Sales Between Funds, the Sartor Case, and Continuation Funds (IV): An Exegesis of Article 22(g) of the Chilean Funds Act

Chile's Single Funds Act (Ley Única de Fondos, LUF) provides, in Article 22(g), that, without prejudice to the other prohibitions established in other laws, the following actions or omissions are contrary to the LUF when carried out by fund managers and, where applicable, by persons participating in the fund's investment decisions or who, by virtue of their position, have access to information regarding the fund's investments: engaging in conduct that violates the following prohibition: the acquisition or disposal of assets on behalf of the fund where the management company itself, a private fund under its management, or a related company acts as the seller or purchaser.

In this article, we will further examine the wording of this provision. Specifically, we will reflect on what the law means when the heading of the provision itself indicates that we are dealing with cases of “Prohibitions.”

Prohibition

In this regard, we must consider two approaches to the meaning of the term prohibition underlying the title of the rule. One is a private law approach, and the other is a financial law approach (in this case, securities law). This article focuses on the private law approach.

Private Law Approach

With respect to the first approach, we will confine ourselves to classical civil law. As is well known, legal rules may be prohibitory, permissive, or mandatory. One might consider that Article 22, taken as a whole, is a prohibitory provision, but this is not the case.

As we know, a prohibitory rule imposes a duty not to act, and the prohibited act may not be performed under any circumstances. It allows neither the act nor the omission in any situation whatsoever. For this reason, it has been said that a prohibitory law and the prohibited act are one and the same thing. The act cannot be carried out in any respect. If the law authorizes the act through any exception, then we are dealing with a mandatory rule rather than a prohibitory one. Furthermore, when the law prohibits something in explicit terms, as Article 22 of the LUF does under the heading “Prohibition,” this fact alone does not mean that the legislature has enacted a prohibitory law.

An important factor in classifying a law as prohibitory is the effect of its violation: namely, the nullity of the act or contract carried out in breach of the prohibition (nullity as a sanction), unless the law itself specifies a different consequence.

Returning to Article 22 of the LUF, we may conclude that it contains both prohibitory and mandatory rules. Accordingly, we reject the notion that every provision within it is prohibitory. Article 22(i) of the LUF establishes a mandatory rule, namely, an exception to the prohibition on the management company conducting transactions that are more advantageous than those carried out by the fund on the same day. Such conduct is permitted if the price differential is transferred to the benefit of the fund.

For the purposes of our discussion, we believe that Article 22(g) itself contains four cases that undoubtedly constitute prohibitory rules. These would include acquisitions or disposals between:

A private investment fund (FIP) and its manager;

A private investment fund and another private investment fund managed by the same manager;

A public fund (FP) and its manager; and

A public fund and a private investment fund managed by the same manager. This last prohibition is reinforced by Article 88 of the LUF.

By contrast, it is open to debate whether acquisitions or disposals between a private investment fund and a company related to the management company, as well as equivalent transactions involving a public fund and a related company of the manager, should be regarded as prohibitory rules.

This issue arises in connection with Article 88 of the LUF and its interpretation by the regulator, the Financial Market Commission (CMF), in Ordinary Official Letter No. 14,178 of 2018. Article 88 provides that private investment funds may not engage in transactions or operations with public funds unless they are managed by management companies that are not related to each other. In this regard, the CMF has held that, considering this rule, if there is no transaction or operation directly between a private fund and a public fund, but rather between companies in which those funds participate indirectly (whether or not such companies are related to the manager), then, in principle, there would be no violation of Article 88.

The CMF therefore interprets Article 88 restrictively and does not extend it to other forms of prohibition. This reasoning would necessarily lead to the conclusion that Article 22(g) would not apply in the situations under discussion, for two possible reasons.

The first reason would be that Article 22(g) does not apply because, in the specific case addressed by the regulatory opinion, no “related parties,” within the meaning of Article 22(g), can exist. That is, where a private investment fund and a public fund participate in companies, such companies could never become related parties of the management company of both funds.

