Third-country managers and the AIFM Directive
Luxembourg’s fund industry is keenly awaiting the outcome of negotiations between the European Union’s legislative institutions on the final form of the proposed Directive on Alternative Investment Fund Managers. Finalisation of the directive could open up new opportunities for Luxembourg as a domicile and servicing centre for alternative funds, but the EU has been slow to reach agreement on a number of outstanding issues, notably the treatment under the directive of managers and funds based in countries outside the union.
Following the publication of a first draft of the directive by the European Commission on April 30, 2009, the directive has been subject to intense debate and repeated redrafting. In May this year the European Parliament and the EU Council of Ministers approved versions of the text that differ significantly on a number of issues. Since then representatives of the Parliament, Council and Commission have been seeking agreement through ‘trialogue’ discussions on a compromise version that can be sent to the Parliament for a first reading during its October session.
On August 27 Belgium, which holds the presidency of the Council of Ministers, published a further proposal incorporating areas where the trialogue negotiations appear to have resulted in a consensus, but notably excluding the contentious topics of access to EU investors by third-country managers and funds, as well as disclosure requirements for private equity funds on their portfolio companies.
The Parliament’s current draft of the directive lays down in Article 35 the conditions under which an alternative investment fund domiciled outside the EU can be marketed to professional investors in Europe. This requires an agreement between the regulator of the targeted EU market(s) and that of the fund domicile’s regulator to ensure full exchange of information on the fund’s activities, certification by the Commission that the third-country jurisdiction meets EU standards on countering money laundering and terrorist financing, tax information exchange agreements are in force with the fund domicile jurisdiction, and that the third country offers EU-based alternative managers comparable market access.
According to the Parliament’s version, a non-EU manager seeking to market funds within EU member states must comply with Article 39a of the draft text, which requires that the manager agrees with the future European Securities and Markets Authority (Esma) to comply with the directive voluntarily and accepts the jurisdiction of EU courts on any matter arising from the directive. There must also be an agreement between Esma and the manager’s home regulator under which the latter would exercise Esma’s regulatory powers with regard to the manager. Similar provisions apply to non-EU managers seeking to offer management services within one or more EU member states.
Article 39a requires that if the non-EU manager wishes to market a non-EU fund within a member state, the funds must meet the conditions of Article 35, as they would in the case of an EU-based manager. The text says the agreement can be revoked should either the non-EU manager fail to comply with the directive or its regulator fail to adhere to its agreement with Esma on delegation of regulatory powers. The Commission is charged with supervising whether the third countries are complying satisfactorily with the agreements.
It should be noted that the European Parliament’s version of the text does not grant non-EU managers the same marketing ‘passport’ enjoyed by EU managers under the directive, under which a fund authorised in one EU jurisdiction may be marketed to professional investors in other EU states once the manager notifies its home regulator of its intention to do so. By contrast, the text makes third-country managers subject to the approval process described above for each EU member state in which it seeks to market funds to investors.
The version of the text approved by the Council in May simply proposes that member states may allow authorised EU-based managers to market non-EU domiciled funds to professional investors on their territory as long as the manager complies with the directive and appoints an independent depository, and yet-to-be-defined “co-operation arrangements” are in place between the manager’s home regulator and the supervisory authority of the fund domicile.
The Council would also let member states allow managers based outside the EU to market their funds to professional investors subject to national rules as well as articles 19, 20 and 21 of the directive covering the publication of annual reports, disclosure to investors and regulatory reporting, and Section 2 covering minimum capital requirements. The text also requires co-operation between the home regulator of the fund manager and that of the target market covering exchange of information for oversight of systemic risk. Again, the co-operation arrangements are to be worked out subsequently by the Committee of European Securities Regulators, the forerunner of Esma.
What do these proposals mean for managers based outside the EU that currently access European investors through national private placement regimes? The Council text as it stands would allow this channel to remain open, subject only to regulatory co-operation on systemic risk and the same transparency and capital requirements to which EU managers would be subject under the directive.
By contrast, the Parliament’s draft insists that non-EU managers comply with the AIFM Directive and requires their regulators to act as Esma’s proxy in overseeing that compliance, as well as subjecting the managers to the jurisdiction of EU courts, if they wish to gain access to professional investors within an EU market. Because this process does not offer all the benefits of the full cross-border distribution passport, it has to be repeated for each additional member state the manager wishes to target, with the likelihood of both further delays and additional bureaucratic effort and cost.
Take the example of a Brazilian manager seeking to market its fund to pension schemes in France. If the fund were domiciled in the Cayman Islands, this would require that the manager comply with the directive and that the Brazilian regulator, the CVM, agree with Esma to oversee the manager’s compliance. In addition, there would have to be a separate agreement between Cima, the Cayman regulator, and France’s AMF covering supervision of the fund.
