The Dubai International Financial Centre (DIFC) is a financial free-zone located in Dubai with its own established set of laws and regulations as well as a financial regulator and court system. Established in 2004, the DIFC is arguably the best-known financial hub for the Middle East, with an active financial services industry comprising local, regional and global managers. There are currently more than 1,500 active companies operating in the DIFC with a combined workforce of more than 21,000 people. This article is designed as an introduction to the DIFC funds regime, the licensing regime for fund managers and investment advisers, and considerations for structuring investments in the countries of the Gulf Cooperation Council (GCC – which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE)).
Many of these topics were discussed during a seminar hosted by the financial services group of Dechert’s DIFC office on 27 September 2016, which was attended by more than 80 managers, advisers and investors.
DIFC Funds Regime
In common with other popular fund domiciles globally, the DIFC has created an attractive infrastructure for the asset management industry, including: a zero rate of tax in the DIFC; a good network of double taxation treaties; no restrictions on foreign ownership; the ability to establish certain types of funds on an accelerated basis; and regulatory oversight by the Dubai Financial Services Authority (DFSA). While only a small number of funds has been domiciled in the DIFC to date, the rate is increasing and it is anticipated that this trend will continue.
The Collective Investment Law, DIFC Law No. 2 of 2010, as amended (Funds Law) frames the creation and regulation of funds in the DIFC and sets out three types of DIFC-domiciled funds: Public Funds; Exempt Funds; and Qualified Investor Funds.
Public Funds are highly regulated funds that require the prior approval of the DFSA. There is no minimum subscription amount per investor, nor is there a limit on the number of investors. Investors in a Public Fund may be Professional Clients or Retail Clients as defined under DIFC law (these definitions largely follow the standards that would be expected in other jurisdictions).
Exempt Funds are less regulated than Public Funds and do not require the prior approval of the DFSA. However, the fund manager of an Exempt Fund must notify the DFSA at least 14 days prior to the offer of interests in the fund. The minimum subscription amount in respect of an Exempt Fund is US$ 50,000 per investor, and the maximum number of investors is 100. Investors in an Exempt Fund must be Professional Clients.
Qualified Investor Funds (QIFs) were introduced in 2014. QIFs are the least regulated form of fund in the DIFC, being exempt from many of the regulations applicable to Public Funds and Exempt Funds. QIFs do not require the approval of the DFSA; however, the fund manager of a QIF must notify the DFSA at least 14 days prior to the offer of interests in the fund. The minimum subscription amount in a QIF is US$ 500,000 per investor and the maximum number of investors is 50. Investors in a QIF must be Professional Clients. The ability to offer less-regulated fund regimes, and to put the onus of compliance on the manager rather than, directly, a regulator, is a theme that other fund domiciles are also now adopting1.
Given the “light touch” approach of the DFSA with respect to QIFs and the relative speed in setting up QIFs, a number of regional managers have recently chosen to domicile funds in the DIFC as QIFs, rather than in other offshore or tax-free jurisdictions.
DIFC Licensing Regime
The DFSA is responsible for the licensing and regulation of financial services in the DIFC.
It is important to note that a financial services licence from the DFSA does not automatically authorise its holder to perform, outside of the DIFC (whether in other areas of Dubai or the greater UAE), any activity that is permitted under such licence. Similarly, a financial services licence issued by a financial regulator in another part of the UAE does not automatically enable the holder to perform the relevant financial service(s) in or from the DIFC. For all intents and purposes, the UAE and the DIFC should be regarded as separate and independent jurisdictions.
Other than Islamic financial services (which are governed by additional DIFC legislation and DFSA rules), the licensing and regulatory framework of the DIFC is principally derived from the Regulatory Law, DIFC Law No. 1 of 2004, as amended (Regulatory Law).
The Regulatory Law empowers the DFSA to (among other things) issue and administer supplementary rules and regulations for financial firms setting up and operating in the DIFC. Pursuant to this power, the DFSA has issued and maintains a rulebook with which firms must comply (DFSA Rules).
The DFSA Rules are largely based upon the equivalent rubrics issued by financial regulators in other global financial centres (principally, the handbook issued by the Financial Conduct Authority of the United Kingdom) and, in the same vein as the source material, are divided into modules that address separate topics. Aside from the universally applicable modules (e.g., the General Module), the modules most relevant to asset managers are those pertaining to: the Collective Investment Rules; Prudential – Investment, Insurance Intermediation and Banking; and (in the case of firms dealing with Shariah-compliant products) the Islamic Finance Rules.
