The revised legislation reflects in particular the requirements of the European Union’s Directive on Alternative Investment Fund Managers, which will take effect on July 22, 2013. It also follows some aspects of Luxembourg’s funds legislation of December 17, 2010, which transposed into national law the Ucits IV Directive governing cross-border distribution of retail funds within the EU and introduced other changes affecting non-Ucits funds.

In addition, the revisions to the SIF regime reflect the experience of Luxembourg’s regulator, the Financial Sector Supervisory Authority (CSSF), over the more than five years since it was established by legislation of February 13, 2007. Over that period the number of SIFs has grown from around 220 (vehicles recategorised from Luxembourg’s previous regime from institutional funds) to 1,387 at the end of January 2012, and they account for more than one-third of all investment funds domiciled in the grand duchy.

The revised legislation was submitted to the Chamber of Deputies on August 12 last year. Although it was originally hoped that the law could be adopted by the end of the year, it was not until January that Parliament’s Finance and Budget Committee approved an amended version of the draft bill. The committee finalised its report on the legislation to the full Chamber on February 28, and it received almost unanimous approval from deputies a week later. The law will come into force on the day following its publication in the Mémorial, Luxembourg’s official journal.

The revisions to the legislation include measures to bring the SIF law into line with AIFM Directive rules covering areas including delegation, risk management and the handling of actual or potential conflicts of interest. Following the December 2010 legislation, it will allow sub-funds of a SIF umbrella structure to invest in other compartments of the same structure in the same way that Ucits funds can do.

The most notable change abolishes an eye-catching, but not heavily used, provision of the 2007 SIF that allowed fund promoters to wait until up to a month after the launch of a fund to submit it to the CSSF for approval. Henceforth funds must be authorised by the regulator before they can be launched.

In its advice to Parliament, Luxembourg’s Chamber of Commerce noted that “one might regret the disappearance of certain advantages relating to the approval and information procedures that up to now have made [SIFs] particularly flexible investment vehicles”.

However, the Council of State, which is responsible for scrutinising legislation, said in its report that this change was “more a measure of legal security and a codification of existing practice than a restriction, since almost all promoters applied for approval before launching their funds in order to avoid the risks and costs entailed by any changes to the documentation, operating model or investment policy that the CSSF might have required in the case of approval sought following the launch of the fund”.

The legislation is relatively short, consisting of just 18 articles covering five A4 pages. The first article states that the activity of management of a SIF must comprise at a minimum management of the investment portfolio. This explicitly excludes from the SIF regime passive funds that seek to create value solely by the long-term holding of assets and creates a distinction between SIFs and private wealth management companies created under Luxembourg’s law of May 11, 2007, but it does not exclude private equity or real estate funds.

Article 2 requires SIFs to have in place procedures to verify that its investors qualify as sophisticated rather than retail clients. The Council of State argued that this measure was superfluous, but the Finance and Budget Committee decided to retain it as a means of reminding SIFs and their promoters of their obligations.

Article 3 allows SIFs created as open-ended investment companies (Sicavs) to benefit from measures in the 2010 law under which fund articles of association drawn up in English no longer need to be translated into French or German. In addition, such funds no longer need to send shareholders physical (as opposed to electronic) copies of their annual reports unless this is specifically requested, Finally, given potential for high turnover of shareholdings in a SIF, they may establish a registration date five days preceding an annual general meeting of shareholders for the purposes of determining voting rights and what constitute a quorum.

Article 5 of the draft law amends Article 42 of the 2007 SIF legislation, which allowed promoters of a fund to apply for approval of their articles of association, choice of custodian and their executives and portfolio managers after the fund’s launch rather than before. This change brings SIFs into line with funds created under the 2010 legislation.

A new requirement makes authorisation subject to notification of the persons responsible for management of the SIF’s investment portfolio to the CSSF, which must certify that they are of good reputation and have the experience necessary to manage the type of alternative investment fund in question. Any changes in the identity of the fund’s portfolio managers must also be notified to the regulator.

Article 6 creates a new Article 42bis of the legislation requiring SIFs to implement systems to detect, measure, manage and monitor the investment risk of its individual positions and their contribution to the portfolio’s overall risk profile. They must also be structured and organised to minimise the risk of conflicts of interest, and draw up rules to manage such conflicts that do arise to prevent any harm to investors. The CSSF is mandated to draw up regulations setting out detailed requirements in these areas.

Reflecting the CSSF’s experience in supervising SIFs since 2007, Article 7 defines the conditions under which SIFs may delegate various tasks and functions to third-party providers. The CSSF must be informed in advance and delegation should not affect oversight of the fund; individuals or legal entities to which portfolio management is delegated must be authorised or licensed for that function and subject to prudential regulation, unless the CSSF grants permission for delegation to individuals or entities that do not meet this requirement.

