Authors: Michel Mengal and Jérôme Wigny1
INTRODUCTION - BASIC CONCEPTS, A FEW FIGURES & A BIT OF HISTORY
1. Generalities - As from the early 1990s, the CSSF2 has approved the establishment of Guaranteed Funds3 in Luxembourg and developed a body of mainly unpublished prudential rules which any fund should comply with in order to name or claim itself as "guaranteed" or to suggest in any way that it is offering or securing some kind of Guarantee4 to investors. The purpose of this paper is to summarise and provide a few insights into this prudential regime, as well as to comment on it where appropriate. This paper expresses the views and is mainly based on the past daily practice of our firm, but does not purport to expose exhaustively the different types of Guarantees or Guaranteed Funds in existence nor how the latter may be operated.
2. Evolving regime - It should be noted from the outset that the praetorian regime applicable to Guaranteed Funds is evolving and that what may have been approved in the past may no longer be possible or will be subject to additional conditions. This paper is qualified entirely by the foregoing sentence. To illustrate, this means that when we refer to certain arrangements or clauses which have been approved by the CSSF, no assurance may be given that the same or similar arrangements or clauses will be approved in the future.
3. Basic concepts and features - A "Guaranteed Fund" may be defined as a fund which is marketing itself and selling its units or shares with the "Guarantee" given or suggested to each of its potential investors that, at one or several predetermined dates or periods, same investors will recover all or part of their invested capital and possibly (as is the case for most structured products) will in addition obtain any form of financial result or performance determinable on the basis of external objective criteria. 5 6 7
4. Formal agreement and third party guarantor - In anticipation of the developments below, we must point out immediately that in order to be allowed to market and sell a fund under the "guaranteed" label, it is essential for the Guarantee to be formalised by an agreement (the "Guarantee Agreement") between the Guaranteed Fund and an eligible third party guarantor (the "Guarantor"). In the absence of any such Guarantee Agreement and eligible Guarantor, the fund will merely and at most be allowed to advertise and offer its units or shares under the "protected" label.
5. A few figures and a bit of history - The first Guaranteed Fund was established in Luxembourg in 1990. By the end of 2011, 190 Guaranteed Funds were registered, with approximately EUR 40 billion assets under management.8 These funds may be set up using virtually any of the legal forms or financial label available under Luxembourg law (e.g. UCITS, Part II UCIs, SIFs, SICAVs/FCPs, etc.) and be targeting any type of investors. The prudential regime applicable to Guaranteed Funds applies equally irrespective of the form or label of the funds or of the type of investors. Although UCITS IV legislation has indirectly addressed this topic9, no specific body of legislation has been enacted for the purpose of regulating Guaranteed Funds per se, leaving it to national supervisory authorities to deal with this matter on a case-by-case basis.
ELIGIBILITY OF THE GUARANTOR
6. Generalities - The CSSF requires that the Guarantor which will issue the Guarantee to the benefit of the Guaranteed Fund or its investors be a third party fulfilling certain eligibility conditions and criteria. These conditions and criteria are listed in the following paragraphs. The CSSF considers these to be sufficient to approve the Guarantor, but reserves the possibility to request additional conditions to be fulfilled depending on the particularities of the proposed project and intervening parties. Moreover, the CSSF will re-examine the eligibility of each Guarantor each time a new project involving a Guarantor already approved for another Guaranteed Fund is presented. As a result, the fact that a Guarantor has been approved for a previous project does not mean that it will be automatically approved for a new one.
7. Regulated entity and place of incorporation - As a matter of principle, the CSSF requires (i) that the Guarantor be a first class financial institution (e.g. a credit institution, an investment firm, a management company or an insurance company), (ii) that it is duly regulated and subject to prudential supervision deemed equivalent by the CSSF to that applicable in Luxembourg; and (iii) that the regulatory regime to which the Guarantor is subject authorises it to validly grant the Guarantee. Discussions have arisen as to whether such capacity should (or not) be specifically stated in the Guarantor's constitutive documentation. The CSSF considers that this should only be required where the rules applicable to the Guarantor would themselves require such a statement to be made in its constitutive documentation. The Guarantor must be established in a jurisdiction which the CSSF considers as having implemented a financial legal system comparable to that applicable in Luxembourg. As the CSSF will assess on a case-by- case basis the jurisdiction of incorporation of the Guarantor, there is no pre-determined list of foreign jurisdictions which may be considered as automatically eligible. There is little doubt, however, that a Member State of the European Union or of the OECD would not pass this eligibility test.
