Venture Capital Funds as Joint Investment Institutes under the Legislation of Ukraine and Regulations of the EU, by Yosyf Ivanyuk, Managing Partner
- Yosyf Ivanyuk
- Mar 5, 2020
- 17 min read
Updated: Mar 1
Joint investment institutions (hereinafter – JII), in particular venture funds (hereinafter – VF), constitute an important part of the economies of developing countries, as they stimulate investments by natural and legal persons and play a significant role in the development of young companies that build their business on the basis of innovations and innovative technologies (startups). In addition, the use of VFs for the purposes of legitimate tax optimisation or as financial intermediaries within groups of companies is a very common phenomenon in the goods and services market, including in Ukraine. The activities of VFs in Ukraine are generally built according to the European model; however, certain differences and imperfect legal regulation remain, which constitutes a problem in terms of aligning Ukrainian legislation with the unified normative acts of the EU.
The purpose of the publication is to examine the general legal regulation of the activities of VFs and JIIs in EU countries, to compare it with such regulation in Ukraine, and to put forward proposals for improving the said legal regulation in Ukraine.
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I. Concept and Types of Venture Funds in Ukraine and the EU
The special normative legal act regulating the activities of VFs is the Law of Ukraine “On Joint Investment Institutions” dated July 5, 2012 No. 5080-VI (hereinafter – the Law). Thus, a venture fund, pursuant to Part 10 of Article 7 of the Law, is a non-diversified closed-end joint investment institution that carries out exclusively private placement of joint investment institution securities among legal entities and natural persons. A VF may be established as a corporate fund (hereinafter – CF) or a unit fund (hereinafter – UF). The key difference is as follows. A legal entity established in the form of a joint-stock company and carrying out exclusively joint investment activity is a CF (Part 1 of Article 8 of the Law). In this case, a corporate venture investment fund is considered a legal entity established in the form of a joint-stock company. A UF is a set of assets belonging to the participants of such a fund on the basis of common partial ownership, managed by an asset management company and accounted for by it separately from the results of its economic activity (Part 1 of Article 41 of the Law). A UF is established by an asset management company and is not a legal entity, but merely a set of assets managed by the asset management company (hereinafter – AMC). Thus, a CF is a full-fledged legal entity, while a UF is only a set of assets under the management of the AMC.
The main legislative act of the European Union (hereinafter – EU) regulating joint investment is Directive of the European Parliament and of the Council of the European Union No. 2009/65/EC of 13 July 2009 (hereinafter – the Directive)6. Pursuant to Article 1 of this Directive, it regulates the activity of collective investment in transferable securities (eng. “transferable securities”) established in Member States (hereinafter – UCITS). Based on Part 2 of Article 1 of the Directive, such activity consists of:
– collective investment undertakings investing in transferable securities or other liquid financial assets referred to in Article 50(1) of the Directive, capital raised from the public, operating on the principle of risk spreading;
– units which, at the request of the holders, are repurchased or redeemed, directly or indirectly, out of the assets of the collective investments.
The above investment activity, pursuant to Part 3 of Article 1 of the Directive, may be carried out in the form of a common fund (as a fund managed by management companies), an investment trust fund (in accordance with trust law) or as an investment company (in accordance with its statute(s)).
Transferable securities, within the meaning of point (n) of Article 2 of the Directive, are: (i) shares in companies and other securities equivalent to shares in companies; (ii) bonds and other forms of securitised debt; (iii) any other transferable securities that can be obtained by purchase or exchange.
Finally, it should be noted that the Directive does not apply to: (i) closed-end collective investments; (ii) collective investments financed by capital without public advertising of the sale of their units (i.e., securities through which the fund receives investment); (iii) collective investments whose units may be sold, in accordance with the rules of the fund or the instruments establishing the investment company, publicly in third countries; (iv) categories of collective investments provided for by regulatory acts of EU Member States in which such investments are established, to which the rules of Paragraph VII and Article 83 of the Directive will not apply due to the investment and debt policy of such collective investments.
Thus, the Directive does not provide a definition of the concept of VF as an independent subject of investment activity, nor of its types, but clearly defines what UCITS investment activity is and lists the legal forms in which it may be carried out. By analogy, the counterpart of UCITS in Ukraine is open-end JIIs. This conclusion follows from the provisions of the Directive that exclude its application to closed-end JIIs.