A fund’s managers must be able to determine that the delegated provider is qualified and capable, and they must retain ultimate control over the fund’s activities and the ability to revoke the delegation. Delegation should not create conflicts of interest – so, for instance, investment management may not be delegated to the fund’s custodian – and the delegation of functions must be revealed in the fund’s offering documents.

The CSSF’s powers of supervision and enquiry over SIFs are set out in Article 8, which brings the legislation into line with the requirements of the Ucits IV Directive, while Article 9 set out circumstances in which the CSSF or the Luxembourg prosecutors may apply to the courts for the dissolution and liquidation of one or more fund compartments.

Article 10 deals with administrative fines, which the CSSF may publish unless this would seriously affect financial markets, damage the interests of investors or cause disproportionate prejudice to the parties affected. On the insistence of the Council of State, a clause has been inserted into the text confirming that firms may appeal against such penalties.

Under Article 12, the CSSF’s approval is now required for any substantial change made to the SIF’s offering documents, such as the name of the fund or of sub-funds, the replacement of the custodian, administrator, auditor or manager, the creation of new sub-funds or a significant change in investment policy.

Article 13 states that funds are not prohibited from deviating from their investment policy for the purposes of liquidity management, hedging or efficient portfolio management, while Article 14 bars SIFs in the form of companies that are in the course of being liquidated from issuing new shares, except where this is beneficial to the outcome of the liquidation itself. Article 15 allows the CSSF to withdraw authorisation for one or more sub-funds of a SIF while maintaining the authorisation for other sub-funds of the same structure.

Article 16 of the new law follows the 2010 legislation in allowing one sub-fund of a SIF to invest in another. This article clarifies that the rules regarding a company’s investment in its own shares set out in Luxembourg’s 1915 company law do not apply to SIFs. Sub-funds of the same SIF may not cross-invest in each other, and voting rights of shares held by one sub-fund in another are suspended.

Finally, Article 17 stipulates that SIFs established before the date of entry into force of the revision law will have a transitional period up to June 30, 2012 before they are obliged to comply with its requirements on ascertaining that their investors are sophisticated (Article 2, paragraph 3) and risk management and conflicts of interest (Article 42bis), and up to June 30, 2013 to comply with the new rules on the delegation of functions (Article 42ter).

Esma says that in the light of responses to the discussion paper, it will draw up a consultation paper during the second quarter of this year setting out formal proposals for draft regulatory technical standards under Article 4(4) of the directive, “to determine types of AIFMs, where relevant in the application of this directive, and to ensure uniform conditions of application of this directive”.

The authority says it will use the results of the public consultation to finalising the draft regulatory technical standards, which it will submit to the European Commission for endorsement by the end of 2012. Comments must be received by March 23.

Esma seeks to align supervisory practices among European national regulators in the interpretation of certain key concepts of the AIFMD as part of its efforts to achieve a harmonised application of the directive, and may consider developing additional convergence tools for this purpose in future.

Definition of an alternative investment fund manager
Esma notes that Article 4(1)(w) defines the activity of managing alternative funds as performing at least portfolio management or risk management functions, and argues that therefore an entity performing either of the two functions should be considered as managing a fund. Such an entity must therefore seek authorisation as an alternative fund manager under Article 6 of the directive.

No authorisation is required where either portfolio or risk management is carried out under a delegation arrangement with an alternative manager. Article 20 requires that any entity to which portfolio or risk management functions are delegated is authorised or registered for the purpose of asset management and subject to supervision, otherwise prior approved is required from the manager’s home regulator.

According to Esma, Article 6(5)(d) should be interpreted as requiring a manager to be capable of providing, and take responsibility for, both portfolio management and risk management functions in order to be authorised under the AIFMD. However, it may choose to outsource either or both of these functions according to the delegation rules set out in Article 20 of the directive and the Level 2 measures to be announced by the European Commission later this year.

The manager’s liability is not affected by delegation (or further sub-delegation) of portfolio and/or risk management functions to a third-party entity. Esma emphasises that these functions may not be delegated to such an extent as to make the manager effectively a letterbox entity that can no longer be considered as manager of the fund in question. Subject to these requirements, Esma says that a manager may delegate both portfolio and risk management in whole or in part, but it may not delegate both functions in whole simultaneously.

Esma says this also means the manager of an alternative fund does not have to perform the additional functions set out in Annex 1 of the directive, comprising administration, marketing and services relating to fund assets. However, if it does not, these functions should be considered to be delegated to a third party, leaving the manager responsible for their performance under the directive’s rules on liability for delegation liability and responsibility for compliance.

Definition of an alternative investment fund
Regarding the definition of what constitutes an alternative investment fund, Esma acknowledges that the scope of the directive is extremely broad, embracing both funds that invest in traditional assets and those that invest in non-traditional asset classes including shipping, forestry and wine.