The current version of the General Module identifies (and defines) 24 financial service activities that are regulated by the DFSA. Generally speaking, DFSA licences are not categorised by industry or service (i.e., there is no simple “banking” or “asset management” licence). Instead, each licence is granted for a bespoke combination of activities, meaning that applicants are required to identify every activity that will comprise their intended financial service. For example, a banking firm would (at the very least) need to apply for a licence that covers the activities of Accepting Deposits and Providing Credit. While this might appear unduly onerous at first glance, it has the advantage of allowing firms to be able to mix and match (or, indeed, discard) authorisations as suits their exact needs.
One exception is the licence that permits the holder to perform the activity of Managing a Collective Investment Fund – this is the authorisation required to act as a fund manager in or from the DIFC. This licence (which colloquially, but incorrectly, is referred to as a Category 3C licence2) automatically allows the holder to also perform the following activities: Arranging Credit or Deals in Investments; Dealing in Investments as Principal; Dealing in Investments as Agent; Managing Assets; Providing Custody; and Providing Fund Administration – each of which is a facet of a fund manager’s role and would otherwise need to be applied for separately. However, the upshot of this extensive authorisation is that the application process and ongoing regulatory obligations are commensurately more involved than is the case with other licences3.
Consequently, asset management firms in the DIFC often look to structure their operations in a way that properly matches the services they will need to provide with an appropriate level of regulatory oversight.
One such example is a firm wishing to act as an investment manager. While the terms “fund manager” and “investment manager” are often colloquially used interchangeably (and in many jurisdictions there is no distinction between the two roles), in the DIFC there is a difference. According to the Funds Law and the DFSA Rules, a fund manager is an entity that is legally accountable to investors for the management of a fund and its assets. Furthermore, a fund manager’s licence must include a Managing a Collective Investment Fund permission. By way of comparison, an investment manager (although not defined in the Funds Law or the DFSA Rules) refers to the holder of a Managing Assets licence, who is thereby able to perform discretionary portfolio management services on behalf of a fund but is not legally accountable to investors.
This might suggest that establishing a firm as an investment manager rather than as a fund manager should be a foregone conclusion, given that this appears to grant the same powers while minimising liability. However, it should be noted that the Managing Assets licence does not entitle the holder to perform all of the other activities automatically available to a fund manager – this means that, unless such activities are applied for separately, the firm’s operations will necessarily be limited. Furthermore, the DFSA is likely to look very closely at any fund structure proposed by an investment management firm, in order to be satisfied that the firm will not itself be performing fund management activities and to ensure that there is another entity within the fund structure that meets the “legal accountability to investors” aspect of a fund manager’s role.
Another, and more popular, option is to set up an investment advisory firm, which typically involves applying for the Advising on Financial Products or Credit and Arranging Credit or Deals in Investments permissions (colloquially referred to as a Category 4 licence4). In this scenario, the firm does not conduct any fund or portfolio management activities in or from the DIFC, but instead advises an offshore manager or (if applicable) the fund’s board of directors in respect of the management of the fund and/or its assets. Furthermore, the authorisations referred to above also entitle the advisory firm to arrange, structure and negotiate investment opportunities for the fund, as well as to perform marketing and placement services on the fund’s behalf. The investment advisory option has the benefit of a more rapid application process, a lower ongoing regulatory burden and a lower capital requirement. For example, the regulatory base capital requirement for a firm with a Managing a Collective Investment Fund permission is currently US$ 500,000, while the equivalent requirement for an investment advisory firm is US$ 10,0005.
However, as is the case in other jurisdictions where such an approach is equally popular, it is important to: (i) give the offshore manager (or the fund’s board, as applicable) real power to approve or reject the advisory firm’s recommendations; and (ii) avoid having the same (or mostly the same) individuals in control of both the advisory firm and the offshore manager/board. Otherwise, the DFSA is likely to determine that management is actually being conducted within the DIFC.
One final option worth noting is establishing a Representative Office – this is a branch of a foreign regulated entity that is registered with (and authorised by) the DFSA to perform marketing and placement activities in or from the DIFC. The key conditions to this permission are: (i) the activities to be performed by the Representative Office must be within the scope of the regulatory licence held by its head office; and (ii) the Representative Office’s activities cannot relate to DIFC entities (i.e., only foreign funds may by marketed or placed by the Representative Office). While this may sound quite restrictive, it is nonetheless a model that has found some considerable interest, as there are currently over 60 Representative Offices operating in the DIFC.
The above should serve to illustrate the importance of carefully considering which licence is actually required. While the prestige of a full-blown fund management licence is undeniably attractive, it may well be possible for a firm to secure a licence for the functions it truly wishes to perform in a more efficient manner than it otherwise believes. It is no coincidence that of all the asset management firms established in the DIFC, only 25 are fund managers, approximately 100 are investment managers and 300 or so are structured as investment advisers.