We believe this first rationale is questionable, as it is highly doubtful that no company could ever possess characteristics sufficient to classify it as related to the management company of the relevant fund. In this regard, it should be remembered that, in Chile, funds are not corporations, unlike in jurisdictions such as the United States, where funds may indeed take corporate form. Therefore, one may seriously debate whether a fund's segregated pool of assets can be analogized to any type of legal entity. Consequently, it may be reasonable to interpret a manager as being related to a fund in the same way that it may be related to a corporation, and thus also related to the corporations owned by that fund. One need only consider concepts such as controlling entity, corporate group, conflict of interest, or management authority as factors in determining whether legal entities are related. Furthermore, establishing whether a company is related to a management company may be extremely difficult, including in cases where that company belongs to a fund managed by that manager.

As is well known, Chile's Securities Market Law introduces factors beyond ownership to determine related-party status, including the concept of management. In our view, a manager, even when it has no ownership interest in the fund it manages, may nevertheless be related to a company owned by that fund by virtue of its management role. Moreover, the regulator could also determine the existence of a relationship between the company and the manager on the basis of a conflict of interest criterion.

A second reason for not applying Article 22(g) in the CMF opinion is to interpret it as a mandatory rule that is subject to the exception embodied in Article 88, as interpreted by the regulator. Thus, for example, Article 22(g) would prohibit transactions between a fund and a company in which its manager has an ownership interest, but would not prohibit transactions between a fund and a company owned by another fund managed by the same manager, even where that company could be regarded as related to the manager for reasons other than ownership. In such a case, Article 88 would function as an exception.

This interpretation assumes that there are transactions permitted under Article 88, at least according to the CMF's reading, that would simultaneously be prohibited under Article 22(g). Such a contradiction could only be resolved by treating Article 22 as containing mandatory rules, whereby compliance with Article 88 would render the transaction permissible. This is because Article 22(g) encompasses multiple distinct factual scenarios within a single rule.

This second rationale appears stronger than the first.

Now, if that specific scenario under Article 22(g) is indeed mandatory in nature, the consequence is that the law imposes either a duty to refrain from an action (not carrying out the acquisition or disposal) or a requirement that must be satisfied (that acquisitions and disposals comply with Article 88, which, under the regulator's interpretation, would be both a necessary and sufficient condition).

We further believe that this mandatory rule is one of public policy, not necessarily because it protects public order or morality, but because Article 22 itself, in its penultimate paragraph, expressly provides that although invalidity might otherwise be the appropriate sanction, the affected acts “shall not have their validity affected.” The fact that the law expressly prevents invalidity implies that, absent such language, the acts would otherwise be invalid. Invalidity is precisely the sanction generally associated with mandatory rules enacted in the public interest.

In any event, this would be a public policy rule because it is essential to society and the general interest. It does not merely protect individual interests; it cannot be waived by agreement of the parties; it safeguards the interests of third parties (the investors); it protects parties operating with fewer informational or decision-making tools; and it contributes to the organization of credit and capital allocation within the jurisdiction.

We should immediately dismiss the notion that these rules are intended to protect consumers or establish a public-law regime. Rather, they are designed to address the classic agency problem that arises between fund managers and fund investors. The rule exists solely for that purpose. Moreover, a violation of the rule disrupts the objective legal order even where no subjective right has been affected. For this reason, in numerous enforcement decisions, the CMF repeatedly emphasizes that financial regulation protects an essential public good: confidence and trust in the market, even in the absence of an injured subjective right.

It should also be noted that the relevant defect would arise from the status or condition of the parties involved rather than from the nature of the transaction itself. Although nullity is unavailable, that does not prevent us from identifying the legal defect.

Accordingly, we must consider the applicable sanctions. As noted above, invalidity is not the consequence; rather, liability is. This is the sanction ordinarily associated with violations of mandatory laws serving private interests and is equally applicable to mandatory laws enacted in the public interest. Article 22 itself establishes the relevant sanctions, providing for administrative, civil, and criminal penalties, as well as the right to seek damages.

Administrative sanctions are directly related to the subject of the next article, where we will examine the financial-law understanding of prohibition. Criminal sanctions apply only where the conduct falls within the scope of a specific criminal offense.

Finally, regarding the distinction between civil sanctions and the right to claim damages, the former concerns contractual relationships involving funds, such as those between managers and investors, or the contract underlying the prohibited transaction itself, but may also extend to non-contractual relationships, for example with the fund's manager. The latter, by contrast, pertains specifically to liability as an alternative remedy that compensates for the inability to declare the transaction null and void. In a sense, the law recognizes that the inability to obtain nullity may itself cause harm to the parties. The civil liability route, the law wisely acknowledges, constitutes the optimal solution.