Investment funds

Investor protection enhanced two-fold in Luxembourg

d'Lëtzebuerger Land vom 22.11.2012

In the aftermath of the financial crisis, investor protection has shot to number one place on the agendas of politicians and regulators throughout the world. The pressure on each to protect citizens and economies from further fall-out and to try to prevent the reoccurrence of such a drastic crisis has never been greater. One of the many advantages of Luxembourg is that the government, regulators and the business community operate in close proximity and share a spirit of mutual understanding and cooperation. As such, the Grand Duchy is well-known across the globe as a well regulated jurisdiction that responds rapidly to changes in regulation. A state fully compliant with OECD guidelines that still takes investor protection very seriously.

Two examples of how Luxembourg decision makers can cooperate in the best interests of all are the country’s welcome of the European Commission’s AIFMD (alternative investment fund managers directive) and the recent circular issued by the CSSF (Commission de surveillance du secteur financier), Circular 12/546. The AIFMD is a directive that was first proposed by the European Commission in 2009 in direct response to popular and political pressure following the financial crisis. Its goal is to create a comprehensive and effective regulatory and supervisory framework for AIFs (alternative investment funds) at the European level thereby enhancing investor protection. The AIFMD is directed to fund managers managing AIFs and covers by exclusion all investment strategies that would not be UCITS (Undertakings for collective investment in transferable securities) eligible. This would include amongst others, hedge funds, private equity, venture capital and real estate investments. AIFs can be complex in nature and are subject to limited regulation (as many investments are structured through holding companies as opposed to funds) and generally lack liquidity – issues that the AIFMD seeks to address and control.

As far as Luxembourg is concerned, it has become well-known for alternative investments since the introduction of its SIF (specialised investment fund) law in 2007 to cater to the investment appetite of sophisticated investors with a minimum of 125 000 euros to invest. The SIF is a very flexible product that can accommodate most of the alternative investment strategies while providing the investor protection of a regulated fund. However, Luxembourg is perhaps best known for its UCITS funds. These are regulated investment funds that have been established in accordance with UCITS Directives and which, once registered in one member state, may be freely marketed on a pan-european basis. UCITS funds are used widely by European investors and also sold to outside the EU where their popularity is due, in part, to the high level of investor protection they provide.

Issued in 24 October 2012, a recent CSSF Circular looks at the authorisation and organisation of Luxembourg UCITS management companies and self-managed investment companies, setting down “inter alia” requirements applicable to their governing bodies. It clarifies the substance requirements applicable and lays out clear rules on internal control functions and delegation, including administration. Although the management company may be authorised to delegate to other parties one or more of its functions, it has to retain the monitoring of delegated activities as well as the determination of the investment policy of each UCITS, the definition of the risk profile and the implementation of certain policies.

The AIFMD and the CSSF circular seek to enhance investor protection by providing clear definitions and guidelines for several important grey areas. According to the European Commission, the AIFMD “is focused on regulating the activities of AIFM, since it is the AIFM who is responsible for all key decisions in relation to the management of the fund. Financial stability and investor risks stem primarily from the conduct and organisation of the manager and the providers of key services, notably the depositary and valuation agents. The most effective response is therefore to focus on these entities.”.

Specifically it addresses the following issues:

- remuneration: All AIFM are required to put remuneration policies in place that take into account all categories of staff, including senior managers and risk takers, whose professional activities have a material impact on the fund they manage. This will require additional disclosure requirements on the annual report.

- conflicts of interest: The AIFM shall maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to identify, prevent, manage and monitor conflicts of interest.

- risk management: The AIFM shall, functionally and hierarchically, separate the functions of risk management from the operating units, including portfolio management. Remuneration of control functions must also be independent of the business areas they control.

- delegation: AIFs may, subject to strict requirements, delegate part of its management functions. However, under no circumstances may any part of portfolio or risk management be delegated to the depository. The AIFM is at all times responsible to the board of directors for the correct performance of all functions, delegated or not.

As for CSSF circular 12/546, it clarifies substance requirements and lays out clear rules on internal control as follows:

- Members of the board of directors and conducting officers must be of sufficiently good standing and have adequate professional experience.

- members of the board should limit the number of other professional commitments in order to ensure the correct performance of their duties.

- There must be at least two conducting officers who should live in Luxembourg or be in a position to commute every day.

- conducting officers should form a management committee in order to be able to take all actions required within the scope of their responsibilities and tasks should be split to avoid conflicts of interest.

- the conducting officers must be supported by qualified staff working in Luxembourg and should communicate on a daily basis, holding regular meetings that are documented.

- the management company (Manco) must not be mainly composed of representatives of the depositary bank.

- where a Sicav has appointed a Manco, the board of directors of each should not be composed of the same people.

- although some activities may be delegated (e.g. portfolio management, administration, compliance, internal audit, IT), certain others may not; the choice of service provider, the definition of risk profile and the implementation of certain policies for example. A written due diligence process must be performed before activities are delegated to a third party.

Some readers will feel swamped by the detail. The real test as to whether the new regulations will protect investors can only be known in time, and as with all preventative medicine there could be unintended side effects. For many firms the directives are a reflection of best practice already implemented. However for mid-sized investment funds struggling in difficult market conditions the increased costs of compliance could significantly reduce profitability over the next few years.

Whilst all agree in a post Madoff world that investor protection is paramount, risk can never be fully avoided. Luxembourg is in a position to lead in the provision of risk management know-how thus reinforcing its position as the leading funds hub within the EU.

Daniela Klasén-Martin
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