Article 2(3) of the directive lists various entities that fall outside its scope, including holding companies. This is defined as a company with shareholdings in one or more other companies through which it carries out a business strategy or strategies. It must either operate on its own account and be listed on a regulated EU market, or alternatively its annual report or other official documents must make clear that it has not been established for the main purpose of generating returns for its investors through divestment of its subsidiaries or associated companies. However, Esma cautions that the holding company exemption should not be used as a means of circumventing the provisions of the directive.

Article 3 lists entities that would fall under the scope of the directive were they not exempted. These include managers of one or more funds whose only investors are the manager itself, its parent or subsidiaries, or other affiliated companies within the same group that are not themselves funds. Family office and similar private investment vehicles that do not raise external capital should not be considered as alternative investment funds, while insurance contracts and joint ventures are also excluded.

Esma is calling for feedback from stakeholders on whether they see merit in further clarification of the notion of family office vehicles and what “investing the private wealth of investors without raising external capital” should cover. It also asks whether “insurance contracts” and “joint ventures” need further clarification, whether further detail of the characteristics of holding companies is required, and whether any of the other exclusions or exemptions need further clarification.

Through a ‘mapping exercise’ surveying EU regulators, Esma has identified six categories of alternative fund: funds that invest in similar assets as Ucits funds but do not meet Ucits diversification or leverage rules; funds that invest in assets not eligible for Ucits; private equity funds; venture capital funds; real estate funds; and ‘alternative alternatives’ vehicles including commodity funds.

Esma has concluded that concentrating on asset classes or on investment strategies are not the best methods of determining what constitutes an alternative investment fund under the directive.

Instead it proposes various criteria: capital-raising that involves at least some kind of communication between the entity seeking capital or its representatives and prospective investors that results in the transfer of cash or assets to the fund; collective investment seeking to generate a return from pooling investors’ capital; the absence of any rule limiting the sale of shares or units to a single investor; a fixed and defined investment policy that is communicated to investors; the fund rather than the investors owns underlying assets; and the manager has responsibility for the management of those assets.

The application of various articles of the directive depends on different factors such as whether they are open-ended or closed-ended, internally or externally managed, whether they employ substantial leverage and or whether or not they use a prime broker. In addition, Esma’s Level 2 advice to the Commission notes that the principle of proportionality should be followed in some (but not all) areas.

Esma suggests that open-ended funds be defined as those whose units or shares may, at the holder’s request, be repurchased or redeemed without any limitation, directly or indirectly, at least annually. It proposes to tackle the question of what constitutes an alternative fund “of significant size” in drawing up guidelines on sound remuneration policies.

Appointment of an alternative investment fund manager

Article 5 of the directive requires each alternative fund to have a single manager responsible for compliance with the directive. However, depending on the fund’s structure, more than one entity could be capable of being designated – for instance the fund itself, where internal management is legally possible, or another entity responsible for the portfolio and risk management functions.

The directive itself does not set conditions or criteria for the appointment or selection of a manager – it can be any legal entity authorised as an alternative investment fund manager under the directive.

Treatment of Ucits management companies

Article 6(2) allows an authorised alternative manager also to act as a Ucits management company provided it is authorised as such. After the AIFMD enters into force, a Ucits management company that already manages alternative funds must seek separate authorisation under the directive.

Esma says a Ucits management company will be able to provide services including investment management to an alternative fund even where it cannot be the appointed manager, for example because the fund is internally managed. In such a case the Ucits management company’s activities will continue to be authorised under the Ucits Directive and it will not need separate authorisation under the AIFMD. A single entity will be able to obtain authorisation under both directives.

Treatment of MiFID firms and credit institutions

Investment firms authorised under MiFID and credit institutions authorised under the Banking Consolidation Directive are not required to obtain authorisation under the AIFMD to provide investment services such as individual portfolio management to alternative funds. They may continue to provide services to funds under the rules governing delegation arrangements.

Although Article 6(2) of the AIFMD says no external alternative fund manager may engage in activities other than those referred to in Annex I or the management of Ucits, Article 6(4) permits a manager to provide portfolio management services to clients including funds where it is not the appointed manager, as well as non-core services such as investment advice, safekeeping and administration, and receipt and transmission of orders.

Esma therefore argues that a firm authorised under MiFID or the Banking Consolidation Directive cannot be the appointed manager of an alternative fund nor obtain authorisation under the AIFMD, but they may provide investment services such as individual portfolio management in respect of alternative funds.

The Esma proposals cover both physical ETFs, which replicate the performance of stock, bond, commodity, currency or other indices by holding shares or other securities in the proportions that make up the index in question, or a sample thereof, and synthetic ETFs, which use swap transactions to obtain the economic performance of the index, using a basket of securities as collateral.

The consultation paper, ESMA/2012/44, proposes regulatory requirements covering Ucits ETFs, other index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices, which seek to replicate a quantitative or trading strategy.