Direct regulation of VF activities in the EU is provided by Directive No. 345/2013 on European Venture Capital Funds (hereinafter – the EuVECA Directive or EuVECA), adopted on 17 April 2013. Based on the content of the provisions of the EuVECA Directive, the primary reason for its adoption was the need to protect venture capital from certain rules of the AIFMD (hereinafter – the AIFMD Directive) that are unsuitable for the sector of investments through VFs, such as excessively high capital requirements and the obligation to appoint a depositary. To solve this problem, European legislators adopted a Directive that allows venture capitalists to place their funds (invest) throughout the EU without having to comply with all the requirements of the AIFM Directive.
Simply put, investments through VFs concern investing funds in small and medium-sized businesses (hereinafter – SMEs). Therefore, this form of investing should be simplified, which is why the EuVECA Directive was adopted.
At the same time, the activities of investment funds in the EU are also regulated by the AIFMD Directive. Thus, the AIFMD Directive establishes rules for the authorisation, ongoing operation and transparency of managers of alternative investment funds (hereinafter – AIFMs) that manage and/or market alternative investment funds (hereinafter – AIFs) in the EU. In turn, as stated in point (a) of Part 1 of Article 4 of the AIFMD Directive, alternative investment funds mean collective investment undertakings, including sub-funds of alternative investment funds (hereinafter – AIF), which:
– raise capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors;
– do not require authorisation pursuant to Article 5 of the Directive.
At the same time, based on recital 6 and Part 2 of Article 2 of the AIFMD Directive, it applies to the activities of:
– alternative investment funds of both open-end and closed-end type, which in particular include VFs in the EU pursuant to the provisions of the AIFMD and EuVECA Directives,
– common funds (contractual law), investment trust funds (trust law), investment companies (statutes) or funds established in any other forms. Thus, point (b) of Part 1 of Article 4 of the AIFMD Directive provides that AIF managers are legal entities that carry out economic activity in the management of alternative investment funds. Thus, a parallel can be drawn between asset management companies / joint-stock companies that manage venture funds and AIF managers in the EU. The common feature is that the asset management company or joint-stock company is the analogue of the AIF manager in the EU, but the clear definition of the legal form of the AIF manager is determined by the specific substantive law of the EU Member State where such manager carries out its economic activity (or on the territory of which, within the EU, a non-resident manager carries out its activity through a branch / subsidiary or fund). The AIFMD Directive also defines that each alternative investment fund (the manager – the legal entity of such fund) must be authorised in accordance with the provisions of this AIFMD Directive and the national legislation of the state where it is established or carries out its investment economic activity.
Article 9 of the AIFMD Directive contains obligations of EU Member States regarding the capital of AIF managers. Thus, the standard requirement for the size of initial capital of internal AIFs is EUR 300,000, but Part 2 of this article provides an exception according to which the initial capital may be EUR 125,000 where the AIF manager is an external manager (i.e., an organisation that manages investments on a principle similar to that described in the Law regarding asset management companies / joint-stock companies). If the manager manages funds whose investment portfolio exceeds EUR 250 million, the manager must provide an additional amount of own capital equal to 0.02% of the excess amount, but not more than EUR 10 million; at the same time, the own capital of any AIF manager may not be less than the amount provided for in Article 21 of Directive 2006/49/EC, which is equivalent to one quarter of the previous year’s fixed expenses.
Finally, the EuVECA Directive should be characterised, since it is specific to qualified venture funds in the EU and entered into force on 1 May 2018. Pursuant to Article 1 of the EuVECA Directive, it applies to managers of collective investments in relation to the marketing of venture capital in the EU, thereby contributing to the functioning of the internal market. At the same time, managers of collective investments under the EuVECA Directive must meet the following criteria:
– assets under management: (i) must not exceed EUR 100 million, or (ii) must not exceed EUR 500 million provided that within five years from the date of the first investment (first investments) there is no repayment thereof;
– they must be established and carry out activities within the EU;
– they must undergo authorisation (a form of licensing in the EU country of their registration);
– they must manage portfolios of qualified venture funds.
