On 14 March 2008 the Norwegian Ministry of Finance put forward a proposal for legislation regarding changes in the Investment Funds Act which will allow the establishment of Norwegian hedge funds (referred to as “special funds”). The draft legislation will also to a larger extent than today open for marketing of overseas hedge funds in Norway.
The new rules for investment advice entail, among other things, that the advisor must be of the opinion that the investment is specifically “suited” to the investor in question. The requirement for a specific assessment entails that the authorities can not classify a group of funds as being generally unsuitable for non-professional investors. The core elements in such a suitability assessment will be whether the investment is in accordance with the customer’s investment objectives, whether the customer is financially capable of handling the risk and that the customer has the necessary experience and knowledge to understand the risk. The Ministry notes that it is precisely such considerations that a potential investor in a special fund should receive qualified advice on. Reference is made to the fact that poor advice can result in liability for compensation for the advisor.
This imposed “channelling” through an investment advisor does not apply to professional investors as defined in the Norwegian securities regulations (implementing the MiFID definition of a professional investor).Regulation of the product – exemptions from important rules in the investment funds act
Special funds differ from regular investment funds (UCITS-funds etc.) by the fact that they often aspire to positive yields regardless of the market development, and to achieve such yields there are fundamental differences between the investment strategies in hedge funds and traditional funds. It is normal for hedge funds to debt finance parts of investments, engage in short selling and enter into derivative contracts. The main risk in regular investment funds is associated with the development in the financial instruments the fund has invested in (i.e. general market risk) which is handled through detailed requirements for risk spreading and placement restrictions. Special funds that seek absolute yields are not necessarily exposed to general market risks in the same manner. Based on this, a number of exemptions are proposed from the general rules contained in the Investment Funds Act that regulate such risks. For certain issues special rules are also proposed for special funds that will take into consideration these differences in risk.
Requirement for prospectus
No changes are proposed to the general prospectus rules which apply to regular investment funds. The management company must therefore ensure that a complete and abbreviated prospectus is prepared for the relevant fund.
Requirements for articles of association
Special requirements are proposed for the articles of association of a special fund, including requirements for the articles of association to state the fund’s area of investment, strategy, risk guidelines and methods for risk management. A number of special funds will have investment strategies that will be difficult to define in writing in the articles of association because flexibility in strategy is a central characteristic of such funds. The more detailed requirements for descriptions of risk will have to be specifically assessed and the exercising of judgment by Financial Supervisory Authority’s will no doubt be a decisive factor. Furthermore, in the regulation the Ministry could set more detailed requirements for the special fund’s risk and management of risk. Like the present situation, the articles of association shall be included in the complete prospectus.
The issue and redemption of units
The continual issue and redemption of units is a central characteristic of investment funds. However, according to the draft legislation the special funds are granted the right to restrict the issuing of new units (“closed access”) because such funds will have an actual need to limit their size to maintain profitability. According to the draft legislation, special funds are also granted the opportunity to restrict the unit holders’ rights to continual redemption of units (“closed exit”). This is due, among other things, to the fact that the investment strategies used by a number of special funds assume a certain level of predictability in the fund’s liquidity. However the fund must be open for redemption at least once a year. The minimum annual opening period shall not be less than two weeks. In addition, the fund shall be open for redemption in connection with certain special occurrences, including amendments to the articles of association. In the preparatory works of the proposed legislation, special mention is made of the responsibility investment advisors will have for informing potential non-professional investors about such restrictions in the redemption right.
Eligible assets and requirements for diversification
With regard to rules on eligible assets, it is proposed that special funds (as opposed to general funds) shall be able to invest in, among other things:
• Unlisted financial instruments: The exemption applies both with regard to shares, money market instruments and bonds etc. In principle the exemption applies to the special fund’s right to invest in unlisted derivatives. However, the right to invest in derivatives assumes amendments to the derivative regulation. The derivative regulation will also allow special funds to be able to invest in credit derivatives and currency futures and currency options.
• Fund in funds: The right to establish Norwegian special funds that invest in foreign special funds is conditional upon, among other things, the foreign fund and the administration of this being subject to adequate monitoring in the home country. In addition, it is a condition that satisfactory regulatory cooperation is established between the Financial Supervisory Authority and the home country of the management company. Therefore it is not a requirement that regulatory cooperation is established with the fund’s home country. This is important with regard to the many funds that are established outside the EEA area.