Were the manager to offer French institutions a Luxembourg-domiciled SIF, for example, rather than a Cayman fund, this additional oversight of the fund would not be necessary. It’s not fully clear from the Parliament’s draft, but it appears that the oversight agreement between Esma and the CVM would cover the marketing of the fund to investors in other EU countries.
However, this would require active approval from regulators in these additional markets, rather than the mere notification procedure that would apply to EU-based managers. If the Brazilian manager planned to focus on investors throughout Europe, they might consider it worthwhile to shoulder the cost of setting up a Luxembourg management company in order to enjoy the full benefits of the AIFM passport and avoid the need to be supervised by the CVM according to EU rules, which may prove complicated in practice.
However, this may not be the end of the story. The Belgian presidency is understood to be seeking a compromise on the third-country access issue that would contain elements of both approaches. Under this idea, which is reported to be under consideration by member states, non-EU managers would be able to obtain access to EU member states’ markets by complying with the directive, but existing national private placement regimes would remain in place for at least another five years.
After this period the national regimes would end, according to one suggestion, or be subject to a review and a possible rollover for a further five years, according to another. Belgium has also suggested that ‘passive marketing’ – where investors take the initiative in approaching fund managers – continue to be permitted with regard to funds outside the EU, subject to only limited restrictions on the investors. This contrasts with a provision in the Parliament’s draft that would explicitly bar European investors from non-EU funds that do not meet all the conditions set out in Article 35.
Discussions over the coming weeks are likely to determine the final form of the AIFM Directive and the rules that will apply to third-country managers and funds. Once the text is finalised and the final stages of the legislation procedure is underway, non-EU managers may soon face a choice on the best method of accessing European investors. If agreement is reached soon, the directive will stay on track for implementation in 2012.
Subcription tax for ETFs and Microfinance funds to be abolished
On 5 May 2010, the Luxembourg Prime Minister Jean-Claude Juncker proposed various measures to Parliament as part of his annual state of the Union. In his speech, Mr. Juncker outlined the possible tax measures for individuals and companies, which, if enacted, would be applicable as from tax year 2011. One of these measures concerns exchange traded funds and microfinance funds and more specifically the abolishment of the annual subscription tax (“taxe d’abonnement”) of 0.01% on the NAV that these funds must currently pay. These proposed exemptions are aimed to increase the competitiveness of Luxembourg compared to other financial centres and as such to promote Luxembourg as a domicile for the establishment of ETFs and Microfinance funds. These changes are expected to be implemented by the end of this year through an amendment of the law of 20 December 2002 on undertakings of collective investment (the "Law of 2002") when the Law of 2002 will be amended to implement the measures provided for in the UCITS IV directive.
Migration or relocation of offshore funds to Luxembourg
The Madoff scandal which has led to the quasi-collapse of the banking sector has changed the fund industry landscape. The ability to relocate in Luxembourg opens new horizons to offshore promoters and investors.
The global economic downturn and the perspective of the implementation of the European Directive on Alternative Investment Fund Managers are additional factors which increase the desire of promoters to move to Luxembourg.
Confirming such trend, more and more pure offshore funds are already administered via Luxembourg. So, why not directly have your fund domicile in Luxembourg. Luxembourg offers numerous advantages (I) as well as different manners to operate such migration (II).
I. Key advantages of relocation to Luxembourg
The regulatory characteristics of Luxembourg as well as its peculiar environment made Luxembourg the leader of the fund industry in Europe.
(A) 1st European Fund domicile
Luxembourg became in a few decades one of the leading locations for investment funds, being the first-largest fund services centre in Europe and the second worldwide, after the USA. Since 1959, when the first fund was established the investment fund industry hugely expanded. As at 31 December 2009, total AUM of Luxembourg investment funds reached EUR 1,840.993 billion. Over the last twelve months, the volume of AUM increased by around 12%. Luxembourg hosts more than 75 % of UCITS authorized for cross-border distribution in the European Union (EU).
