On 6 January 2011 The Emirates Securities and Commodities Authority (ESCA) released a new draft regulation on investment funds in the UAE (the Regulation) for public consultation. The deadline for submitting comments or responses to ESCA is now closed, and it is expected that the Regulation will soon be discussed and approved by ESCA.
It is hoped that the Regulation, along with the existing and upcoming securities laws administered by ESCA, will provide a better regulatory environment for the issuance of domestic investment funds, as well as the distribution of foreign funds in the UAE.
This article highlights the proposed key changes under the Regulation and examines some important points contained in the initial draft.
EXISTING LEGAL FRAMEWORK
Under the current legal framework, the setting up and marketing of investment funds in the UAE requires approval from the UAE Central Bank, in accordance with the procedures set out in the Central Bank Board of Directors’ Resolution No 164/8/94, regarding the regulation for investment companies and banking, financial and investment consultation establishments or companies (Resolution 164). Since its promulgation, Resolution 164 has undergone two amendments in 1995 and a recent amendment in 2000.1
Article 4.1 states that, except for exempted funds under Federal Law No 10 of 1980 (UAE Central Bank Law), it is prohibited to set up and market investments without prior approval from the UAE Central Bank.
The UAE Central Bank categorises a licensee who can establish and manage funds as an investment company. The category ‘investment company’ was originally defined as a juridical person who conducts the business of financial investment.This category was later clarified in the first 1995 amendment to be either a sole proprietorship owned by a UAE citizen, or a company with one of the legal forms stipulated under Federal Law No 8 of 1984 (UAE Commercial Companies Law). However, if the investment company is a limited liability company, its paid-up capital should not be less than AED50m.
On approval by the UAE Central Bank a licensed investment company may conduct business as follows:
- opening investment accounts and managing portfolios on behalf of others, whether individuals or companies;
- subscribing in the capitals of companies and debt instruments issued by major companies;
- preparing feasibility studies for projects, and marketing allotments and the shares of stock companies;
- establishing and/or managing investment trust funds;
- acting as a trustee for funds entrusted to it by a donor to manage on behalf of a beneficiary;
- establishing and/or managing investment trust funds;
- participating in extending and/or managing joint loans;
- studying and marketing company mergers and ownership;
- establishing and/or managing other investment with special approval on a case-by-case basis;
- acting as a broker in the sale and purchase of local and foreign securities; and
- dealing in foreign currencies, and providing banking, financial and investment consultations services.
Article 8.2 of Resolution 164 lists the following conditions for granting a licence to an investment company:
- the paid-up capital should not be less than AED25m (for a limited liability company it should not be less than AED50m);
- national ownership should not be less than 51% of the total paid-up capital;
- the chairperson and the majority of the board of directors must be UAE nationals; and
- the founding members must meet the necessary requirements in relation to personal integrity and professional qualifications as deemed appropriate by the UAE Central Bank.
Article 4 of Resolution 164 applies to funds’ prospectus and stipulates that only a licensed investment company, or a bank licensed to operate in the UAE, can market investment funds in the country. The prospectus must contain information relating to the fund in a format acceptable to the UAE Central Bank. The information must include the:
- fund’s objectives;
- amount of capital;
- allotment of units;
- investment policies;
- evaluation method; and
- management procedures.
An approved investment fund is required to publish its quarterly financial report in a local newspaper in a format acceptable to the UAE Central Bank, to ensure that information pertaining to the status of the investment fund is available to the public. The fund manager is also required to make public the market price of the fund’s units and the latest net asset value of the units in comparison to its previous value. This must be done weekly.
The existing Resolution 164 is viewed to be very far from being a comprehensive and exhaustive regulation to govern the dynamic funds market of the UAE.
PROPOSED CHANGES UNDER THE REGULATION
The main changes that are proposed under the Regulation are as follows:
- the licensing authority would no longer be the UAE Central Bank, ESCA would be the new authority;
- the structure of local funds will be changed, as will the associated regulatory requirements;
- the definition of foreign funds will be provided, as will approval processes associated with them; and
- disclosure and due diligence will be required.
ESCA AS THE LICENSING AUTHORITY
Under the Regulation, licensing authority will be shifted from the UAE Central Bank to ESCA. Article 3 provides that any UAE-based investment fund must obtain a licence from ESCA. It further provides that any fund promotion requires prior approval from ESCA.
Making ESCA the licensing authority will streamline the regulation of the securities industry in the UAE as it will be industry driven. The move is also in line with ESCA’s objectives to encourage investment in funds that are in the best interests of the national economy, stabilising the country’s finances. Strategically, this will enhance the administration of the securities and commodities framework in the UAE.