Within the meaning of the EuVECA Directive (Part 2 of Article 2), a qualified venture fund is a collective investment:
– of at least 70% of the aggregate capital contributions and non-targeted capital in assets that are qualified investments, calculated on the basis of amounts invested after deduction of all relevant expenses and monetary reserves and equivalents, which is intended to be carried out within the established terms in accordance with the rules or founding documents;
– which does not use more than 30% of its aggregate capital contributions and non-targeted invested capital for the acquisition of assets other than qualified investments, calculated on the basis of amounts that may be invested after deduction of all relevant expenses and monetary reserves and their equivalents;
– which is carried out on the territory of an EU Member State.
Where the above main criteria and restrictions are met, an AIF manager registered in one EU Member State may market qualified venture funds in all other EU Member States: (i) to professional clients (customers); (ii) to other investors who invest at least EUR 100,000 and who have confirmed that they are aware of the risks of such investment(s); (iii) to managers, directors and employees involved in the management of investment funds.
Thus, it can be concluded that an alternative investment fund in the EU may be a JII of both closed-end and open-end type if it meets the features and criteria for AIFs defined by the AIFMD Directive, and a qualified venture fund under EU law is a type of alternative investment fund managed by an authorised manager to which the provisions of the EuVECA Directive may apply. The EuVECA Directive imposes additional restrictions and criteria on venture capitalists in order to simplify the conduct of activities and promote venture investments in EU Member States. Where a venture fund in the EU does not meet the requirements of the EuVECA Directive for the purposes of conducting investment activity in simplified form, it will be considered a full-fledged AIF and the provisions of the AIFMD Directive will apply to it. At the same time, the AIFMD Directive does not apply to VFs that operate in accordance with the EuVECA Directive (except where this is expressly provided for in the EuVECA Directive). A similar rule applies to alternative investment funds that operate in accordance with the AIFMD Directive (except where this is expressly provided for in the Directive).
II. Investment Activity of Venture Funds in Ukraine and the EU
The activity of a VF directly depends on the assets that the VF may acquire. The Regulation on the Composition and Structure of Assets of a Joint Investment Institution, approved by Decision of the National Securities and Stock Market Commission dated 10 September 2013 No. 1753, establishes that assets may not include: (1) securities issued by the asset management company, the custodian of the JII’s assets, the Central Securities Depository, the property valuer of the JII, or the auditor (audit firm) of such JII; (2) securities of other JIIs; (3) privatisation securities; (4) agreements on participation in a construction financing fund (CFF).
Proceeding from the contrary, a VF has the right to act as an investor with respect to any other types of assets. As a result, it can be concluded that the legislator has taken a relatively lenient approach to the scope of activity of a VF and has granted such a VF the possibility to carry out broad-profile investment activity.
A VF is a non-diversified and closed-end JII and carries out exclusively private placement of securities, i.e. the issue prospectus and amendments thereto are not disclosed (Part 10 of Article 7 of the Law and Paragraph 3 of Part 2 of Article 52 of the Law).
Based on the provisions of Part 10 and Paragraph 4 of Part 1 of Article 7 of the Law, the closed-ended nature of a VF means that the VF or the asset management company of the VF does not assume obligations to repurchase securities issued by such VF (the company managing its assets) before the termination of the VF. Thus, the Law expressly provides that in the case of investing funds in VF securities, there are no guarantees regarding the return of investments on the basis of the securities issued and acquired by investors, i.e. in all cases investment in a venture fund is high-risk, and the only guarantee for the investor is the reputation of the relevant VF.
Therefore, under Ukrainian legislation a VF is a non-diversified closed-end JII that carries out exclusively private placement of securities among legal entities and natural persons. A VF is not qualified or specialised and therefore has no requirements as to asset structure, except those provided in general for JIIs in the Regulation. In addition, a VF cannot be considered diversified, since it does not meet all or at least one of the characteristics inherent to diversified JIIs provided for in Part 4 of Article 7 of the Law.
Regarding the legal regulation that may apply to VFs in the EU territory, the Directive should be applied, but it regulates only general issues of joint investment; therefore, at the level of national normative legal acts of EU Member States certain specific features of legal regulation are already established, in particular regarding whether a VF may be of closed-end or open-end type, as well as the prospectus for the circulation of its transferable securities.