(B) A comprehensive regulatory framework
Legal structures offered by Luxembourg:
Luxembourg was the first member country to implement the European directive on Undertakings for Collective Investment in Transferable Securities (UCITS) back in the late 1980’s and is as of today the leader in the European fund industry offering diversified structures which meet the needs of investors and promoters. The law of 20 December 2002 relating to Undertakings for Collective Investment in Transferable Securities shaped the investment fund market differentiating between the regulated undertakings for collective investments in transferable securities (UCITS Part I or UCITS) and a lighter regulated vehicle, the undertakings for collective investments (Part II Funds), both designed for retail investors. Further to the enactment in February 2007 of the law on specialized investment funds (SIF), designed for sophisticated investors, Luxembourg offers investors and promoters a broad choice of legal structures to suit their expectations. They can be divided in the following three categories:
- UCITS Part I (1843 as at 31 December 2009);
- Part II Funds (649 as at 31 December 2009); and
- SIFs (971 as at 31 December 2009).
A major characteristic of UCITS is the European passport which provides UCITS with the possibility of distributing their units within the EU (i.e a benchmark of more than five hundred millions of European consumers) with only having to respect formal compliance in other states whereas offshore funds wishing to distribute their units in the EU at large shall apply in every member state for such distribution. The UCITS IV directive to be in force in 2011 will also speed up the cross-border distribution of UCITS funds. In contrast, Part II Funds can only market their units in other EU countries after complying with the specific conditions stipulated by the authorities in the relevant country, which make them a less attractive choice as migration vehicle.
UCITS were traditionally limited to investment in long/short equity. Such scope was extended by the UCITS III directive and the eligible assets directive of 2007 which allows UCITS to invest in, i.a derivatives in general, OTC derivatives (TRS, contracts for difference etc), to adopt synthetic shorting strategies, investments in hedge fund indices, etc always in accordance with the limitations set forth by Luxembourg regulations.
The SIF is a lightly regulated and tax efficient fund, which gives fund promoters an onshore alternative to consider (as compared to traditional offshore jurisdictions such as Cayman and BVI) when deciding on the jurisdiction for setting-up a fund and the type of fund vehicle to use. The SIF is dedicated to sophisticated investors.
Finally, promoters can choose between two types of legal structure for an investment fund (UCITS, Part II Funds and SIFs): an investment company with variable or fix capital (SICAV / SICAF) or a common contractual fund (FCP). Both vehicles can create segregated sub-funds, each with a different investment policy. The choice of whether to create a fund as an FCP or an investment company is manly based on tax considerations, as an FCP is tax transparent.
The Luxembourg regulatory authority:
The CSSF, which authorizes and monitors all Luxembourg registered funds, is an experienced and pragmatic regulator responding to promoters’ needs in insuring rigorous prudential supervision and in implementing the flexible European legal framework responding to nowadays investors’ researches of security.
In light of these benefits, inwards re-location to Luxembourg seems to be a pragmatic choice in these times of financial turmoil.
II. Steps for relocating your fund to Luxembourg
Relocation of a fund to Luxembourg can mainly be achieved by choosing for one of the following three methods: (A) a contribution in kind of all the assets and as the case may be the liabilities to a Luxembourg fund which is open to UCITS, Part II Funds and SIFs whether in the form of SICAVs / SICAFs or FCPs, (B) a re-domiciliation of an offshore fund to Luxembourg which is only open to UCITS, Part II Funds and SIFs in the form of SICAVs or SICAFs or (C) a merger of an offshore fund into a Luxembourg fund which is only open to UCITS, Part II Funds and SIFs in the form of SICAVs or SICAFs. The choice of the type of relocation will depend mainly of the legal structure and not of the specificity of the investments contemplated. The timing of such relocation can consequently vary according to the vehicle transferred to Luxembourg and the methods chosen.
(A) Contribution in kind by an offshore fund to a Luxembourg UCITS, Part II Fund or SIF
Which Luxembourg investment vehicles can be used:
An offshore fund can contribute all its assets and liabilities at the incorporation of a SICAV or an FCP or to an existing SICAV or FCP. It results in the offshore fund becoming a shareholder of the Luxembourg fund. Such contribution does not result in an automatic universal transfer. The assignment of all its assets and, as the case may be, its liabilities shall be made on a case-by-case basis in conformity with the relevant applicable laws.
Main steps:
Such contribution process will only be possible if (i) the legal documentation of the Luxembourg vehicle authorizes (or does not forbid) subscription by contribution in kind and (ii) if the contributed assets can be considered as eligible assets according to Luxembourg laws. Luxembourg entities with variable capital will approve the contribution by a resolution of the management bodies whereas entities with fixed capital will hold a meeting of shareholders resolving on such increase of the capital. In both cases, a valuation report will be issued by an independent Luxembourg auditor in respect of the contributed assets.
(B) Transfer of registered office of an offshore fund to a Luxembourg UCITS, Part II Fund or SIF
Which Luxembourg investment vehicles can be used:
Re-domiciliation of an offshore fund can only be considered for investment companies (SICAVs and SICAFs) not for FCPs. It is the easiest way to relocate since the offshore fund does not cease to exist but is merely transferred to Luxembourg, without discontinuation of its legal personality.
