The Dubai Financial Services Authority (DFSA) has implemented a new regime for credit funds, which comes into force on June 1, 2022. The new regulation primarily impacts the managers of credit funds domiciled in the DIFC, but there are some implications for non-DIFC credit funds. The new regulation results in heightened regulation of DIFC credit funds and their managers (as compared to other DIFC funds and their managers) and, in practice, will likely operate as a new licensing category, with higher fees and additional compliance obligations.
Whether the DFSA’s approach will encourage or discourage the formation of credit funds in the DIFC remains to be seen, but the new rules provide welcome clarity on the DFSA’s approach with regards to an increasingly popular asset class.
DIFC Credit Funds
A DIFC fund is a “Credit Fund” if its investment objective is to use at least 90% of its assets to “Provide Credit,” including by acquiring loans, which means to purchase, take transfer of, take credit risk or part of credit risk attaching to, or take other exposures to, the loan. “Providing Credit” means providing a Credit Facility to any natural or legal person in his capacity as a borrower or potential borrower. A “Credit Facility” means any facility that includes any arrangement or agreement that extends monetary credit, whether funded or unfunded, to a Person, including but not limited to any loan or syndicated loan, mortgage, overdraft, financial lease, letter of credit, financial guarantee, trade finance, transaction finance, project finance, asset finance, or the financing, discounting, or factoring of invoices.
Under the DFSA’s new regime, a DIFC Credit Fund is limited in terms of the credit instruments it can utilize, and the borrowers and counterparties to which such credit instruments can be extended. In particular:
- a DIFC Credit Fund may not provide the following types of Credit Facility: (a) letters of credit, (b) financial guarantees or (c) cross-border trade finance (trade finance for the trade of goods or services that takes place wholly within a country is permitted on the basis that it is less operationally complex and involves a lower degree of risk); and
- a DIFC Credit Fund may not provide Credit Facilities to the following borrowers: (a) a natural person; (b) the Fund Manager, a Related Party of the Fund Manager or any other person acting for or on behalf of the Fund Manager;(c) another fund or fund manager; (d) a financial institution or a person related to a financial institution; (e) a person who intends to use the credit for the purpose of trading in investments, commodities or crypto assets; or (f) a person who intends to use the credit for the purpose of Providing Credit.
DIFC Credit Funds are subject to a number of additional rules and restrictions, as follows:
- Management:As a general rule, a non-DIFC fund manager (External Fund Manager) may manage a DIFC Fund, but this is not permitted for a DIFC Credit Fund, which must be managed by a DFSA-regulated Fund Manager.
- Structure: A DIFC Credit Fund must be an Investment Company or an Investment Partnership (not a trust).
- Professional Clients Only: A DIFC Credit Fund must be either an Exempt Fund or a Qualified Investor Fund, meaning that a DIFC Credit Fund can only be open to Professional Clients (as defined in the DFSA Rules).
- Term: A DIFC Credit Fund must be established for a finite period not exceeding 10 years. The DFSA rules require that any redemption or distribution before the end of the Credit Fund’s term requires the approval of a majority in interest of investors.
- Strategy: In addition to the limits on the types of credit facility and types of borrowers that a DIFC Credit Fund may engage with (as noted above), the Fund Manager of a DIFC Credit Fund must:
- have a clear strategy that aims, within a specified period not exceeding three years from the date the Fund is established, to achieve a diversified portfolio of loans that limits exposure to any one person or corporate group to a maximum of 25% of net assets (the “risk diversification limit”),
- not enter into borrowings that exceed 10% of the DIFC Credit Fund’s net asset value at any time,
- have sound and well-defined criteria for credit granting and acquisition of loans and, for that purpose, the process for approving, amending, renewing and re-financing credit and acquiring loans must be clearly established,
- have internal methodologies in place to assess the credit risk of exposures to individual obligors, securities or securitisation positions and credit risk at the portfolio level, which do not rely solely or mechanistically on external credit ratings,
- have ongoing monitoring and administration of the various credit risk bearing portfolio positions and exposures, including for identifying and managing problem credits and for making adequate value adjustments and provisions, and
- have a comprehensive stress testing programme carried out at least annually (or, at the request of the DFSA, more frequently).
