When an institutional investor in Israel invests in an investment fund, it must comply with regulations set in the Supervision of Financial Services Regulations. In particular instances, the manner funds manage their affairs contradict these regulations.
Holding Units in an Investment Fund
A clear instance of such a contradiction is the case of full and complete proprietary and control rights. According to Regulation 21(a), “An institutional investor shall hold an asset only if its right in it is a proprietary right, including the perpetual lease right, its control over the asset is direct, full and complete, and there is no lien or mortgage on the asset.” In practice, this regulation states that an Israeli institutional investor may hold its units in an investment fund only if these units are under its full and complete ownership and control.
However, the typical documentation of investment funds is inconsistent with this requirement. Investment funds tend to make transfers of units of these funds to third parties contingent upon the approval of fund managers, because fund managers reserve the right to determine the identities of investors in their funds. This practice by investment funds of restricting transfers of units in funds may cause an institutional investor to violate the regulations, since the regulatory requirement of “full and complete control” can be interpreted as requiring Israeli institutional investors to ensure their right to sell their units in the investment funds and not to agree to grant fund managers the power to prevent them from transferring their units to third parties.
Interpreting the Regulation
According to this interpretation of the regulation, there must be no restriction on the rights of Israeli institutional investors to sell their units in a fund, since, if an Israeli institutional investor is the owner with full and complete control over these units, it must also hold the right to sell its units in a fund at any time. In other words, the regulatory authority may consider fund managers’ power to prevent the sale of units in the fund as detracting from the “full and complete ownership” within the context of the regulation.
The Court’s Position
This interpretative approach is not merely theoretical. Support for it can be found from inferences in case law. In a 1991 District Court (Tel-Aviv) ruling, the court held that the legislative authority’s objective in the regulation is to ensure the liquidity of a financial entity’s assets so that, when necessary, if the financial entity encounters cash flow difficulties, it may dispose of these assets. Therefore, and in light of the fact that restrictions on transfers may make it difficult for institutional investors to liquidate their units in the funds, Israeli institutional investors must not be subject to these restrictions on transfers.
The Pragmatic Solutions
Normally, managers of private equity funds have considerable interest in assisting their investors to effectuate transfers of units. This is in order to maintain good relations with investors and support the value of the fund’s units in the secondary market. For this reason, it is usually quite easy for fund managers to agree to undertake not to refuse approval of such transfers for unreasonable reasons. This undertaking, included in the side letters to Israeli institutional investors, provides some degree of a practical transfer right. This is one of several solutions to reconcile between the understandable desire of fund managers to determine the identities of investors in their funds and the provisions of the regulatory regulation as interpreted by some institutional investors in Israel.
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Barnea Jaffa Lande’s investment funds team is at your service if you have any question in this regard.
Adv. Roy Engel heads the firm’s investment funds practice.
Adv. Yakov Vilenski is an associate on the team.