The relevance of the issue of applying the Directive to VFs in Ukraine in the context of European integration is growing. If we model a situation in which Ukraine is an EU Member State, then at the level of national legislation of Ukraine the Directive will not apply to VFs, since the Directive, pursuant to its Article 3, does not apply to closed-end investments. In Ukraine VFs are always of closed-end type, and their issue prospectus is confidential and not publicly disclosed. Therefore, in the future it will make sense to align Ukrainian national legislation with EU law, in particular with the Directive, to eliminate discrepancies. Such unification in the context of VFs can be carried out in two ways: (1) amendments to the Law in the part regarding the application of the Directive to VFs that eliminate the criteria mentioned above which do not allow the Directive to be applied to VFs, or (2) amendments to the Law that will distinguish VFs into closed-end and open-end types.
III. Licensing, Accreditation and Custody of Assets of Venture Funds in Ukraine and the EU
In Ukraine a VF is a financial institution, since Clause 1 of Part 1 of Article 1 of the Law of Ukraine dated 12 July 2001 No. 2664-III classifies investment funds as financial institutions; however, regarding VFs this norm of the law is merely formal and has no logical basis. This is explained by the fact that a VF does not provide financial services but carries out investment activity, while the management of the assets of the venture fund itself is carried out, in accordance with the requirements of the Law, by an asset management company – a financial institution. As a result, a VF is not a subject of licensing in matters of providing financial services. The Licensing Conditions for Carrying Out Economic Activity in the Provision of Financial Services (except for professional activity in the securities market), approved by Resolution of the Cabinet of Ministers of Ukraine dated 7 December 2016 No. 913, impose no requirements for licensing the investment activity of VFs as a type of JII. However, the Licensing Conditions for Carrying Out Professional Activity in the Stock Market (Securities Market) – Activity in Asset Management of Institutional Investors (Asset Management Activity), approved by Decision of the National Securities and Stock Market Commission (hereinafter – the Commission) dated 23 July 2013 No. 1281, provide that licensing of asset management activity of institutional investors is carried out by the Commission, and an asset management company, as one of the licensing subjects, may obtain a license for professional activity in the stock market – activity in asset management of institutional investors (asset management activity). Thus, the investment activity of a VF is not subject to licensing, while the activity of managing the assets of the VF carried out by the AMC is subject to licensing by the Commission. An additional argument in support of the above is that, pursuant to Clause 3 of Section I of the Regulation on the State Register of Financial Institutions, approved by Order of the State Commission for Regulation of Financial Services Markets of Ukraine dated 28 August 2003 No. 41 (as amended by the Order of the National Commission for State Regulation in the Sphere of Financial Services Markets dated 28 November 2013 No. 4368), the Regulation applies to all legal entities except joint investment institutions.
Thus, under Ukrainian law a VF is a financial institution, but such a norm of the law is merely formal, since a VF does not provide financial services.
Under EU law collective investments are not carried out without obtaining the relevant authorisation, or, as it is called in Article 5 of the Directive – authorisation from the EU Member State. Such authorisation consists of obtaining the relevant license or authorisation in the EU Member State and proper compliance with the national regulatory acts of the relevant EU Member State. Part 2 of Article 5 of the Directive states that the analogue of an asset management company – management company (hereinafter – “management company”) – must obtain authorisation in the EU Member State for the management of assets of a particular fund, approve the rules of the fund and the fund’s depositary. In fact, a similar practice regarding joint investment institutions, in particular regarding VFs, also operates in Ukraine. Thus, the issue of licensing asset management companies as managers of VF assets is regulated by Decision of the National Securities and Stock Market Commission dated 23 July 2013 No. 1281 (hereinafter – the Decision). Pursuant to Clause 4 of Section I of the Licensing Conditions for Carrying Out Professional Activity in the Stock Market (Securities Market) – Activity in Asset Management of Institutional Investors (Asset Management Activity), a license for professional activity in the stock market – activity in asset management of institutional investors (asset management activity) may be obtained by an asset management company.
It should be noted that the institution of a depositary for collective investments is effective, which is also present in Ukraine, as expressly provided for by the Law. Thus, pursuant to Part 1 of Article 22 of the Directive, the assets of a common fund must be entrusted to a depositary for safekeeping. Such a depositary is accountable to the management company authorised in the relevant EU Member State and is liable to investors for improper performance of its functions in the safekeeping of assets (Article 24 of the Directive). In addition, Part 3 of Article 22 of the Directive provides a list of non-exclusive obligations of the depositary. Thus, such obligations include, inter alia, ensuring that:
(i) the sale, issue, repurchase, redemption and cancellation of issued securities and the calculation of their value are carried out in accordance with the applicable law and the rules of the fund;
(ii) instructions of the management company are executed in accordance with the applicable law and the rules of the fund;
(iii) in operations involving the assets of the common fund any compensation is directed to it within ordinary time limits;
(iv) the income of the common fund corresponds to the applicable law and the rules of the fund.