The proposals envisage additional obligations regarding collateral where any Ucits funds, not just ETFs, use total return swaps, tighten the eligibility criteria for investment by Ucits in strategy indices, oblige Ucits ETFs to identify themselves as such, and seek to facilitate the redemption of ETF shares by investors directly with the fund’s provider or on a secondary market.

A Ucits ETF is defined as “a Ucits, at least one unit or share class of which is continuously tradeable on at least one regulated market or multilateral trading facility with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value.”

According to chairman Steven Maijoor, Esma has drawn up the proposals in response to concerns about the increasing complexity of ETF products marketed to retail investors, which involve investment strategies and risks far removed from the simple replication of well-known indices covering highly liquid markets.

Regarding a mooted distinction between complex and non-complex Ucits, Esma says it will wait for the outcome of negotiations on the revised MiFID directive, on which the European Commission has proposed removing structured Ucits from the scope of instruments automatically categorised as non-complex.

The guidelines have been broadened to reflect 65 responses to a discussion paper issued by Esma in July 2011, which urged the authority to cover not only ETFs but all Ucits engaged in securities lending or tracking an index.

The discussion paper on policy orientations on Ucits ETFs and Structured Ucits (ESMA/2011/220) examined possible measures to mitigate the risk of highly complex products that might be difficult to understand and evaluate being made available to retail investors, the potential systemic risk such funds might cause, and their impact on financial stability.

Esma proposes that all Ucits exchange-trade funds be obliged to use ‘ETF’ in their name as an identifier, and that investors should be provided with additional information about the investment policy and valuation of actively-managed ETFs that do not track an index or seek to outperform one.

It is also seeking feedback on an appropriate regime for secondary market dealings in ETF shares. For example, one option is that that a Ucits ETF or its management company should replace the market-maker if it is no longer willing or able to act as such, and if necessary make arrangements for investors to sell shares directly back to the fund or manager if redemption in the marketplace is disrupted. Alternatively, investors could be given the right to redeem their shares directly with the ETF at any time.

The consultation paper proposes that index-tracking ETFs disclose through their prospectus the index being tracked and details of its components, the means by which it replicates the index and its implications, for example counterparty risk in the case of synthetic ETFs, the degree of tracking error exhibited by the fund and the factors likely to affect this, such as transaction costs, liquidity and dividend reinvestment.

Esma says index-tracking leveraged ETFs should disclose their leverage policy, its costs and risks, and the impact of short exposure combined with leverage.

Esma recommends that collateral posted to mitigate counterparty risk in securities lending transactions should comply with the criteria set out in the July 2010 guidelines of the Committee of European Securities Regulators on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS (CESR/10-788), as well as the strengthening of diversification and haircut criteria.

These requirements would also apply to repo and reverse repo activities. This is designed to ensure that collateral posted in the context of efficient portfolio management techniques should respect the Ucits diversification rules, and that Ucits should have a documented and appropriate haircut policy for each category of assets received as collateral.

Esma proposes that all Ucits investing in total return swaps be subject to the same obligations on collateral management as with securities lending. On Ucits investing in strategy indices, it mostly follows the proposals in the 2011 discussion paper on eligibility of indices, including the 20/35 per cent diversification requirement, disclosure to investors and due diligence to be carried out by the Ucits.

The authority also reiterates the need to tackle issues such as the sale of complex ETFs to retail investors and the absence of harmonised regulation on the manufacturing and management of these products.

Esma also says it will consider whether and how guidelines agreed for Ucits can be applied to regulated non-Ucits funds established or sold within the EU and the establishment of harmonised definitions covering all exchange-traded products.

The consultation paper calls for industry members and other stakeholders to submit comment on the draft guidelines by March 30. The final guidelines should be ready for adoption by mid-2012 and apply to any new investment made, collateral received, or document or marketing communication issued after that date. Requirements relating to information to investors and the general public, including a fund’s Key Investor Information Document, will take effect at the latest 12 months after the guidelines are adopted.

Nevertheless, until the Commission comes up with the final rulebook and all primary and secondary AIFMD-related legislation is adopted into the national law of European Union member states, questions will remain about the overall impact of the directive, especially as it affects managers, funds or service providers located in jurisdictions outside the EU.

‘Equivalence’ dropped

For industry members, one of the most important aspects of the final advice document sent to the Commission on November 16 is the removal of reference to the ‘equivalence’ of third-country jurisdictions, which had already been dropped from the legislative text finally agreed by the European Council and Parliament in November 2010.

The concept of equivalence was re-introduced in Esma’s consultation paper on possible implementing measures relating to supervision and third countries, published in August 2011. With regard to the delegation of investment management or depositary functions to entities outside the EU, the requirement for equivalence was regarded as a potential barrier to investment by funds in non-EU jurisdictions, as well as creating the probably impossible task of assessing the equivalence or otherwise of dozens of jurisdictions before the directive came into force.