Structuring Investments in the GCC
Foreign investors seeking to invest in GCC countries (and outside free-zones, which have either more relaxed or no foreign ownership restrictions) face a number of hurdles, including: foreign ownership restrictions; tax issues; local corporate law issues; and local and complex policies and procedures that can be difficult to navigate.
As a general rule, only GCC nationals and GGC-owned companies may own land in Dubai. However, there are a number of designated areas in Dubai where foreigners may own land (so-called Designated Areas) although the Dubai Land Department (DLD) currently only allows title to be registered in an individual’s name or in the name of a Jebel Ali Free Zone Company even in those Designated Areas. This is largely due to the fact that the DLD wishes to ensure that land transfer fees (calculated at 4% of purchase price) are paid on the transfer of title as well as on the transfer of shares in the land-owning company, so that both direct and indirect transfers of title are subject to the transfer fees.
The DIFC Authority (the entity established to oversee the development, management and administration of the DIFC) is currently in discussions with the DLD to enter into a memorandum of understanding pursuant to which DIFC companies may also hold title to land in Designated Areas.
The Wider UAE and Other GCC Countries
With a few exceptions, companies formed in the UAE must be wholly-owned by GCC nationals (or GCC-owned companies) or, alternatively, a UAE national (or a UAE-owned company) must own at least 51% of the capital in a UAE company. Similar foreign ownership restrictions apply in other GCC countries. Many foreign investors have, in the past, entered into (and continue to enter into) nominee arrangements with UAE nationals, pursuant to which the UAE national holds 51% of the capital in a UAE company for the benefit of the foreign investor. Such arrangements are unlikely to be upheld in a UAE court and may be in breach of UAE law. It is therefore critical that foreign investors seek proper legal advice when making investments in the UAE, and consider other forms of structures (including structured finance arrangements) to enable the foreign investor to obtain the economic benefit of investments in the UAE.
A common structure that has been developed over the last few years is for a foreign investor to: (a) acquire up to 49% of the capital in a UAE limited liability company (UAE LLC); and (b) finance a DIFC Special Purpose Company (DIFC SPC), wholly-owned by a UAE national, pursuant to a profit-sharing arrangement (commonly referred to as a Mudaraba in the Islamic finance industry) for the purpose of the DIFC SPC acquiring the balance of the capital in the UAE LLC. The financing arrangement is typically secured by way of the UAE national charging or pledging the shares in the DIFC SPC in favour of the foreign investor. Similar structures have been used in other GCC countries – in particular, in Saudi Arabia, which imposes up to 25% tax on non-GCC ownership.
Typically, investors benefit from structuring joint ventures and shareholding arrangements in foreign jurisdictions (e.g., the Cayman Islands) in light of such jurisdictions’ flexible and robust company and corporate laws. For example, with the exception of DIFC companies, it is not possible to have more than one class of shares in a company in the GCC. Furthermore, it is difficult in practice to enforce “drag-along”, “tag-along” and other similar arrangements in a GCC company (with the exception of DIFC companies), because shares cannot be transferred unless all shareholders cooperate and sign the necessary share transfer documents in the presence of a public notary in the local jurisdiction. Not only might this requirement cause significant costs and delays, but the process may not be possible where there is a shareholder dispute. These risks can largely be mitigated if the investors hold their interests in the GCC company indirectly through a foreign holding company and enter into a shareholders’ agreement at the level of the foreign holding company.
However, the advantages of DIFC companies in comparison to other GCC corporate regimes need to be seen in context – some of the main reasons why DIFC companies are not often used for holding companies/joint ventures are because DIFC companies must have office space in the DIFC, employ staff and prepare audited financial statements. Clearly this has cost implications which can make this model less attractive. To address these issues, the DIFC Authority has recently created a new form of company called the DIFC SPC, which is intended to be a quicker and more cost-efficient entity to establish. In particular, a DIFC SPC does not require a physical office, employees or audited financial statements. At present, a DIFC SPC can only be used as part of a structured financing transaction, although the DIFC Authority has recently stated that it is preparing a consultation paper regarding a new type of special purpose vehicle.
While there are a number of hurdles faced by foreign investors seeking to invest in GCC countries, foreign investors continue to be attracted to investment opportunities in the region, and there are a number of structures that have been developed to address such hurdles. DIFC entities can offer significant advantages when developing such structures. As highlighted above, the DIFC Authority has consistently reviewed its own laws and regulations and cooperated with other regional and foreign authorities to help create a truly international financial free-zone.