8. Financial resources - The Guarantor must have adequate and sufficient financial resources to issue the Guarantee and to honour its engagement under the Guarantee Agreement. The main concern of the CSSF in this respect is, not surprisingly, to ensure that the Guarantee is not only "formal", but also that it is "effective" in that it may be successfully and practically implemented when needed. The CSSF will therefore examine the financial situation of each Guarantor in light of the features and specifics of each particular project (e.g. type of Guarantee, amounts guaranteed, etc.). The CSSF is moreover likely to ask whether the Guarantor has already taken similar engagements towards other funds which could affect its ability to honour the commitments resulting from the Guarantee Agreement under review. On this basis, the CSSF could refuse to allow a Guarantor (although previously approved in relation to another Guaranteed Fund) to act as guarantor for other additional funds. In practice, it is recommended to communicate to the CSSF, at the time of initial filing, an indication / list of the Guarantees the Guarantor has already granted in relation to other funds. It should be noted that the adequate and sufficient financial resources requirement is not deemed to be met automatically because the Guarantor is a "credit institution", even if established in the EU.
9. Incompatibilities - The CSSF does not accept the depositary bank of a Guaranteed Fund acting as its Guarantor. On the contrary, the fact that the Guarantor also acts as investment manager of the Guaranteed Fund should not, in principle, be an issue, as several entities have already been approved as Guarantors for funds for which they were acting as management companies. The CSSF, however, requires that where an investment manager also acts as Guarantor, it does not take responsibility for asset valuation or risk management. Besides, there is no pre-determined list of services or functions which, if provided or assumed by the Guarantor, would automatically conflict with its obligations under the Guarantee Agreement. The CSSF will therefore assess on a caseby- case basis whether any such conflict could arise therefrom and, where appropriate, refuse to approve a potential Guarantor on that basis.
10. Acting both as swap counterparty and Guarantor - In the past, in the case of funds using swaps for the purpose of achieving a certain return, the CSSF has generally taken the position that the Guarantor may not act as counterparty in the swap agreement in order to avoid the situation where the sole (and therefore meaningless) purpose of the Guarantee would be for the counterparty to guarantee its own obligations under the swap10.
FORM AND CONDITIONS OF THE GUARANTEE / GUARANTEE AGREEMENT
11. Generalities - No specific rules have been developed regarding the form which the Guarantee Agreement should take, provided that it is legally binding for the Guarantor and that it covers the features of the Guarantee described to the investors. A Guarantee Agreement could hence take the form of a unilateral commitment by the Guarantor, or of a bilateral agreement between the Guaranteed Fund and the Guarantor. The CSSF has, however, identified several key points regarding the substance of the Guarantee which should be respected, regardless of the type of Guarantee which will be implemented.
12. Scope and benefit - The Guarantee may be granted to the fund or to the investors, in the latter case generally via the depositary acting on the investors' behalf11. Although the CSSF has apparently never approved set-ups where both the investors and the fund would simultaneously be the beneficiaries of the Guarantee, we see no reason why such a set-up would be refused.
13. Conditionality and (non-)revocability of the Guarantee - In principle, a Guarantee need not be 'on first demand' and may be subject to certain conditions, provided that such conditions are specifically stated in the Guarantee Agreement and disclosed to investors (see the section below regarding information of the investors).
14. Termination - Guarantee Agreements may not, in principle, be terminated on the initiative of the Guarantor, although this has already been accepted in certain circumstances12. No specific list of pre-approved circumstances has been established and the CSSF has made it clear that certain termination events approved in the past might prove no longer acceptable today.
15. Applicable law and competent courts - The CSSF does not require the Guarantee Agreement to be subject to a particular law. It is doubtful, however, that - in line with our developments under point 7, above - the CSSF would accept the applicable law to be that of a jurisdiction which the CSSF does not consider as having implemented a financial legal system comparable to that applicable in Luxembourg. In the past13, the CSSF proved more restrictive on this as it required Luxembourg Law to apply and Luxembourg Courts to have jurisdiction (although not exclusive) in the case of any dispute arising from the Guarantee Agreement.