According to a commonly accepted interpretation of the Luxembourg law on commercial companies dated 10 August 1915 (the “Company Law”), even if a company has been incorporated abroad, if such company has its central administration in Luxembourg, it shall be considered as a Luxembourg company. However such transfer must be allowed out-ward and in-ward and it may trigger difficulties with companies incorporated in a common law country whereby a company shall have the nationality of its seat of incorporation.
Main steps:
The migration process will require the amendment of the by-laws and of the prospectus of the fund to be in compliance with Luxembourg law. The offshore fund will need to obtain the approval of the CSSF, which will review the documentation of the fund to check the compliance with Luxembourg law. Backward, you will need to inform the investors of the fund of such re-domiciliation and they will most likely need to provide their approval (or, as the case may be their decision to withdraw from the fund) according to the law of the originating state. You may have to change the service providers. However, it may be a benefit for investors, as it may trigger less costs.
(C) Cross-border merger
Which Luxembourg investment vehicles can be used:
A cross border merger occurs when an offshore fund is absorbed into a Luxembourg fund, its assets and liabilities being transferred to the absorbing Luxembourg investment vehicle (UCITS, Part II Fund or SIF) against the issuance of new units in the Luxembourg investment vehicle to the unitholders of the absorbed offshore fund, which is then dissolved.
For the time being, the UCITS III Directive solely provides a regulatory framework for merger of investment companies (SICAV) and not for FCPs, being understood that a cross border merger is only allowed if the legislation of the offshore fund does not prohibit such merger. UCITS IV Directive which will come into force in 2011 will change the landscape of European cross border mergers of funds as it will allow all types of UCITS (SICAVs, FCPs, etc.) to merge into another fund structure. In the light of the UCITS IV Directive, a cross-border merger means a merger of UCITS (i) at least two of which are established in different Member States; or (ii) established in the same Member State into a newly constituted UCITS established in another Member State.
Main steps:
The main steps of the merging process are the following: it will usually begin with the approval of both management bodies of the merging companies and the adoption of a common merger project. Such project must then be published according to local laws and will require in most of the cases the approval of the shareholders of each vehicle. A report shall be established by an independent auditor valuing the share exchange ratio. The merger process will be finalized and effective once the general meetings of shareholders of the merging vehicles have given their approval.
III. The impact of a relocation to Luxembourg for investors
A relocation to Luxembourg can in certain circumstances be an advantage from a tax perspective, as a Luxembourg fund, if set-up as an investment company (SICAV) (irrespectively whether it is a UCITS, Part II Fund or SIF) can benefit as of this date from 27 double tax treaties entered into by Luxembourg and third countries. The relocation of a fund to Luxembourg usually does not trigger a capital realization event for existing investors of the offshore fund.
Moreover, a move to Luxembourg has usually a minimal impact on the investments of investors. Investors may continue to hold the same number of units of the same class of the same sub-fund, as the case may be or will receive in consideration units of the same value in the new Luxembourg fund. The investment objective may remain in most of the cases identical subject to compliance with Luxembourg law. The management of the relocated fund will usually ensure that the fund remains registered in the same countries as they were previously registered for sale. The administrative fees may also be reduced in comparison with offshore legislations which can have a positive impact on the performance of the fund.
New requirements on the identification of the beneficial owners of Luxembourg SICARs
The Luxembourg regulatory authority (Commission de Surveillance du Secteur Financier or CSSF), as competent authority to exercise the supervision within the meaning of article 11(1) of the Law of 15 June 2004 relating to the investment companies in risk capital, as amended or supplemented from time to time (the “SICAR Law”), requires all Luxembourg SICARs to transmit to the CSSF the identity of their beneficial owners in compliance with article 32 of the SICAR Law and for the first time in the half-yearly reporting as at 31 December 2009.
Such information on the identity of the beneficial owners is required for (i) the authorisation of the SICAR and (ii) in the context of half-yearly reporting.
In its Newsletter of October 2009 (available on the website of the CSSF, www.cssf.lu), the CSSF has confirmed that an updated table K 3.1 will be published on its website and has also specified the concept of “beneficial owner” as follows:
- Application of the definition of beneficial owner as provided in Article 1(7) of the law of 12 November 2004 on the fight against money laundering and terrorist financing, as amended (the “2004 Law”).
- Application of the concept of beneficial owner to any natural person who owns or controls directly or indirectly a percentage of more than 25% of the SICAR’s shares as well as any natural person who otherwise exercises control over the management of the SICAR.
