Fraud in the sub line market – should we be concerned?

Some commentators have stated that the sub line market is “shaken” by this news. While this may be the usual media hype, as this is the first known fraud to occur in the subscription line market, we understand some lenders, at least, are reviewing internal procedures and due diligence processes to look to ensure that the commitments securing the subscription facilities they have written exist.  Indeed, investors in funds may also be seeking similar assurances so that they are not ‘on the hook’ for the commitments of a defaulting investor.

Jersey is a leading, internationally recognised jurisdiction for the establishment, management and administration of collective investment funds.  For lenders with exposure to Jersey funds, the regulatory environment here, as well as the potential penalties, should provide comfort.

There are a number of different fund structures in Jersey, ranging from highly regulated by the Jersey Financial Services Commission (JSFC), to those with light touch regulatory oversight.  Fund regulation and the regulation of fund service providers in Jersey falls under the Collective Investment Funds (Jersey) Law 1988 (CIF Law) and the Financial Services (Jersey) Law 1998 (FS Law) alongside, in the case of smaller funds, the Control of Borrowing (Jersey) Order 1958 (COBO).

CIF Law

The more regulated funds (generally public funds open to more than 50 investors) are subject to regulation under the CIF Law.  In determining whether to grant a certificate under the CIF Law, the JFSC can look at the integrity of the applicant and its principal persons (i.e., its directors or partners) as well as the promoter, fund manager or investment adviser.

Funds holding a certificate issued under the CIF Law are required to be audited.  Certain retail funds will also be subject to greater scrutiny by the JFSC.

Funds regulated under the CIF Law must also have services provided by firms regulated under the FS Law (further details below).  Further, some funds are also required to have an investment manager who must be established in an OECD member state or a state that is or subject to a memorandum of understanding with the JFSC or otherwise approved by the JFSC; and either be regulated in that state or satisfy certain criteria under the relevant guide applicable to the fund.

FS Law

Jersey Private Funds (JPF) (which are a very common fund structure and make up a large number of funds established in Jersey) are not subject to direct regulation; a key factor in their popularity.  A JPF cannot be offered to, nor have more than, 50 investors.  Each JPF however, must have a ‘designated service provider’ (DSP).

A DSP must be regulated by the JFSC under the FS Law.  In particular, the DSP is responsible for, inter alia, (i) ensuring that all necessary due diligence on the JPF and its promoter is carried out and ensuring that the promoter of the JPF has put in place appropriate measures to ensure that all service providers to the JPF are fit and proper and can fulfil the tasks in a responsible, professional and suitable manner and (ii) ensuring compliance with all necessary Jersey AML/CFT requirements applicable to the JPF.

For all funds regulated under CIF, Jersey incorporated/resident GPs must themselves hold a registration under the FS Law and Jersey resident managers must be approved under the FS Law if marketing to investors in the EU under the AIFMD regime).  All service providers who hold licences issued under the FS Law are themselves subject to regulation for their own business activities.  In particular, each such entity must organise and control its affairs effectively for the proper performance of its business activities and be able to demonstrate the existence of adequate risk management systems.

Each entity licenced under the FS Law are required to conduct AML/CFT on the fund(s) to which it provides services, which will require an understanding of the investors in such fund.

So while a DSP, or other Jersey service provider, may not be involved in any fraud, a failure by the DSP (or service provider) to:

• meet its AML/CFT obligations; or
• have the appropriate policies and procedures in place to identify any irregularities/suspect fraud,

may lead to penalties or other sanctions being imposed by the JFSC.

Penalties

The JFSC has a number of possible sanctions at its disposal when looking to enforce compliance with relevant laws.

1)    The JFSC may issue directions to an entity requiring an action to be done (or not done).

2)    The JFSC has the ability to issue public statements for a variety of reasons, including for the breach of any applicable Codes of Practice or if any directions have been given.

3)    The JFSC may also revoke a licence/certificate (or impose more restrictive conditions) – for the Jersey based service providers this could have a substantial and material effect on their business.

4)    The JFSC may impose fines under the civil financial penalty regime.  Where there is a breach of any applicable Code of Practice, fines may be imposed on both the regulated entities and, where such breach was committed with the consent, or connivance of, or is attributable to neglect on the part of a director of that entity, such director.

The JFSC has, in the past two years, imposed a number of civil financial penalties on regulated firms for breaches of their regulatory obligations.  Most recently, in February 2021, three SG Kleinwort Hambros entities were fined a combined GBP 719,451.21 for such failings (co-operation and an early settlement entitled these entities to a 50% discount on the penalty to be imposed).

We are not aware of any penalties being issued by the JFSC to directors under the civil financial penalties regime.  However, we note that for the most serious contraventions for intentional or reckless behaviour the JFSC may impose a maximum fine of GBP 400,000.

Conclusion

These mechanisms are not designed to (and cannot) prevent criminal actions by individuals within a fund.  There are detailed and exhaustive checks and balances to govern the management of a fund but these cannot be assured to prevent an individual who is intent upon committing a crime from doing so.  It is, however, anticipated that the management and governance structure of an entity which meets the JFSC’s regulatory requirements will make it rather more difficult for an individual to behave in this way.

If you require further details please get in touch with Andrew Weaver, James Gaudin and Daniel Healy.