16. Fees, costs and expenses of the Guarantee - The CSSF is not opposed to the fees, costs and expenses for establishing and maintaining the Guarantee being borne by the Guaranteed Fund, provided that these fees, costs and expenses are reasonable and that their amount, percentage, methods of calculation, etc. are adequately disclosed to investors. Nothing prevents these fees, costs and expenses from being borne by a service provider of the Guaranteed Fund and paid out of these service provider's fees (e.g. management fees).
INFORMATION OF INVESTORS
17. Generalities - Information to investors consists of certain key disclosures which should systematically be inserted in the prospectus of any Guaranteed Fund, as well as in allowing investors to access the Guarantee Agreement. These two items are further developed in the following paragraphs.
18. Prospectus - The prospectus of a Guaranteed Fund must contain all necessary disclosures for an investor to understand the object, nature and scope of the Guarantee, together with any additional information necessary for an investor to understand the type of Guarantee granted to the fund and its principal terms. The following minimum information should also be disclosed in the prospectus: (i) name of the Guarantor; (ii) when the Guarantee may be triggered and conditions applicable thereto; (iii) circumstances in which the Guarantee Agreement may be terminated and conditions applicable to such termination and (iv) fees, costs and expenses in relation to the Guarantee which are not covered by service providers' fees (see point 16, above).
19. Guarantee Agreement - Investors should be granted access to and be able to consult the Guarantee Agreement. This requirement may be fulfilled by either appending a copy of the Guarantee Agreement to the prospectus, or by indicating in the prospectus where a copy of the Guarantee Agreement may be consulted or where copies may be obtained, in both cases free of any charge.
REPORTING AND SUPERVISORY OBLIGATIONS
20. For statistical and supervisory purposes, the CSSF holds an internal (non-public) list of all Luxembourg Guaranteed Funds. To this end, each Guaranteed Fund should provide a monthly ad hoc electronic report to the CSSF. The report (the "Report") must be sent no later than on the 10th day following the end of the month of reference. This reporting requirement is notified by the CSSF to each newly authorised Guaranteed Fund in a distinct letter sent together with the letter of approval. The Report should include the following information: (i) identification numbers (of (x) the fund, (y) the relevant sub-funds and (z) the relevant class(es) of shares/units); (ii) reference currency of the relevant class of shares/units; (iii) NAV per share/unit as at the last business day of the month of reference; (iv) NAV per share/unit benefiting from the Guarantee; (v) number of shares/units issued per class of shares/units; (vi) starting and final dates of the Guarantee; (vii) name of the Guarantor(s); (viii) own funds of the Guarantor (as at the last business day of the month of reference in the reference currency of the guaranteed class of shares/units) and (ix) any appropriate comment.
CONCLUSION
21. The approach taken by the CSSF is a good example of how the Luxembourg supervisory authority has been capable of combining a flexible approach towards innovative products, whilst ensuring a high level of supervision and investor protection. Although Guaranteed Funds have not been subject to a specific body of regulations, the CSSF has indeed developed a fairly consistent body of prudential requirements to ensure that Guaranteed Funds may be set up in Luxembourg in a secure legal environment whilst being subject to a high level of supervision, adequate investor protection and a controlled use of the "guaranteed" label. We understand that, with a view to reinforcing transparency in relation to its prudential requirements, the CSSF is considering issuing and publishing a list of FAQs dedicated to Guaranteed Funds.
Footnotes
1 The preparatory work, analysis and drafting of a paper rarely result from the sole efforts of the person signing it. However basic, this paper makes no exception to that. In this case, the efforts have been shared by several Elvinger, Hoss & Prussen colleagues, in particular by Anne-Gaëlle Delabye, Joachim Cour, Michel Marques Pereira and La Vigar.
2 The CSSF is the Commission de Surveillance du Secteur Financier, i.e. the Luxembourg financial supervisor.
3 As further defined / described below.
4 As further defined / described below
5 According to the CSSF (Annual Report for 2011, page 112), "Guarantee-type UCIs aim to offer investors some security given the fluctuations inherent in financial markets. According to the investment policy pursued by the funds concerned, the guarantee ensures that the investor is reimbursed a proportion of the invested capital or is fully reimbursed his initial investment or even receives a return on his investment at the end of one or several pre-determined periods".