- Identification of beneficial owners required where the investors of the SICAR are legal persons other than the entities referred to under Article 3-1 of the 2004 Law allowing the application of simplified customer due diligence procedures. The information on beneficial owners must be provided independently from the setting-up of a nominee structure.
Requirements regarding half-yearly financial information for SICARs
In its circular 08/376 regarding financial information to be submitted by investment companies in risk capital (SICARs), the Luxembourg regulatory authority (Commission de Surveillance du Secteur Financier or CSSF), as competent authority to exercise the supervision within the meaning of article 11(1) of the Law of 15 June 2004 relating to the investment companies in risk capital, as amended or supplemented from time to time (the “SICAR Law”), requires all Luxembourg SICARs to transmit to the CSSF half-yearly financial information (the “Half-Yearly Report”) in compliance with article 32 of the SICAR Law and for the first time for the financial reporting as at 31 December 2008.
Such requirements on the disclosure of the Half-Yearly Report is a confirmation of the will of the CSSF to strengthen its supervision of SICARs.
SICARS shall draw up their Half-Yearly Report, if appropriate on a compartment basis, in accordance with table K 3.1 (available on the CSSF website (http://www.cssf.lu) under the section Legal reporting/Periodic reporting/SICAR).
The reference dates for the drawing up of the Half-Yearly Report are 30 June and 31 December of each year. SICARs must transmit the Half-Yearly Report to the CSSF within 45 calendar days from the reference date.
Finally it should be reminded that any SICAR shall also submit to the CSSF a copy of its audited annual report as soon as it is available and in any event within six months from the end of the period to which the report relates (article 28 of the SICAR Law).
Luxembourg UCITS "hedge funds"
For a long time, Luxembourg hedge funds and funds of hedge funds have been set up under several wrappers, namely funds submitted under part II of the law of 20 December 2002 on UCIs (the “2002” Law) and specialised investment funds (SIF) governed by the law of 13 February 2007 (the “SIF Law”). As of today, hedge fund managers are considering launching UCITS platforms (especially “sophisticated UCITS”). As widely known, UCITS funds are harmonised European retail fund vehicles that can be sold globally and which benefit from the European passport enabling investment managers to easily market their funds within the EU. The total amount invested into UCITS was around EUR 4.6tn at the end of 2008, and experts forecast that it is set to grow to between EUR 7tn and EUR 9tn by 2012. As of 30 September 2009, the assets under management (AuM) of Luxembourg UCITS were about EUR 1.39tn which represents 78% of the total AuM of all the Luxembourg undertakings of collective investments ((Test of a footnote)).
The UCITS framework is attracting attention from hedge fund managers mainly because of the increased demand from investors for regulated products, transparency and liquidity sought in the aftermath of the Madoff case, the benefit of the European passport, the continuous broadening of the eligible asset rules for UCITS, the strong risk management framework, the future benefits of UCITS IV (when implemented by 2011) and the implications of the recent proposed EU hedge fund Directive (AIFM Directive) for non-UCITS vehicles.
European passport
As mentioned, the European passport provides hedge fund managers with a possibility to distribute the shares or units of the fund within the EU. The European passport makes distribution easier for these fund promoters since they do no longer have to be reviewed for substance in other EU member states but only with respect to formal compliance. The new simplified notification procedure provided by UCITS IV (to be in force by 2011) shall also attract the attention of hedge fund managers since it will speed up the cross-border distribution of their funds.
Eligible assets
Hedge fund managers driven by the investor demand are looking for products which can deal with their alternative investment policy as well as replicating their hedge fund strategies.
The UCITS directive adopted in 1985 (UCITS I) (when speaking about eligible assets) did not provide a detailed definition of the term ‘transferable securities’, even though it referred to the term repeatedly. In order to ensure a uniform application of the UCITS directives as well as helping EU member states to develop a common understanding as to whether a given asset category is eligible for a UCITS, the European institutions have decided to clarify such definitions in the eligible assets directive of 19 March 2007 (the “Eligible Assets Directive”) and the CESR’s guidelines concerning eligible assets for investment by UCITS (the “Eligible Assets Guidelines”) transposed in Luxembourg by the Grand-Ducal Regulation of 8 February 2008 and the CSSF circular 08/339.
Traditionally, the investment strategies of UCITS were limited to long / short equity. The main innovation was to extend the assets eligible for UCITS in order to enable UCITS III vehicles to invest in, inter alia, OTC derivatives (e.g. total return swaps, contracts for difference, etc.), to adopt synthetic shorting strategies (as physical shorting is not allowed), 130/30 strategies, investments in hedge fund indices, and so forth. These strategies are now possible subject to certain counterparty exposure limits in the sense that the global exposure through the use of derivatives does in principle not exceed 100% of the net asset value of the assets. Hence UCITS’ overall risk exposure may in principle not exceed 200% of the net asset value on a permanent basis.