Regulatory co-operation approach

Esma’s advice to the Commission tackles the issue of regulatory co-operation between third countries where funds or managers are domiciled and EU member states by proposing an approach based on Iosco’s Multilateral Memorandum of Understanding Concerning Consultation and Co-operation and the Exchange of Information.

It proposes that an MMoU be centrally negotiated by Esma to avoid the need for third-country regulators to conclude multiple bilateral co-operation arrangements, ensuring a level playing field by removing the opportunity for regulatory arbitrage. However, details what this would mean in practice and how co-operation agreements should be concluded may not be announced before mid-2012.

Article 20 of the directive provides that where portfolio or risk management functions are delegated by an EU-based manager (or sub-delegated) to an entity located outside the union, regulatory co-operation arrangements should be in place between the manager’s home regulator and the third-country supervisor of the entity to which the functions are delegated.

The regulatory co-operation arrangements should be based on written agreements and enable the manager’s home regulator to obtain on request information required for its supervisory duties under the AIFMD, obtain documents held in the third country and conduct on-site inspections of the entity to which portfolio or risk management functions have been delegated (either directly, by the third-country regulator, or jointly).

The co-operation arrangements should also ensure notification by the third-country regulator of any breach of the directive’s requirements and the ability to perform “sufficiently dissuasive” enforcement actions in such a case.

The third-country entity will be deemed to meet the AIFMD’s requirements for delegation if it is authorised or registered to carry out asset management based on local criteria and is effectively supervised by an independent regulator. Independence in this case means compliance with the criteria and methodology set out in Part II of the Iosco Objectives and Principles for Securities Regulation and the Basel Committee Core Principles.

The EU manager’s home regulator must approve in advance the delegation of portfolio or risk management to a third-country entity that is not authorised as an asset manager, as it would also have to do if such an entity was based in the EU.

Framework for depositaries

As with the criteria for delegation of portfolio or risk management, the concept of equivalence of third-country regulation has been removed from the advice on assessing the prudential regulation and supervision of non-EU depositaries to alternative funds.

Instead Esma says the depository should be authorised and supervised by an independent regulator with adequate resources to fulfil its tasks. The local regulatory framework should set out eligibility criteria for depositaries “that have the same effect” as those applicable to credit institutions or investment firms within the EU.

The minimum capital requirements and operating conditions applicable to the depositary should have the same effect as those applicable within the EU, depending on whether it is a bank or an investment firm, while the local requirements regarding performance of the depositary’s duties should have the same effect as those set out in the AIFMD. Esma advises that the third-country legislation should be assessed by comparing eligibility criteria and operating conditions with EU requirements.

The local regulatory framework should provide for the application of enforcement action in the event of breaches of the directive’s requirements, and ensure that the liability of the depositary to investors in the event of loss of assets should be capable of being invoked either directly or indirectly through the manager, depending on the nature of the investment structure. If the depositary is supervised to more than one regulatory authority, all of them should meet the requirements.

Under Article 21 of the directive, if the criteria are met, the Commission should adopt implementing acts stating that the prudential regulation and supervision of a particular third country have the same effect as EU law and are effectively enforced.

Private placement rules

Regarding co-operation between EU and third-country regulators for the marketing of non-EU funds within the EU under national private placement arrangements – and subsequently the marketing of non-EU funds or EU funds run by non-EU managers under a passport – Esma says the agreements should cover exchange of information for supervisory, enforcement and other regulatory purposes, as well as the ability of the EU regulator to carry out on-site inspections directly or jointly with the non-EU regulator.

The latter should co-operate in the event or breach of either EU or local regulation, and assist the EU regulator by providing information required for systemic risk oversight. Co-operation agreements should allow information provided to the EU regulator to be passed on to its counterparts in other member states, to Esma itself or to the European Systemic Risk Board.

This part of the Esma advice, as well as that regarding depositaries, stresses that managers, funds or service providers should not benefit from more lenient regulatory treatment as a result of being based in a non-EU jurisdiction, and that regulatory co-operation arrangements should take this into account.

Determining the member state of reference

Finally, the Esma advice proposes more detailed guidelines for determination of the member state of reference that will supervise non-EU managers taking advantage of the AIFMD passport in or after July 2015.

In the event of a dispute over the designation of the member state of reference, the decision should take into account in which EU member state the manager intends to develop effective marketing to investors for most of its funds, either through direct relationships or third-party distributors. The criteria should include the domicile of most targeted investors, the language of the offering and promotional documents, and the member states where advertisements are “most visible and frequent”.

EU regulators identified by the manager as being potentially its member state of reference should contact each other and Esma. Following consultation or receipt of relevant documentation, they should exchange views within a week and subsequently take a joint decision on the designation. The Level 1 text of the directive provides that where the regulators cannot agree, Esma will decide.

