Luxembourg becomes first EU country to adopt Ucits IV Directive on December 16
Luxembourg has become the first European Union member state to transpose the Ucits IV Directive into national law. Various provisions of the legislation will come into force as of January 1 following approval of the law by the Luxembourg Parliament on December 16.
Luxembourg was also the first EU country to incorporate into national law the original Ucits Directive, which was formally adopted by the European Community (as it then was) almost 25 years ago to the day, on December 20, 1985.
The legislation replaces the law of December 20, 2002 on undertakings for collective investment – the legislation that implemented the Ucits III directives in Luxembourg. It was placed before Parliament on August 6 this year and will be published shortly in the Mémorial, Luxembourg’s Official Journal.
In addition to transposing the Ucits IV Directive into national law, the new legislation implements additional legal changes for both Ucits and non-Ucits funds as well as management companies. As with previous fund legislation, Part I deals with Ucits funds and Part II funds outside the scope of the EU Directive.
Existing Ucits funds have a choice between becoming subject to the new legislation immediately as of January 1 or remaining governed by the 2002 law until July 1, when they will automatically become subject to the new legislation. Ucits funds established between January 1 and July 1 next year have a similar choice, but all existing non-Ucits (Part II) funds will automatically be subject to the new law immediately.
The same timescales apply to the management companies of these categories of funds; most other provisions of the legislation, including tax provisions, take effect on January 1.
Luxembourg finance minister confirms Ucits IV transposition before year-end
Luxembourg finance minister Luc Frieden has confirmed that the legislation transposing the European Union’s Ucits IV Directive into national law will be approved by Parliament before the end of this year, making it the first EU member state to implement the investment funds directive.
Speaking at the opening of the PwC Banking Day conference on December 2, Frieden said the legislation would be voted on before the Chamber of Deputies concludes its work for Christmas. “ I will sign it before leaving on holiday,” he was quoted as saying by the business magazine paperJam. “Thank you to Parliament and to Lucien Thiel, the rapporteur of the legislation, for their impressive work.”
Frieden added that he also wanted to see the EU Directive on Alternative Investment Fund Managers adopted into Luxembourg law as quickly as possible. The AIFM Directive was approved by the European Parliament on November 11 but must be formally approved by EU finance ministers on behalf of the European Council and published in the Official Journal in order to become law.
Minister says UK will launch tax-transparent fund vehicle
The UK has unveiled plans to launch a tax-transparent fund regime in a bid to take advantage of the inclusion of master-feeder structures in the European Union’s Ucits IV Directive, which will take effect from July 1 next year.
The financial secretary to the Treasury, Mark Hoban, has announced that the UK government plans to launch a consultation exercise before the end of this year on how best to implement the directive.
The UK authorities recognise that the country is not an attractive domicile for master-feeder structures because of the lack of a suitable tax-transparent fund vehicle, and they plan to remedy this.
Analysts say that the ability to create tax-transparent funds have been an important factor in Luxembourg and Ireland becoming the leading domiciles for funds established under the Undertakings for Collective Investment in Transferable Securities regime, established by the EU in the 1980s as a framework for cross-border fund distribution.
UCITS IV cross-border mergers - general overview
The Ucits IV directive covers both domestic and cross-border fund mergers of Ucits funds, involving all kinds of funds – contractual, corporate and unit trusts. Mergers can involve entire umbrella fund structures or only certain sub-funds. The merger techniques used may vary from one EU member state to another (not all countries offer all three types of legal structure, for instance).
The laws of the member state in which the resulting merged entity will be domiciled will guide the merger, but the operation is subject to the authorisation of the regulator of the fund that is transferring its assets and liabilities to another Ucits. The directive’s provisions do not apply where one or both of the merging funds is not a Ucits.
The directive offers three types of merger scheme. In the first case a Ucits or some of its sub-funds, on being dissolved, transfer their assets and liabilities to another existing Ucits; in the second case, two or more Ucits or sub-funds, on being dissolved, transfer their assets and liabilities to a newly-created Ucits fund; in the third case, one or more Ucits or sub-funds transfer their assets and liabilities to an existing sub-fund of the same Ucits, to a newly-created Ucits, or to an existing Ucits or sub-fund. In this case the Ucits or sub-funds transferring the assets are liquidated once their liabilities have been discharged.