Increased investor protection through risk management procedures
According to article 42 (1) of the 2002 Law, UCITS must implement a risk management strategy that enables them to monitor and measure the risk of the positions and their contribution to the overall risk profile at any time. The Luxembourg regulator (CSSF) has classified UCITS on the basis of their risk profile into sophisticated UCITS and non-sophisticated UCITS. A sophisticated UCITS (these are the UCITS which hedge fund managers tend to set up) are UCITS which mainly use derivative financial instruments and / or are making use of more complex strategies or instruments. According to the CSSF, a sophisticated UCITS must entrust to a risk management unit which is independent of the entities in charge of making investment decisions, the task of identifying, measuring, monitoring and controlling the risks associated with the portfolio’s positions. For instance, the following criteria need to be fulfilled by the risk management unit, namely it must have (i) a sufficient number of qualified personnel with the necessary knowledge, (ii) the necessary tools (IT and others) to do its task and (iii) conducting persons of the board (in case of a self-managed SICAV) or of the management company that are actively associated with the risk management process. Sophisticated UCITS must use the Value-at-Risk approach (VaR), which means that the potential loss that a UCITS portfolio could suffer within a certain time period is estimated. In principle (subject to derogation granted by the CSSF), a confidence interval of 99%, a holding period equivalent to one month and an effective observation period of risk factors of at least one year are amongst others the standards used for calculating the VaR.
Impact of UCITS IV
As widely known, the UCITS IV Directive has been adopted by the European Parliament on 13 January 2009 and by the European Council on 22 June 2009. The UCITS IV package aims to introduce the following amendments to the UCITS III legal regime: (1) a management company passport (allowing UCITS to be managed by a management company authorised in another EU member state), (2) a simplified notification procedure for cross-border distribution, (3) a replacement of the simplified prospectus by a key investor information document, (4) a framework for UCITS mergers and (5) master-feeder structures leading to greater pools of assets and economies of scale. All of the above measures may provide hedge fund managers with additional incentives to set up a UCITS structure as they will allow economies of scale and reduce costs (because, amongst others, of the absence of the need of a local management company and due to the simplified notification procedure for cross-border distribution).
Impact of the proposed AIFM directive (if adopted in its current form)
On 29 April 2009, the European Commission submitted a draft Directive on Alternative Investment Fund Managers (AIFM) to the European Parliament and the European Council, marking an attempt to create a regulatory framework for European alternative investment fund managers of non-UCITS funds: a common set of rules in terms of licensing and supervision. This Directive (if adopted) would apply to all managers that manage and market non-UCITS funds in the EU with AuM exceeding ?100m or ?500m if the funds are not leveraged and are not redeemable for at least five years. An important point with respect to this draft Directive is that the European passport towards third party funds (non EU domiciled funds – such as, for example, Cayman funds, BVI funds, Bermuda funds, etc.) would only enter into force three years after the transposition of the proposed Directive. In other words, the distribution of offshore funds to professional investors will only be possible after such period and will therefore restrict the possibility to raise funds in Europe. Even more stringently, non-EU AIFMs wishing to market within the EU will have to apply for an authorisation to a EU member state, which will only be granted if the country where the AIFM is based has put into place prudential regulations equivalent to those of the Directive and has tax co-operation agreements in place with the relevant member state’s regulators.
Certain hedge fund managers of non-EU domiciled funds are anticipating these proposed changes and are thinking to re-domicile or restructure their existing funds into Luxembourg UCITS funds or SIF funds. For the time being, this proposed directive has been criticised by the industry as being disproportionate and discriminatory, and amendments should be expected.
Today, hedge fund managers driven by more risk averse institutional investors are looking for more regulated vehicles with superior risk management procedures, and as such, the appeal of the UCITS legal framework accessing hedge fund strategy returns and offering wide reaching investor protection rules and investor information requirements has attracted their attention.
Luxembourg and the AIFM Directive
On April 29, the European Commission submitted a draft Directive on Alternative Investment Fund Managers to the European Parliament and European Council, marking the first attempt to create a comprehensive regulatory framework for managers of non-Ucits funds in the European Union. In return, they would benefit from a EU passport for cross-border distribution to professional investors.
The main innovations focus on the supervision, disclosure requirements and distribution of alternative funds. These proposals will only introduce a minimum threshold for member states, and countries such as France and Germany may well impose stricter requirements.