It is intended that the UAE Central Bank will continue to carry out its supervisory role in assessing the financial situations of licensed investment funds (Article 28 of the Regulation). The UAE Central Bank will carry out inspections and prepare periodic inspection reports on the licensed funds, and will send copies of the reports to ESCA for their necessary action. Approval of the UAE Central Bank will also be required alongside the ESCA approval for marketing and distribution of foreign funds.
LOCAL FUND STRUCTURES AND REGULATORY REQUIREMENTS
Unlike the existing Resolution 164, Article 1 of the Regulation defines ‘local funds’ and ‘foreign funds’. The definition of a local fund is ‘any investment fund established in the state and licensed by the authority other than those established in the free zones’. A foreign fund is:
‘Any investment fund established outside the state in accordance with applicable laws and regulations of a foreign state, as well as investment funds established in the free zones in the state.’
It also defines other fund categories as follows:
- Investment fund: an investment pool assembling the savings of investors in return for issuing investment units of equal value and rights, and taking one of the forms prescribed by law.
- Open-ended (mutual) investment fund: a fund with a variable capital that increases with the issuance of new units and decreases with the redemption of existing units. It is permitted, subject to the approval of the authority, to trade its units on the market after listing.
- Close-ended investment fund: a fund with a fixed capital, unredeemable units (unless at the end of its life cycle or if otherwise provided for in its articles of association and its investment policy). Units may also be traded on the market after listing, in accordance with controls approved by ESCA, and in line with its articles of association and prospectus.
- Exchange-traded fund: open investment fund established to invest the majority of its funds in an investment combination that is compatible with the combination of a market price index or a combination of an investment portfolio defined by its investment policies, allowing trading of the fund’s units on one or more markets.
There is no category or definition for exempted funds under the Regulation except to the power and authority reserved for the UAE Central Bank.
The important change to note is that any funds issued within a UAE free zone will not be considered to be local funds. An investment fund issued in the Dubai International Financial Centre (DIFC), for example, will still require require ESCA approval before it can be promoted within the UAE.
Application for fund establishment
One of the main changes under the proposed Regulation is that only joint stock companies with paid-up capital of at least AED10m can apply to establish a local investment fund. Under the existing Resolution 164, applicants for fund licenses can be any form of company registered under the UAE commercial companies law. In addition, the Regulation proposes a change to the minimum capital requirements of applicants. Currently, minimum capital requirement is AED25m for all companies other than limited liability companies, where the minimum capital must be no less than AED50m.
The Regulation provides exemptions on minimum capital requirements for banks, financial investment companies, branches of foreign banks and any entity licensed by the UAE Central Bank. These exempted entities are instead required to submit an unconditional bank guarantee in favour of ESCA in the sum of AED10m. This guarantee can be used by ESCA to cover any financial obligations towards any investor at their discretion. However, it is not clear from the Regulation under what circumstances ESCA can encash this guarantee.
Unless the entity is an exempted entity as explained above, the activity of a licensee company must be limited to establishing investment funds. In addition, Article 7 requires that the entity that establishes a local investment fund must have a permanent office within the UAE and its address must be declared in the fund’s prospectus.
The Regulation also introduces investment limits for local investment funds that are being used for investment in general and for specific investment in traded securities. For local investment funds, investing companies must invest no less than 10% of the funds capital and no more than 49% of the capital unless the fund is closed-ended. Similarly, limits are set for investment in traded securities and these are detailed under Article 11 of the Regulation.
These new requirements will serve to protect investors and can arguably be compared to the EU Products Directive.
Articles of association and prospectus
The proposed Regulation requires the articles of association of a local fund to have more specific minimum contents. The specific contents are set out in Article 8, and this is a another good step in ensuring transparency and protection for potential investors.
In relation to the prospectuses, it is stated that the official language should be Arabic. A prospectus may be prepared in English, but, in the event of any conflict, Arabic will prevail. There is no provision on specific contents for a prospectus, but the format of a prospectus must comply with a format set by ESCA.
Requirements of the board of the fund
Other new requirements under the Regulation are in respect of fund board formation and the obligations of the board members (Article 25).
Board members will have to ensure the financial statements of the fund comply with the rules of disclosure in a manner that guarantees transparent reporting on the unitholders’ financial investments. Board members of a Sharia-compliant fund will also be required to ensure that the fund complies with the applicable rules and fatwas issued by the fund’s Sharia board, and to provide all data and information to the Sharia board to assist their decision-making process.
The Regulation contains extensive and clear provisions on the rights, powers, obligations and liabilities of service providers to local funds. These provisions are set out in part 3 of the draft and aim to regulate the relationship between the service providers, local fund, unitholders and ESCA. There are three categories of service providers defined under the Regulation, which are investment manager, administrative service company and custodian. This new regulatory environment will be a welcome improvement and shall instill confidence in investors and investment companies in establishing and investing in local funds.