The directive sets out the notification process between the home regulator of the merged fund and that of the fund that will be merged into it, as well as deadlines for the merger process. The documentation should set out the type of merger and of Ucits funds involved; the background and rationale for the proposed merger; the expected impact on the unit-holders or shareholders of the merging funds; the criteria used in valuing the funds’ assets and, where applicable, liabilities; the calculation method of the exchange ratio; the planned effective date of the merger; the rules applicable to the transfer of assets and the exchange of units; and where applicable, the fund rules or instruments of incorporation of the merged Ucits.
The depositary and the auditor of fund to be merged into another must validate the criteria for calculation of assets and liabilities, the cash payment per unit and the exchange ratio. The directive also sets out the information that must be provided to unit-holders or shareholders of the Ucits that will merge into another fund.
Merger costs may not be charged to the Ucits fund unless it does not have a designated management company (i.e. it is a self-managed Ucits).
UCITS IV cross-border distribution - general overview
The simplified notification procedure is designed to remove bottlenecks in the procedure for cross-border distribution of Ucits funds. Power to grant the ‘passport’ is held by the fund’s home state regulator, while the regulators of member states into which the fund is to be marketed have no power of veto or delay, nor of review of marketing arrangements in advance of authorisation.
Once notification of marketing in another EU state has been submitted to the regulator of the fund domicile, it has a maximum of 10 working days to review it. Marketing of the fund may begin as soon as the fund domicile’s regulator has transmitted the notification (electronically) to the regulator of the state where the fund is to be marketed.
The new arrangement will involve regulators dealing directly with each other. At present, the fund manager has to complete a notification procedure involving the submission of numerous documents (in some cases translated) to the regulator of the target market, which then has up to two months to respond. The time taken by target market regulators to approve distribution for funds from other states currently ranges from just one day to the full two months.
Any changes to the marketing arrangements for a fund distributed in one or more other member state must be notified in advance to the target market regulator(s). The Ucits must ensure its marketing arrangements are compliant with the rules of the target market before asking its home regulator to launch the notification procedure.
These arrangements cover areas such as information to investors on fund ranges and prices, the appointment of local paying agents, representatives or distributors and the use of nominee structures, and any special information requirements designated by the target market regulator for local investors. Member states must publish full information on their local laws, regulations and other rules relating to the marketing of foreign Ucits “in a clear and unambiguous manner” and by electronic means (i.e. on a web site).
UCITS IV management company passport - general overview
Under Ucits IV, a company authorised in its home member state to manage Ucits funds may manage funds domiciled in any EU member state. This means that for the first time the regulator of a Ucits fund may be different from that of the fund’s management company. The Ucits IV rules for management companies apply whether or not they make use of the passport for managing funds in other EU countries.
The management company is required by its home regulator to have sound controls and procedures appropriate to the management of the specific Ucits fund(s) it manages, which means the regulator must have must have knowledge of both the management company and its funds. The management company must also comply with its home country rules on delegation of functions, risk management and prudential supervision. However, the regulation and functioning of Ucits funds is subject to the law of the country where the fund, not the manager, is domiciled.
If the management company wants to delegate one or more functions to a third party, whether in the same country or elsewhere, it must seek permission from its home regulator, which must inform the regulator of the fund domicile. Any delegation must leave the management company with “substance” and it retains liability for acts and functions it has delegated. It must also put in place arrangements to provide any information sought by the regulator of the fund domicile.
The management company must comply with the rules of the fund domicile in areas including establishment and authorisation of Ucits funds; issuance and redemption of units or shares; investment policies and limits, including the calculation of total exposure and leverage; restrictions on borrowing, lending and uncovered sales; valuation of assets and the fund’s accounting; calculation of the issue and/or redemption price; rules regarding errors in NAV calculation and related investor compensation; and distribution or reinvestment of income.
The manager must also conform with the fund domicile’s rules on disclosure and reporting requirements, marketing arrangements, merging and restructuring of Ucits, licensing and supervision fees, and investors’ voting rights.
The depositary must be established in the Ucits fund’s domicile and have an agreement in place with the management company regulating information flows, including guaranteed access to the fund’s books and records wherever they may be held, to enable the depositary to verify continued compliance with the fund’s risk profile and regulatory requirements.
UCITS IV Key Investor Information Document - general overview
The Key Investor Information Document (KIID) is a short document designed to describe the fund in terms that investors should find straightforward and easy to grasp, in a standardised format over two A4 pages. Its aim is both to improve understanding among retail clients of how funds operate and what risks they entail, and to reduce the volume of text that promoters have to translate into other languages in order to market their funds in other countries.
