refers to the terms of investment, risks and objectives of the hedge fund compiled into a legal document. It includes a description of the business, management profiles and financial statements of the business. The offering memo or mandate serves as an invitation, to potential investors, to do business with the fund, while at the same time providing the fund with protection against liability for the sale of unregistered securities.
According to the National Treasury Department of South Africa (2012), Hedge funds in South Africa comprise of the following legal structures:
- Partnership agreements en commandite (limited liability for silent partners who invest capital into the hedge fund)
En commandite partnerships are the common structure used for the formation of a hedge fund. It provides for a maximum of 20 partners which comprises of General Partners and Limited Partners, who are investors in the fund. General Partners are authorised to represent the partnership in its everyday business and is liable for any loss which cannot be covered by the partnership business. Limited Partners are also known as “silent partners” as they do not part take in the business activities. As a result, Limited Partners are only liable for their partnership contributions. This type of partnership is suited for hedge funds aiming at high net worth individuals.
According to Alternative Investment Management Association South Africa (AIMA SA) (2009) many hedge funds have opted for a trust structure or an investment company which issues variable rate debentures to investors. The investor then receives interest on the loan made to the investment company periodically, and the interest given is in relation to the performance of the fund.
The above structures are permitted by the Collective Investment Scheme Control Act of 2002 provided that there is a clear identification and separation of the assets, with emphasis on the separation of the hedge fund from its manager. Managers of all hedge funds with potential South African investors are required to be registered with, or authorised by, the Registrar irrespective of the value of the assets of the fund.
South African fund entities are currently regulated by the Collective Investment Scheme Control Act (CISCA) while hedge fund managers are regulated by the Financial Services Board (FSB) together with all other financial services providers under Financial Advisory and Intermediary Services Act (FAIS). The licence requirements for managing hedge funds are stricter than those placed on other financial managers.
A hedge fund requires an FSP category II licence which allows the fund to provide discretionary management services. This licence is needed in conjunction with a category IIA for the actual management of a hedge fund. Licence requirements are put into place to allow the FSB full access to the hedge fund manager, products and services managed by the fund and the fund’s client files, including mandates. Regular audits are carried out on all managers, and ad hoc requirements are requested from time to time according to AIMA SA (2009).
To obtain a license to start a hedge fund, applicants must go to www.fsb.co.za. This website provides information on the procedure of obtaining an FSB number, the fee required and the forms needed to be declared by a financial services provider. The form requires applicants to provide information regarding the operational ability of the fund (regarding insurance policies, guarantees and information regarding the fund’s clientele) as well as the services the fund intends to outsource and to whom.
Hedge funds must also adhere to the Financial Intelligence Centre Act (FICA) which aims to assist in the identification of the proceeds of unlawful activities, the combating of money laundering and the financing of terrorist activities (Financial Stability Board, 2013). The control measures put in place for money laundering in terms of FICA are based on three principles of detection and investigation:
- Intermediaries to the financial system must know with whom they are conducting business
- A paper trial on transactions through the financial system must be kept for record purposes
- Possible money laundering transactions must be brought to the attention of investigating authorities
It is then the compliance officer’s role to detect reportable transactions or proposed transactions that are deemed “suspicious or unusual transactions” the nature of these transactions is determined by section 29 of FICA. Failure to comply with this regulation may result in criminal charges for both the attorney as well as the fund manager(s) responsible.
According to the Financial Action Task Force (2009), financial institutions under FICA are prohibited from establishing a business relationship or concluding a single transaction with a customer before determining and verifying a customer’s identity or of any person acting on behalf of the customer or on whose behalf the customer is acting. These control measures are put in place to establish and verify the identity of the clients of financial institutions and to keep certain records, report certain information and to implement measures that will assist them in complying with FICA. The Director of the Financial Institution Centre (2013) states in the “Guidance for accountable institutions on client identification and verification and related matters” various risk indicators to be used to determine the level of risk associated with different customers.
Apart from the initial start-up services in determining the legal structure and assisting with the compliance of legislation about hedge funds mentioned above, there are various other services offered by the legal industry to the financial services and investment management practices. Bowman Gilfillan (2012) include, but are not limited to, the following services as offered to the financial services and investment management industry:
- Drafting and negotiating investment management agreements, custody agreements, investment advisory agreements and dealing agreements.
- Creating legal documentation of the above-mentioned agreements. Custody in this regard refers to the care of safeguarding of something. This may be used in limited partnerships.
- Securities trading and securities lending arrangements.
- Reviewing prospectus.
- A prospectus is a document containing information relating to the sale of an investment to the public. In light of the Consumer Protection Act, the prospectus should be in plain and simple language so that it is understandable to the customer (investor).
- Reviewing private placement memoranda.
- Private placement memorandum refers to a written brief regarding the sale of an entire issue of security to a group of investors, who undertake not to resell the investment within a specified period.
- Subscriptions for interests in investment funds and negotiating side letters about such subscriptions.
- A subscription agreement is an application to join the limited partnership by the investor.
- Legal due diligence exercises in relation to investment management.
- Due diligence is the process of reviewing and monitoring the operation and management of hedge fund managers.
- Tax law about investment funds, structuring of financial products and investors.
Legal service providers are essential for the start-up of a hedge fund, although they offer an attractive list of services for fund management but is not typically necessary for the industry. However, the addition of legal services provides the fund with an advantage regarding professionalism, the opportunity to meet potential investors and legal benefits regarding ensuring legal procedures are being complied with and have conclusive legal documentation. Attorneys are to provide sound legal advice to their clients, informing their clients of any illegalities of the contracts entered into by them.