6 According to Jacques Elvinger in the conference paper "Legal Aspects linked to Guaranteed Funds" produced on the occasion of Guaranteed Funds 98, MGI Conference (Luxembourg, January, 1998), "a guaranteed fund is to be defined as a fund where the investor is covered against a loss in value of his investment below a predetermined minimum. The predetermined minimum may correspond to the amount of the initial contribution, but it can also correspond to a variable amount such as a percentage of the increase of an index over a certain period". This conference paper may be consulted on link.
7 According to the Annex to the Commission's Green Paper on the enhancement of the EU framework for investment funds (SEC(2005) 947) dated 12 July 2005, page 45, "Guaranteed Funds are products offering a protection against the full volatility of markets in the form of either a guarantee of capital or income. However, the investment techniques in guaranteed funds can be used in a way that complies fully with the UCITS directive. Therefore, guaranteed funds might be UCITS or non-UCITS, depending on the designer's aim."
8 In its Annual Report for 2011, page 112, the CSSF notes that:
"In 2011, the number of guarantee-type UCIs fell from 192 to 190 and the number of entities from 400 to 360. The net fall in entities is attributable to the launch of 31 new entities as well as to guarantees either expiring or not being extended for 71 entities.
As at 31 December 2011, the 360 entities were divided into 43 entities guaranteeing unitholders only a proportion of the capital commitment, 181 entities guaranteeing repayment in full of the capital commitment (money-back guarantee) and 136 entities offering their investors a return in addition to the initial subscription price.
In 2011, net assets of guarantee-type UCIs decreased by EUR 1.72 billion to EUR 40.27 billion, i.e. a decrease of 4.1%. It is also worth noting that guarantee-type UCIs set up by German promoters alone accounted for 91.2% of the total net assets of guarantee-type UCIs."
9 References to guaranteed funds have been identified notably in the following documents listed in abbreviated form: (i) the Commission Regulation 583/2010; (ii) the Final Report ESMA/2011/112; (iii) the Consultation Paper ESMA/2012/44; (iv) the Working Document ESC/7/2005); (v) the Advice CESR/08-087); (vi) the Consultation CESR/08-035); (vii) the Technical Advice CESR/09-949; (viii) in the latter's Annex CESR/09-1026; (ix) the Technical Advice CESR/09-552; (x) the latter's Addendum CESR/09-716; (xi) the Guidelines CESR/10-108; (xii) the Guide CESR/10-532; (xiii) the Guidelines CESR/10-530; (xiv) the Template CESR/10-794; and (xv) the Guide CESR/10-1320. Most references in the working documents and guidelines regarding structured and guaranteed funds refer to the specific disclosure duties to be specified in the KIIDs in order to enhance investor protection and awareness. Further discussions on investor demand and confidence inter alia in relation to structured and guaranteed funds may be found in the Commission's Green Paper COM(2005) 314 final, as well as its Annex SEC(2005) 947.
10 Jacques Elvinger, op. cit., page 6.
11 There may be legitimate reasons for the guarantee to be given to the investors rather than to the fund. In this regard, see Jacques Elvinger, op. cit., page 7.
12 For illustration purposes and without this list purporting to be exhaustive, the following termination clauses have been approved by the CSSF (even though they might no longer be acceptable): (i) amendment made to the prospectus of the Guaranteed Fund, without the approval of the Guarantor, the outcome of which would be an increase of the commitment of the Guarantor; (ii) merger, division or liquidation of the Guaranteed Fund without the prior consent of the Guarantor; (iii) termination by decision of the Guaranteed Fund (or pursuant to a change in applicable laws or regulations) of a derivative agreement entered into with a financial institution used by the Guarantor for the purpose of granting the Guarantee; (iv) change of depositary bank or of management company (or of the control over the management company) of the Guaranteed Fund without the prior consent of the Guarantor; (v) withdrawal of the authorisation of the Guaranteed Fund; (vi) change of applicable laws or regulations making it impossible for the Guaranteed Fund to pursue its investment policy, and/or to comply with its investment restrictions; and (vii) provisions of the Guaranteed Fund becoming illegal, it being impossible for the Guarantor to amend them.
13 Jacques Elvinger, op. cit., page 6.
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