The introduction of the KIID in Ucits IV follows the failure of the ‘simplified prospectus’ concept incorporated into the Ucits III Management Company Directive to offer investors a document they could understand or to relieve significantly the documentary burden on fund promoters, in part due to variations in the way the provision was implemented by different EU member states as well as concern among promoters that omitting extensive sections of the full prospectus might expose them to legal risk.
The KIID is intended to be self-sufficient. The new directive stipulates that at a minimum, it should contain the name of the fund, a short description of the fund’s investment objectives and policy, a description of past performance or performance scenarios, details of costs, and the fund’s targeted risk/reward profile, as calculated by the Synthetic Risk and Reward Indicator (SRRI). It should be written in plain language and predefined form, content and length, enabling investors to compare one fund with another more easily.
Material changes to the fund – for instance, changes in the SRRI or in management charges – will require amendment of the KIID and notification of regulators in all countries where the fund is marketed, in addition to annual updates that must be introduced within 35 working days of the end of each year. Existing funds will benefit from a ‘grandfathering’ clause giving them a transition period of up to 12 months to publish a KIID; any funds launched on or after July 1, 2011 must have the KIID ready at time of launch.
The document must be published in one or more of the official languages of any member state in which the fund is marketed, or any other language approved by the country’s authorities. By contrast, there is no obligation to translate the full prospectus and financial accounts of the fund if these are already available in “a language customary in the sphere of international finance” – in practice English.
UCITS IV master-feeder structures - general overview
Ucits IV brings master-feeder fund structures within the remit of the Ucits regime, around a decade and a half after they proved one of the stumbling blocks that led to the ‘Ucits II’ proposals being abandoned.
The new directive defines a feeder fund as one authorised to invest at least 85 per cent of its assets in another Ucits, It may hold up to 15 per cent in cash, derivatives for hedging purposes or property for its own use. Its status as a feeder fund is granted by the regulator of the country in which it is domiciled and should be granted within 15 working days of submission of the application.
A master fund must have a feeder fund as a unit-holder or shareholder, must not be a feeder itself, and must not invest in any feeder fund. If the master and feeder funds have different depositaries and auditors, they must enter into an information-sharing agreement, and if the funds have different accounting years, the auditor of the master fund must make a special report on the closing date of the feeder fund.
An agreement between the feeder and master funds is required to ensure that the feeder fund can meet its regulatory requirements and that any commission paid to the feeder as a result of its investment into the master fund is paid into its assets rather than to its management company.
The master fund must notify its home regulator of the identity of any feeder funds, and if the funds are domiciled in different countries, the master fund’s regulator must notify the feeder fund’s regulator of the investment. The feeder fund must reveal in its prospectus details of the investment objective or policy of the master fund, costs relating to the feeder fund’s investment and any tax implications.
Luxembourg bill of law transposing the UCITS IV Directive
On 6 August 2010, the Luxembourg Ministry of Finance submitted to the Chamber of Representatives a draft law intended to transpose the “UCITS IV Directive” into domestic legislation.
The bill as submitted to the Luxembourg Parliament is expected to replace the already existing Law of 20 December 2002 on undertakings of collective investment (the "2002 Law"), which covers both UCITS (Part I UCIs) and non-UCITS (Part II UCIs).
The new draft text provides for the following key changes to the current UCITS regime following the text of the “UCITS IV Directive”:
- Management company passport allowing a management company set-up in one EU Member State to act as management company for UCITS set-up in other EU Member States; this will be achieved through a mechanism of mutual recognition and authorization;
- Simplification of the procedures for cross-border distribution;
- Harmonization of the legal framework governing UCITS mergers (domestic and cross-border) ;
- Possibility to establish master – feeder structures: a UCITS (feeder) can be (fully) invested in another UCITS (master);
- The concept of simplified prospectus existing under UCITS III is replaced by a key investor information document (“KID”), which contains comprehensible information similar for the UCITS of each Member State.
Even if the UCITS IV Directive is silent on tax matters, the Luxembourg government proposed some tax changes in order to reinforce the attractiveness of Luxembourg as a location for funds and management companies by abolishing the subscription tax for tracker funds.
The bill contains flexible transitional provisions according to which existing UCITS and management companies as well as UCITS and management companies created between the entering into force of the new law and 1st of July 2011 may choose to be subject to the new law or remain under the 2002 Law until the 1st of July 2011.
However, all UCITS and management companies will be subject to the new law as of the 1st of July 2011 (exemptions apply regarding some aspects, such as the “key investor information” document - UCITS which choose to remain under the 2002 Law will have to replace their simplified prospectus by the 1st of July 2012).
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.