• Other assets: No amendments are proposed to the current statutory rules that require the assets of investment funds to be placed in financial instruments. However, there is the possibility that special rules could be provided for this in a regulation. Units of limited partnerships are currently not defined as financial instruments under Norwegian law, and are thus exempted from the investment universe of investment funds. A regulation as mentioned above might rectify this situation, if the Ministry should choose to do so.
With regard to the requirements for diversification of the investments of special funds , the following is proposed:
• Special funds are exempt from the general obligation to ensure a composition of the portfolio which “appropriately spreads the risk of loss”.
• The prohibition against securities fund placements in one individual company not constituting more than 5% of the fund’s capital shall not apply for special funds.
• With regard to the placement restrictions for an individual issuer, it is, however, proposed that the prohibition against owning more than 10% of the shares in an individual issuer shall apply for special funds. To the extent to which this restriction should entail a restriction for certain investment strategies, the Financial Supervisory Authority will be able to make exemptions.
Borrowing, short trading and securities lending
An important condition for the investment strategies of many hedge funds will be the right to raise loans (gearing), loan out financial instruments and engage in short trading. For this reason, special funds are exempt from the statutory rules that restrict the Securities fund’s right to engage in such activities.
Since special funds are granted the right to raise loans and trade in derivatives, the question of whether unit holders can be liable for more than their investments can soon be raised. Therefore it is proposed to emphasise in the wording of the Act that unit holders are not liable to the creditors for the fund’s obligations. This applies to investors in their roles as unit holders such that investors can take on obligations for the fund or its creditors on a contractual basis.
The role of the custodian
The custodian for special funds is assigned a special control function pursuant to the draft legislation that in many ways will be a supplement to the on-going supervision by the Financial Supervisory Authority. Among other things, the custodian is given a special responsibility to supervise the management fees. The custodian’s tasks will be regulated in more detail in a regulation.
Requirements for value assessments etc.
As long as special funds are open for subscription and redemption, the net asset value of the fund must be continually calculated to ensure the equal treatment of unit holders. In addition, it is necessary to calculate the fund’s value when determining the management fees, since this will often be based on the development in the value of the fund. At a minimum, such a calculation will be made every sixth month. However, during periods in which the fund is closed, the proposed legislation does not require a continual calculation of the value of the fund.
Requirements for risk management
Pursuant to the proposed legislation, special funds must institute a system for managing risk which makes it possible to monitor and measure the risk in the fund. However, special funds could have a number of different risk strategies and it is therefore proposed that more detailed rules should be introduced for such requirements for risk management in a regulation.
In the proposed legislation it is proposed that a special fund should be relatively free to design its structure for management fees, including discounts on an individual basis. It has therefore been signalled that the current regulation pertaining to differentiation of management fees of investment funds, shall not be applicable for special funds. However it is emphasised in the preparatory works that such individual discounts may not amount to a violation of the basic principle of equal treatment of the unit holders.Marketing and sales of foreign hedge funds in Norway
The Investment Funds Act and the new statutory rules for special funds also apply for foreign “investment funds”. The reference to investment funds entails, among other things, that foreign fund constructions that are included under the scope of Act must have the same fundamental features that characterise an investment fund pursuant to Norwegian law. These are assessments that must still be made after a specific assessment of each fund, and no amendments are proposed in the Act for this point. However it is stated that unit holders in “investment funds” can not be liable to the fund’s creditors, cf. above.
Foreign investment funds, including hedge funds, must, in accordance with applicable laws, have permission from the Financial Supervisory Authority prior to any marketing advertise in Norway. Such permission requires, among other things, that the home country of the fund has rules that give investors “protection that is, at a minimum, at the same level as the protection they receive from investing in a Norwegian investment fund”. No changes have been proposed for these rules. The national “benchmark” will however be changed considerably if the new statutory rules are approved by special funds being exempt from the important placement rules in the Act, such that it could be expected in the future that the Financial Supervisory Authority will, to a greater extent than at present, permit marketing of foreign hedge funds in Norway.
The content of this newsletter is merely an information service from Thommessen. The information is not intended to substitute legal advice. Those who receive this newsletter should not rely exclusively on this information and should always seek professional legal advice. Thommessen takes no responsibility for information in the newsletter that may reveal to be inadequate or incorrect. © 2008 Thommessen Krefting Greve Lund AS Advokatfirma.