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With the approval of Circular 1/2006 on 3 May by the Spanish regulator, the CNMV, the regulation on hedge funds has been finalised after prior approval of the Regulation on Collective Investment Institutions passed on 4 November 2005 (hereinafter, both the Regulation and the Circular, the “Regulations”). Once this regulation is approved, Spanish management companies would be able to file for the licence to manage hedge funds, which would be the prior step for the first product to be launched.

1. New Funds Regulated Under the Circular

   The Spanish Regulations create a specific status for hedge funds for non-retail investors – “Free Investment Funds” (HFs). Very briefly, the key characteristics include:

   • maximum leverage up to 5x NAV; apparently, no limits on exposure in derivatives
   • minimum investment of €50,000 and only marketable actively to qualified investors (ref the Prospectus Directive)
   • quarterly / 6-monthly NAV and liquidity provisions: the final regulation has not ruled the possibility of FoHFs to establish a maximum period notice for redemptions or the possibility of setting up lock-up periods, and this is something that should be finally ruled before the first products are launched.
   • ability to create single HFs and FoHFs with no specified restrictions on concentration / investments, although master-feeder structures may not be possible.

   For retail investors, there are “Funds of Free Investment Funds” (FoHFs) which can be freely marketed. Note the section dealing with limits on such FoHFs (in Regulation 20); this was one of the issues of concern in the final regulations and the Circular now provides:

   • minimum investment of 60% in other eligible funds;
   • as to eligible assets for FoHFs – these may be funds domiciled in an OECD country or funds managed by an entity subject to supervision and domiciled in an OECD country. It is not expressly foreseen whether the investment can be made in a fund of funds or not;
   • that investment in managed accounts is permitted – allowing investment in entities, vehicles or structures domiciled in an OECD country or managed by an entity subject to supervision and domiciled in an OECD country – with investment objectives similar to a Spanish HF; and
   • this can be through use of derivatives, the underlying assets of which may be as in (b), (c) or financial indices composed by assets of (b) and (c) type (Reg 20.2).

   The final regulation has not ruled the possibility of FoHFs of establishing a maximum notification period for redemptions or the possibility of setting up lock-up periods, and this is something that should be ruled before the first products are launched.

   Umbrella funds / different classes or series of shares will be allowed.

2. Distribution of Foreign Hedge Funds

   Foreign open-ended funds may be marketed (if expressly authorised), provided they: (a) comply with criteria applying to Spanish funds and (b) essentially, if they are managed by an OECD-domiciled entity and supervised accordingly but note that this may be denied in the interests of protection of the local industry. Closed-ended funds would follow the provisions of the Prospectus Directive. In any case, it seems that the policy on register foreign funds by CNMV would be very restrictive.

3. Hedge Funds Managers

   Both HFs and FoHFs will be subject to stricter requirements and controls than other asset managers (as to human resources, equity requirements, risk control, organisational, policy and procedural resources, risk measurement and control systems). Managers intending to manage HFs must be expressly authorised by the CNMV, which will check compliance with the requirements.

4. Prime Broker

   The prime broker regulation for Spanish hedge funds is based on Spanish implementation of the Collaterals Directive (through Royal Decree 5/2005). Such Royal Decree is very flexible and, for instance, permits the rehypothecation of the assets by the prime broker. Likewise, in order to guarantee the control of the assets, the Draft of the Circular establishes certain control measures that we will describe briefly here:

   • Disclosure obligations concerning the prime broker and its solvency.
   • In the case the prime broker is authorised to use the assets, this circumstance must be reported to the custodian. The Prime Brokerage Agreement must foresee that the custodian receives the proper information for the compliance of its duties as custodian.
   • As regards the Prime Brokerage Agreement, the Circular has adequated the disclosure on the maximum counterparty risk with a prime broker that is the maximum of the assets collateralised by the prime broker, which can be used (rehypothecated) by the prime broker.
   • The Circular reinforces as well, the obligations concerning the control and measure risk systems, in order to ensure, among others, the monitoring of the positions on the assets given as collateral which the beneficiary has disposed of. Finally, it has removed the obligations of the prime broker being sub-custodian and only a notification to the custodian is required.

   Finally, in order to provide an additional mechanism to protect investors in case of insolvency of the prime broker, according to the Draft of the Circular, the fund may terminate the collateral agreement entered into with the prime broker and proceed with the close-out netting of any payment obligations. The ability to terminate any collateral arrangements so entered will not be fettered in the event of the insolvency of the prime broker.