FOREIGN FUNDS, DEFINITION AND APPROVAL
There are currently no detailed procedures for obtaining UAE Central Bank approval for the marketing of a foreign fund in the UAE. The proposed Regulation sets out detailed guidelines on the promotion of foreign funds in the UAE (Article 2(1)) and the term ‘foreign fund’ is also given a special definition.
Main conditions for licence
The main conditions for obtaining ESCA approval to promote a foreign fund are laid down in Article 36 of the Regulation. The conditions can be summarised as follows:
- the foreign fund must be established and licensed in a foreign state, and be subject to supervision of a controlling authority similar to ESCA or free zone authority in the UAE;
- the related parties involved and responsible for the foreign fund must be licensed by a controlling authority similar to ESCA;
- the foreign fund must enter into contract with local companies licensed by ESCA (including an authorised UAE promoter and distributor) to carry out all the tasks associated with the foreign fund, in accordance with its articles of association and prospectus; and
- the foreign fund must also obtain approval from the UAE Central Bank.
The above conditions are not exhaustive and ESCA shall have the power to impose additional conditions or waive any conditions on a case-by-case basis.
The application for a licence to promote a foreign fund must be submitted to ESCA using the prescribed form and attaching the supporting documents.
The submission documents must be approved and certified by legal advisers that are pre-approved by ESCA and appointed by the foreign fund.
Trading of foreign fund units
Trading of foreign fund units will also be allowed in the UAE but only through a bank licensed by the UAE Central Bank. Units can be traded on the exchange market once approved by ESCA (Article 38).
The Regulation specifies the obligations that authorised distributors of foreign funds must fulfill to obtain a licence in the UAE.
Among the obligations of authorised distributors is the responsibility to a know-your-customer record of the unitholders of the foreign fund.
Perspective on DIFC funds
Any investment fund issued and marketed in the DIFC or outside the UAE will not be subject to these proposed regulations. However, the marketing of DIFC-issued funds in the UAE will still require approval from ESCA, as DIFC-issued funds will be considered as foreign funds for the purposes of promotion within the UAE.
Arguably, since the DIFC is a financial free zone, with its own laws and regulations on investment funds, it could be advantageous if DIFC-issued funds could benefit from a preferred or exempted status under the proposed Regulation. This may improve the marketability of the DIFC as a preferred financial free zone for issuers who wish to market their funds in the UAE.
However, it is important to consider the above in light of Article 4 of Federal Law No 8 of 2004 (UAE Financial Free Zone Law), which sets out restrictions on the activities of companies established in a financial free zone within the UAE.
In addition, Article 3 of Cabinet Resolution No 28 of 2007 (on the Implementing Regulations of Federal Law No 8 of 2004) provides that any companies and establishments wishing to carry on their activities within UAE, but outside the borders of the financial free zones, shall be subject to the federal laws applicable in the UAE.
DISCLOSURE AND DUE DILIGENCE
Another notable change under the Regulation is the requirement on all relevant parties to the fund, according to their role, to conduct a due diligence exercise to ensure all information is transparent and accurate (Article 26(1)).
There are also specific information sharing requirements for administrative service companies, investment managers and founders of funds.
Conflict of interest
The Regulation emphasises the avoidance of conflicts of interest among the parties of a fund. Situations that may constitute a conflict are set out in Article 27 of the draft. However, ESCA reserves the right to exempt a conflict, depending on the nature of a particular transaction.
Failure to conduct due diligence and ensure that all information is transparent and accurate will be a violation of the requirements set out in Article 26(1). If a violation occurs, and the violating party is found guilty, they may be liable to sanctions under Article 40 of the Regulation.
The following sanctions are available to ESCA where there is violation of any provision, decision or control issued by them:
- warning to compel the offender to remove the violation within a specified time period;
- a fine not exceeding the legal limit;
- suspension of licence or approval for a period not exceeding one year; and
- revocation of licence or approval.
Decisions made by ESCA to reject an application for a local or foreign fund, or revoke a licence, can be appealed against by following the procedures set out in Article 41 of the Regulation.
The proposed Regulation indicates that the UAE government is taking steps towards providing a more transparent regulatory framework, based on good governance principles such as those in other global financial centres. The proposed changes will hopefully attract more interest from the domestic and international funds industry, and will spearhead the maturity of the UAE as the leading financial hub in the Middle East.
Heightened requirements associated with due diligence and disclosure will hopefully further align the domestic fund industry in the UAE with more sophisticated and developed jurisdictions worldwide.
As yet, the Regulation does not have a specified table of fees, and costs have not been specified for licensing. It is likely that this will be the next interesting factor for consideration by industry players.
By Muhammad Syamsulfaiz Bin Zainuddin, senior associate, Habib Al Mulla & Co.
- Investment Companies Amendment dated 18 April 1995 (1st of 1995); Investment Companies Amendment dated 18 April 1995 (2nd of 1995); and UAE Central Bank Board of Directors Resolution No 89/3/2000 dated 30 April 2000.