According to Esma, its proposed rules should establish a comprehensive framework for alternative investment funds, their managers and depositaries, and by achieving the directive’s aim of increasing transparency and mitigating systemic risk, ultimately contribute to improved protection of investors.

Esma’s advice is in response to a 2010 request originally sent by the Commission to Esma’s predecessor, the Committee of European Securities Regulators. An advisory body comprised of EU securities regulators that advised the European Commission from 2001 to 2010 on securities legislation policy issues, Cesr was replaced by Esma at the beginning of this year.

November 16 was the deadline for delivery of Esma’s advice to the Commission. The 500-page document takes into account industry feedback received by Esma in response to two consultation papers, published in July and August. The Commission has indicated that it remains open to further input from the industry and other stakeholders before it finalises the rules.

Esma says that while not binding on the Commission, the proposed rules will bring greater clarity on the application of the thresholds that determine the scope of the AIFM Directive, while the provisions regarding operating conditions impose stronger organisational and conduct rules for alternative fund managers, on top of increased reporting requirements to investors and regulators and the rules governing use of leverage.

The advice seeks to clarify the duties of depositaries to alternative investment funds, such as monitoring funds’ cash flows, as well as defining the circumstances in which assets held in custody can be deemed to be lost and the consequences. It also fleshes out the framework under which third-country firms and managers will be able access European investors, both before and after the AIFM Directive’s marketing ‘passport’ is due to be extended to non-EU firms and funds after mid-2015.

The advice document covers four broad areas. The first part, covering general provisions for managers, authorisation and operating conditions, clarifies how the asset thresholds determining whether a manager is subject to the directive will operate. It also details how managers should cover risks arising from professional negligence through the holding of additional capital or insurance. Esma notes that many of its rules in areas such as conflicts of interest, recordkeeping and organisational requirements are based on equivalent provisions of the Mifid and Ucits legislative frameworks.

The second part of the advice proposes a framework governing depositaries of alternative funds, include the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the AIFM Directive.

In response to protests from industry bodies such as the Alternative Investment Management Association (Aima), Esma has dropped the nebulous concept of ‘equivalence’ of third-country regimes with the directive’s provisions. Instead it sets out criteria such as the independence of the financial regulator, the eligibility requirements for organisations seeking to act as a depositary, and the existence of sanctions to punish violations.

Esma says that determination of the circumstances in which a financial instrument held in custody should be considered as lost is crucial in determining whether a depositary is required to return an asset or its value. It proposes that an asset should be considered lost if financial instruments supposedly owned by a fund either cease to exist or are found never to have existed, if the fund has been permanently deprived of its right of ownership over the instruments, or if it is permanently unable to dispose of the instruments directly or indirectly.

The document also aims to clarify what constitutes external events beyond the reasonable ability of the depositary to control or protect against. It also clarifies the reasons that would allow a depositary contractually to discharge its liability to make restitution of the assets.

To assist in preventing the build-up of systemic risk, Esma’s advice clarifies the definition of leverage, how it should be calculated and in what circumstances a regulator should be able to impose limits on the leverage used by a particular manager. It confirms the proposal set out in one of the consultation papers to prescribe two different calculation methodologies for leverage, the commitment and gross methods, as well as a further option, the advanced method, which can be used by managers on request. To increase transparency of alternative funds and their managers, Esma sets out the form and content of information to be reported to regulators and investors, and what information should be included in a fund’s annual report.

Regarding the regulatory co-operation and exchange of information arrangements required to allow non-EU funds or funds from non-EU managers to be marketed in Europe, Esma proposes the institution of written agreements allowing for exchange of information for both supervisory and enforcement purposes.

Agreements should be signed by the European regulators concerned and the third-country regulator of the manager and/or fund, which could take the form of a multilateral memorandum of understanding centrally negotiated by Esma. The detailed content of the co-operation arrangements would take into account international standards, notably the Iosco Multilateral Memorandum of Understanding on co-operation for enforcement purposes and the Iosco Technical Committee Principles for Supervisory Co-operation.

The AIFM Directive was first proposed by the European Commission in April 2009 and agreed by the European Parliament and EU member states in November 2010. The directive was formally signed on June 8 this year, published in the EU Official Journal on July and came into force on July 21; the deadline for transposition into the national legislation of EU member states is July 22, 2013. The marketing passport provisions may, by decision of the Commission, be extended to non-EU jurisdictions any time after July 22, 2015.

The European Securities and Markets Authority (Esma) has published proposals on October 13 to deal with the fact that the majority of European Union member states have not yet approved legislation implementing the Ucits IV directive, even though the deadline to do so passed on July 1.

The European regulator says the proposals are designed to avoid difficulties, where this is possible, arising from the fact that in some cases the legislative framework for proper implementation of the directive, including cross-border regulatory measures, are not yet in place.