Thus, the norms of Ukrainian law regarding the legal regulation of licensing of VF activities and EU law are generally unified. Both jurisdictions share common features regarding licensing and the presence of a depositary for joint investment institutions. In the context of the relevance of European integration, which entails the need to align Ukrainian law with EU law, it can be stated that in the part concerning licensing of VF activities and the presence of a depositary the national laws of Ukraine generally correspond to EU law.
Conclusions. Taking into account the above, the following common features inherent to VFs in Ukraine and the EU can be identified:
– the activity of VFs is clearly regulated by special normative legal acts; in particular, in Ukraine – this is the Law of Ukraine “On Joint Investment Institutions” dated 5 July 2012 No. 5080-VI; in the EU – Directive of the European Parliament and of the Council of the European Union No. 2009/65/EC of 13 July 2009, the EuVECA Directive and the AIFMD Directive;
– the regulatory acts of the EU and Ukrainian legislation take a lenient approach to the investment objects of VFs, i.e. the range of investment of VF funds is very wide and practically unlimited; however, investments must be made in Ukraine taking into account the norms of the Regulation on the Composition and Structure of Assets of a Joint Investment Institution, approved by Decision of the National Securities and Stock Market Commission dated 10 September 2013 No. 1753, and in the EU – taking into account the above directives and norms of national law of the EU Member State where the relevant venture investments are made;
– the manager of a VF, in any case, undergoes a procedure of authorisation or licensing; however, whereas in Ukraine such requirements are established by the Law of Ukraine “On Joint Investment Institutions” dated 5 July 2012 No. 5080-VI, in the EU this issue is regulated by the above directives at the level of unified rules for all EU Member States;
– the legislation of Ukraine and EU law impose requirements on the initial and own capital of the manager of collective investments.
Despite this, there are significant differences regarding the regulation of VF activities in Ukraine and the EU:
– in Ukraine there are no simplified conditions for the activities of venture funds in terms of investing in small and medium-sized businesses, whereas in the EU, for such purposes, the EuVECA Directive entered into force on 1 May 2018;
– in Ukraine the issue of marketing investment proposals is not regulated, while in the EU it is clearly regulated at the level of obligations of EU Member States that are assumed by them after the directives enter into force;
– the EuVECA Directive imposes special requirements on the structure of assets of a qualified venture fund; however, if a venture fund in the EU does not conduct activity in accordance with the EuVECA Directive, only the general rules of the AIFMD Directive and the national laws of the EU Member State where such VF is established will apply to it;
– EU law, by its nature, imposes obligations on EU Member States to implement the provisions and requirements of directives regulating joint investment into national laws, but does not directly regulate investment activity. That is, the first in line for the influence of the normative legal act is the EU Member State, and the second (through the intermediary of the state) is the joint investment institution itself. From the point of view of improving Ukraine’s investment climate, it would be advisable to borrow from the EU the conditions for simplifying the conduct of investment activity for venture funds in Ukraine; however, it is difficult to say whether this will have a significant impact on the development of legislation regarding the regulation of VF investment activity and on the economy of our country as a whole, since, based on the provisions of the Law, VFs in Ukraine have more than sufficient freedom and choice regarding investment objects, and Ukrainian legislation does not impose significant requirements on the structure of VF assets.
Undoubtedly, a positive borrowing from the EU would be the introduction in Ukraine, at the legislative level, of rules for the marketing of VF investment objects. This would significantly improve the legal regulation of investment activity and help prevent, in a preventive manner, unfair or fraudulent activities in the sphere of investing through venture funds.
Originally published in 2019 in Ukrainian (at the Law Review of Kyiv University of Law) as follows:
Ivanyuk, Y. I. (2019). Venture capital funds as joint investment institutes under the legislation of Ukraine and regulations of the EU: General characteristics [in Ukrainian]. Law Review of Kyiv University of Law, 2019(4), 220–227.