- Policies: The Fund Manager must ensure that the DIFC Credit Fund maintains and adheres to appropriate written policies and procedures relating to:
- the assessment, pricing, granting, managing and acquiring of credit, in accordance with a defined risk appetite statement;
- credit monitoring, renewal and financing;
- the criteria, governance and decision making structures for (a) and (b);
- collateral management;
- concentration risk management;
- valuation, including collateral valuation and impairment;
- identification and management of problem debt;
- delegated authority; and
- documentation and security.
- Investor Reporting: The annual report and interim report of a DIFC Credit Fund must include the following information about credit provided and loans acquired:
- a breakdown between senior secured debt, junior debt and mezzanine debt;
- a breakdown between loans with an amortising repayment schedule and loans with bullet repayments;
- a breakdown of the loan-to-value ratio for each loan;
- information about non-performing exposures and aggregated information about exposures subject to forbearance activities; and
- any material changes to the credit assessment and monitoring process.
- Prospectus Content: In addition to standard disclosures for DIFC Funds, a DIFC Credit Fund prospectus must include risk warnings and statements regarding compliance with the foregoing regulatory requirements such as risk diversification strategy and borrowing limits.
- Fees and Base Capital Requirements: The licence application fee for the Fund Manager of a DIFC Credit Fund is $10,000 (usually the fee where the Fund is a QIF is $5,000), and the base annual fee is $10,000 (usually the annual fee where the Fund is a QIF is $5,000). The Base Capital Requirement for a manager of a DIFC Credit Fund is $140,000, which is the same as for retail funds (the Base Capital Requirement for fund managers of other Professional Client funds is $70,000).
- Regulatory Reporting: The Fund Manager of a DIFC Credit Fund is required to make additional reports to the DFSA as compared to the Fund Managers of other DIFC Funds, and must submit the following forms on a quarterly basis: Large Exposure, Arrears and Provision, Credit Activity and Trade Finance Activity.
Foreign Credit Funds
A Foreign Fund is a Credit Fund if its investment objective is, or includes, Providing Credit, including by acquiring loans. Note that this definition does not include the 90% threshold of a DIFC Credit Fund. Morgan Lewis is not aware of any guidance yet, through public announcement or precedent, from the DFSA as to what amount of credit investment activity would cause a Foreign Fund to be treated as a Credit Fund for the purposes of the DFSA Rules, noting that many private equity and venture capital funds allow debt like investment activity.
That said, the impact of the DFSA rules on Foreign Funds is currently limited to the two following matters:
- Management: As a general rule, a DIFC (i.e., DFSA-regulated) fund manager may manage a Foreign Fund, but this is not permitted for a Foreign Credit Fund. This means that the role of a DFSA-regulated entity with respect to a Foreign Credit Fund will likely be limited to that of investment adviser to the Foreign Fund’s manager (if the DFSA-regulated entity has the appropriate Category 4 Advising license), or investment manager (if the DFSA-regulated entity has the appropriate Category 3C Managing Assets license).
- Marketing: There are three legislative provisions under which Foreign Funds may be marketed in the DIFC: Articles 54(1) (a), (b) and (c) of the DIFC Collective Investment law. When marketing under 54(1)(a), the Foreign Fund has to either be a Designated Fund (as defined in the DFSA Rules) or meet such criteria specified the DFSA. Under the new regulations, a Foreign Credit Fund must meet the following requirements:
(i) it is a Closed-ended Fund;
(ii) it satisfies the conditions that would be necessary for it to be an Exempt Fund or Qualified Investor Fund if it was a Domestic Fund;
(iii) it has in place appropriate policies and procedures for assessing, pricing, granting, managing and acquiring credit;
(iv) it has in place an appropriate stress testing programme; and
(v) it is subject to regulatory requirements that provide an equivalent level of protection to that provided under the DFSA Rules (including prospectus disclosure requirements and the various limitations on term, structure, strategy and policies and procedures requirements described above).
However, there has been no change to Article 54(1)(c) of the Collective Investment Law, which is the basis on which many foreign private investment funds are promoted. This only requires that the Foreign Fund is offered by way of private placement only to Professional Clients with an initial subscription of at least $50,000.
If you have any questions or would like more information on the guidance discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Ayman A. Khaleq
William L. Nash
Alishia K. Sullivan