Without prejudice to any measures taken by the European Commission with regard to the late transposition of Ucits IV, Esma says it aims to “address the situation at an operational level in order to minimise, as far as possible, the impact on industry and investors” resulting from failing to bring the directive into national law, and is putting forward practical arrangements for cross-border operations involving one member state that has not yet transposed the directive.

According to PricewaterhouseCoopers, as of September 29 the EU member states that had not yet implemented the directive included Belgium, Finland, Greece, Hungary, Italy, Lithuania, Poland, Portugal, Romania and Spain.

Esma has identified a number of issues that could be handled by arrangements between regulators. Ucits management companies in a member state where the directive has passed into national law may not be able to benefit from the management company passport if the country where it wants to establish a fund has not transposed the directive.

Regulators in member states that have transposed the directive may have difficulties delivering notification of the marketing of Ucits established in their jurisdictions to their counterparts in countries that have not done so, while the regulator of a member state that has transposed the directive may receive a notification for marketing of a Ucits from its counterpart in a country that has not.

In addition, Esma notes that a management company in a member state where the directive has not been transposed cannot create a feeder fund to a master fund established in another EU jurisdiction, nor can it merge one of the Ucits it manages with a Ucits domiciled in another jurisdiction.

The European regulator notes that not all situations arising from failure to transpose the directive can be accommodated through practical arrangements that are “legally sound”.

It says the practical arrangements proposed are based on the jurisprudence of the EU Court of Justice on the direct applicability of self-executing provisions contained in EU directives.

Ucits IV “unequivocally” gives Ucits management companies and investment companies the rights to market Ucits units on a cross–border basis and to provide services that for management companies include the management of collective portfolios on a cross-border basis, Esma says.

It argues that European primary law obliges member states to transpose directives into their national law, leaving them the choice of form and methods, and to create a legal framework in which “the rights and obligations arising from the directive can be recognised with sufficient clarity and certainty to enable citizens to invoke them.”

In other words, member states have an obligation to reconcile their legislation with the objectives of a directive at the end of the transposition period. The European court has held that they are liable to pay damages where loss results from their failure to transpose a directive in whole or part.

Esma is proposing that regulators should not be able to refuse a valid notification for the marketing of a Ucits on their territory under the directive on the ground that their member state has not yet implemented the directive.

However, the regulator of a country that has not transposed the directive cannot deliver new notifications for the marketing of Ucits unless they can satisfy Esma that their national legislation, while not fully implementing Ucits IV, does at least comply with articles 12, 14, 15 and 51 of the directive – governing prudential provisions, rules of conduct, investor complaints and risk management – and where applicable their related implementing measures.

The regulator in the non-transposing country should also able to fulfil its obligations on access to documents under the directive. If these conditions are satisfied, notification can take place on a regulator-to-regulator basis as if both countries had transposed the directive, using a template that Esma will draw up.

Even if the legislation of the non-transposing member state does not comply with the articles in question, this procedure remains possible on condition that the management company and its home regulator certify that the management company complies with these provisions on a voluntary basis.

Esma says management companies in a member state that has implemented Ucits IV should be able to create a fund via the management company passport in a country where the directive has not been transposed, since it says the relevant provisions of the directive are of a self-executing nature. Any existing local rules to the contrary will not be valid.

However, management companies in a country that has not transposed the directive can make use of the passport only if its national legislation already materially complies with articles 12, 14, 15 and 51, and their regulators can provide the co-operation required by Article 101 and implementing measures in the case of remote management.

Esma considers the case of a merger between two Ucits established in the same member state that has not transposed the directive, where at least one Ucits is marketed in other EU countries.

Since the directive requires that both Ucits involved in a merger provide information to their investors, including those in different member states, the merger may take place where the national legislation of the non-transposing fund domicile nevertheless materially complies with the Ucits IV merger rules contained in articles 40, 41, 42, 43 and 45 and their implementing measures –otherwise not.

Due to the “inherent complexity of the operation”, Esma believes that cross-border mergers involving Ucits established in different member states, one of which has not transposed the directive, are not possible on the sole basis of the direct applicability of the directive.

The European regulator also believes that master-feeder structures should not be permitted if one of the two member states in which the Ucits are established has not transposed the directive because this issue also cannot be addressed solely on the basis of the direct applicability of the directive.

Nor, it says, should master-feeder structures be permitted if both the proposed master and feeder Ucits are domiciled in a member state that has not transposed the directive and the proposed feeder Ucits is the subject of a notification of marketing in another member state.

The new legislation, which was placed before the Chamber of Deputies (Parliament) on August 12 and which is expected to become law before the end of this year, aims principally to adapt the SIF law to the requirements of the European Union’s Directive on Alternative Investment Fund Managers, which will take effect in July 2013, including rules on delegation, risk management and the handling of actual or potential conflicts of interest.