The directive would apply to all managers that manage and market non-Ucits funds in the EU with assets under management exceeding EUR100m, or EUR500m if the funds are not leveraged and are not redeemable for at least five years. Hedge, venture capital, infrastructure, private equity, real estate, commodity and non-EU retail funds are all concerned, irrespective of their type, legal structure or domicile.
The directive also regulates the marketing of non-EU funds and the authorisation of non-EU managers. A manager wishing to market a non-EU fund may only do so if the country of domicile has signed an agreement with the member state in which the manager is authorised agreeing to an effective exchange of information on tax matters as laid down by the OECD.
A non-EU manager wishing to market funds within the EU must apply for authorisation by a member state, which will only be granted if the manager’s home country exercises prudential regulation and ongoing supervision equivalent to those laid down in the directive.
The directive would therefore impose significant hurdles on non-EU managers. However, if an authorisation is granted, it will be valid for all member states, allowing those managers to manage and market funds throughout the EU either directly or via a branch without having to comply with each country’s particular legislative requirements.
An independent third party must value the fund assets at least yearly, as well as the shares or units. An independent depositary, an EU credit institution, must be appointed to receive payments from investors, provide safekeeping for financial instruments and verify ownership of fund assets.
Managers must separate risk management from portfolio management functions, measure and monitor the risks associated with each strategy, and implement a due diligence process when investing on behalf of the fund.
The proposal introduces regular reporting requirements to the authorities of the manager’s home member state. The manager must also report to investors on the valuation procedures, liquidity risk management, the existence of illiquid, hard-to-value or side-pocketed assets and each fund’s risk profile.
Once authorised, the manager may provide management services to funds established elsewhere in the EU and market its funds to professional investors in other member states. The European passport to market non-European funds is scheduled to enter into force only three years after the transposition of the directive.
The directive could offer Luxembourg huge opportunities. As drafted, the distribution of offshore funds, such as those established in the Cayman Islands, may only be possible three years after the directive’s ratification, which could accelerate the redomiciliation of offshore funds to Luxembourg.
The proposal will now be debated in the European Parliament. The directive has been criticised by the industry as disproportionate and discriminatory, but if political agreement comes this year, it could come into force in 2011.
Madoff case - Luxembourg court orders winding-up of Luxalpha and Herald (Lux) funds
On 2 April 2009, the Luxembourg District Court (Tribunal d'Arrondissement) has ordered the dissolution and winding-up of Luxalpha SICAV and Herald (Lux) SICAV (two funds which have invested in Bernard Madoff Investment Securities LLC) pursuant to article 104(1) of the Luxembourg law of 20 December 2002 relating to undertakings for collective investments, as amended from time to time.
This court decision means that the decisions taken by the CSSF respectively on 3 February 2009 and 11 February 2009 regarding the withdrawal of Luxalpha SICAV and Herald (Lux) SICAV became final.
The court decision provides that the Luxembourg liquidators of Luxalpha SICAV and Herald (Lux) SICAV represent these SICAVs as well as its investors and creditors, and that their powers will be exercised in Luxembourg and abroad pursuant to the unity and universality principle of the judicial winding-up of companies having their registered office in Luxembourg. The rule applies to movable and immovable property of the SICAVs even if these properties are abroad. The court decision furthermore states that the unitholders of Luxalpha SICAV will be considered as shareholders. The holders of units Luxalpha SICAV and Herald (Lux) SICAV will not need to file their statement of claims in order to assert their rights. They will be convened at least once a year by the liquidators in a general meeting in order to be informed of the results of the winding-up and the reasons why the winding-up procedure is not terminated. The first general meeting will be held before 31 October 2009.
Madoff case (Luxalpha SICAV) - orders imposed by the CSSF on UBS (Luxembourg) S.A.
On 25 February 2009, the Luxembourg regulator (CSSF) (Commission de Surveillance du Secteur Financier) took the following decisions towards UBS (Luxembourg) S.A. The CSSF ordered UBS (Luxembourg) S.A.:
- to put into place the necessary infrastructure (i.e. all sufficient human and technical means and internal rules in order to carry out all the duties and tasks related to the function of custodian bank of a Luxembourg undertaking of collective investment in accordance with the law of 20 December 2002 on undertakings of collective investments, as amended from time to time (the "Law of 2002") and Circular IML 91/75. UBS (Luxembourg) S.A. is required to provide evidence of such adequate guarantees to the CSSF within a period of 3 months as of the date of notification of the decision of the CSSF to UBS (Luxembourg) S.A. It is important to note that the CSSF mentioned that the wrongful execution of the obligation of "due diligence" constitutes a serious breach of the supervisory duty (devoir de surveillance) of a custodian bank and can consequently constitute a violation of a contractual obligation in view of the legal provisions imposed by the Law of 20 December 2002. Article 36 of the Law of 2002 provides that "the depositary shall, be liable, in accordance with Luxembourg law to the shareholders for any loss suffered by them as a result of its wrongful improper performance thereof".