In addition, in some instances the proposed changes will bring the SIF regime into line with Luxembourg’s funds legislation of December 17, 2010, which transposed into national law the Ucits IV Directive governing cross-border distribution of retail funds within the EU as well as introducing other changes affecting non-Ucits funds. For example, the law will enable sub-funds of a SIF umbrella structure to invest in other compartments of the same structure, as is already now the case for Ucits funds.

Moving early to adopt requirements to be introduced by the AIFM Directive is in keeping with Luxembourg’s tradition, maintained over more than two decades, of putting EU legislation in place ahead of many competing European jurisdictions, enabling promoters to plan future fund launches with confidence about the stability of the country’s regulatory regime.

The first of 18 articles of the draft legislation states that the activity of management of a SIF must comprise at a minimum management of the investment portfolio. This stipulation aims explicitly to exclude from the SIF regime passive funds that seek to create value solely by the long-term holding of assets and to create a distinction between SIFs and private wealth management companies governed by Luxembourg’s law of May 11, 2007. However, it does not exclude private equity or real estate funds from the SIF regime. Article 2 requires SIFs to have in place procedures to determine that its investors qualify as sophisticated rather than retail.

Article 3 aligns the SIF rules with various features of the 2010 law. Where the fund’s articles of association are drawn up in English, the legislation no longer insists that these be translated into French or German. Funds no longer need to send shareholders physical copies of their annual reports unless this is specifically requested, and in addition, SIFs may establish a registration date five days preceding an annual general meeting of shareholders for the purposes of determining voting rights and what constitute a quorum.

Article 5 of the draft law amends Article 42 of the 2007 SIF legislation, which allowed promoters of a fund to apply for authorisation by Luxembourg’s regulator, the Financial Sector Supervisory Authority (CSSF) up to one month following their launch. This provision, which in any case was not widely used by the promoters, is now abolished; once the law comes into force funds must have received approval from the CSSF before they can be launched, as is the case for funds created under the 2010 legislation.

A new requirement makes authorisation subject to notification of the persons responsible for management of the SIF’s investment portfolio to the CSSF, which must henceforth ascertain that they are of good reputation and have the experience necessary to manage the type of alternative investment fund in question. Any changes in the identity of the fund’s portfolio managers must also be notified to the regulator.

Under Article 6, SIFs must implement systems to monitor, measure and manage the investment risk of its individual positions and their contribution to the portfolio’s overall risk profile. They must also be structured and organised to minimise the risk of conflicts of interest, and draw up rules to manage such conflicts that do arise. The CSSF may draw up further regulations setting out detailed requirements on risk management and conflicts of interest.

Article 7 defines the conditions under which SIFs may delegate various tasks and functions to third-party providers. Such delegation should not affect regulation of the fund; entities to which portfolio management is delegated must be approved for that function and subject to prudential regulation, unless the CSSF grant permission for delegation to individuals or entities to which this condition does not apply.

A fund’s directors must be able to determine that the delegated provider is qualified and capable, and they must retain ultimate control over the fund’s activities. Delegation should not create conflicts of interest – so, for instance, investment management may not be delegated to the fund’s custodian – and the delegation of functions must be revealed in the fund’s offering documents.

The CSSF’s powers of supervision and enquiry over funds set out in Article 8 aligns the provisions of the SIF legislation with those laid down by the Ucits IV directive, while Article 9 set out circumstances in which the CSSF or the Luxembourg prosecutors may apply to the courts for the dissolution and liquidation of one or more fund compartments. Article 10 deals with administrative fines, which the CSSF may publish unless this would seriously affect financial markets, damage the interests of investors or cause disproportionate prejudice to the parties affected.

Under Article 12, the CSSF’s approval is now required for any substantial change made to the SIF’s offering documents, such as the name of the fund or of sub-funds, the replacement of the custodian, administrator, auditor or manager, the creation or new sub-funds or a significant change in investment policy.

Article 13 authorises funds to deviate from their exclusive investment policy for the purposes of liquidity management, hedging or efficient portfolio management, while Article 14 bars SIFs in the form of companies that are in the course of being liquidated from issuing new shares, except where this is beneficial to the outcome of the liquidation itself. Article 15 allows the CSSF to withdraw authorisation for one or more sub-funds of a SIF while maintaining the authorisation for other sub-funds of the same structure.

The draft law follows the 2010 legislation in allowing one sub-fund of a SIF to invest in another, although not all provisions are identical. This clarifies that the rules set out in Luxembourg’s 1915 company law regarding a company’s investment in its own shares do not apply to SIFs. Sub-funds of the same SIF may not cross-invest in each other, and voting rights of shares held by one sub-fund in another are suspended.

Finally, Article 17 stipulates that SIFs established before the date of entry into force of the revision law will have a transitional period up to June 30, 2012 before they are obliged to comply with its requirements on ascertaining that their investors are sophisticated (Article 2, paragraph 3) and risk management and conflicts of interest (Article 42bis) and up to June 30, 2013 to comply with the new rules on the delegation of functions (Article 42ter).