- to analyse and rectify all the structures and procedures in place in relation to its supervisory duty (obligation de surveillance) as custodian bank and UBS (Luxembourg) S.A. shall pay damages in case of breaches to the above-mentioned supervisory duty as custodian bank imposed upon by Luxembourg law, without prejudice to any contractual provisions to the contrary and/or as the case may be any court decision.
The right of injuction of the CSSF is based on article 59 of the Law of 5 April 1993, as amended from time (the "Law on the Financial Sector"), which provides in paragraph (1) that "where a person subject to the supervision by the CSSF is not complying with the provisions of any laws, regulations or memorandum and articles of association relating to him, or where his management activities or financial situation are not such as to constitute an adequate guarantee of proper discharge of his commitments, the CSSF shall enjoin that person, by registered letter, to remedy within such period as it may prescribe the situation found to exist".
It is furthermore important to set out what the consequences may be in case UBS (Luxembourg) S.A. would not comply with the above orders. These can be found in Article 59 paragraph (2) of the Law on the Financial Sector which provides that "if, by the end of the period prescribed by the CSSF pursuant to the preceding paragraph, the situation in question has not been remedied, the CSSF may:
(a) suspend the members of the administrative, executive or management bodies or any other persons who, by their actions, negligence or lack of prudence, have brought about the situation found to exist or the continued exercise of whose functions may prejudice the implementation of recovery of reorganisation measures;
(b)suspend the exercise of voting rights attaching to shares held by shareholders or members whose influence is likely to operate to the detriment of the prudent and sound management of the persion in question;
(c) suspend the pursuit of that person's business or, if the situation found to exist concerns a particular area of business, the pursuit of the latter."
The CSSF is entitled on the basis of article 53 of the Law on the Financial Sector to request from any person subject to supervision by it (i.e. UBS (Luxembourg S.A.) any information which may be of assistance in the performance of its tasks. The CSSF may in light of this provision inspect books, accounts, registers or any other deeds and documents belonging to such persons.
In view of the above, it will be important for UBS (Luxembourg) S.A. to evidence proof and provide the adequate guarantees (as mentioned above)to the CSSF within the prescribed period of 3 months.
The questions could also be raised what the legal impact is in court of such press releases. The legal impact in court of the content of such press releases is in my opinion limited as press releases or circulars issued by the CSSF so as to limit themselves so as to interpret the rules set out under the applicable Luxembourg laws, without being able in principle to create new rules. In other words, it is not the press release or a circular which can impose by themselves new obligations on parties but only the applicable laws. However, the interpretation made by the CSSF or by a Luxembourg administration is an indication of how the laws could be applied in court, taking into account that the courts could always adopt a different interpretation.
Madoff case - Herald (Lux) - Decision by the CSSF to withdraw the fund from the list
On 11 February 2009, the Luxembourg regulator (CSSF) has announced, in view of the establishment of the responsibilities of the various intermediaries in relation to HERALD (LUX) and the custodian bank HSBC SECURITIES SERVICES (LUXEMBOURG) S.A., to take the following two decisions, namely (1) to withdraw HERALD (LUX) from the list on the basis of article 94 (2) of the Law of 20 December 2002 on undertakings of collective investments which provides that maintaining an entry on a list shall be subject to observance of all the provisions of laws, regulations or agreements relating to the organisation and operation of UCIs and the distribution, placing or sale of their units and (2) thereafter to request the judicial liquidation of HERALD (LUX).
The decision to withdraw HERALD (LUX) from the list of authorized UCIs is based on the fact that Luxalpha SICAV does not observe any longer the provisions in relation to the organisation and functioning of Luxembourg undertakings of collective investments. This withdrawal has as consequence the suspension of all payments made by HERALD (LUX) and the prohibition by HERALD (LUX) to perform any acts other than conservatory acts. The decision of withdrawal will become permanent after a period of one month, except in case of appeals. As soon as the decision of withdrawal will become permanent, the CSSF will request from the Luxembourg court (tribunal d'arrondissement) the judicial liquidation of HERALD (LUX). In case of a liquidation decided upon by the court, the court will appoint a liquidator to realize the assets of the SICAV.
Should you have any questions, feel free to contact me at oliviersciales@cs-avocats.lu.
