Contents

  • Far-Reaching U.S. Financial Reform Legislation Impacts Financial Service Companies Both Within and Outside of the United States
  • Fund Raising for Alternative Investment Funds in Germany
  • CESR's Advice on Complex Financial Instruments: The Implications and Outlook for UCITS
  • Revising the UK Remuneration Code: Considerations for Investment Managers p.10 Marketing of Closed-End Investment Funds in France
  • 11 The Introduction of Funds Re-domiciliation Legislation in Ireland
  • Retail Fund Authorization in Hong Kong: The Moving Goal Posts
  • Russia Finally Adopts Law on Insider Trading

From the Editors

Far-Reaching U.S. Financial Reform Legislation Impacts Financial Service Companies Both Within and Outside of the United States

"This law creates a new, more effective regulatory structure, fills a host of regulatory gaps, brings greater public transparency and market accountability to the financial system and gives investors important protections and greater input into corporate governance."

– Mary L. Schapiro, Chairman U.S. SEC

President Barack Obama signed into law on July 21, 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), thereby effecting the most sweeping changes to the U.S. financial regulatory system since the 1930s.

While the Act's principal focus is on U.S. financial services institutions and U.S. financial markets, a number of its provisions will impact non-U.S. financial services companies operating in the United States or providing products and/or services to U.S. clients and consumers. At the same time, wholesale changes to regulation of financial services are also taking place in Europe where, among a number of other regulatory initiatives, the Alternative Investment Fund Managers Directive (or AIFMD) is proposed to introduce a European regime for management and marketing of alternative investment funds. One of the most important challenges the global financial services industry will face in the next few years will be navigating safely through both sets of these new regulatory initiatives.

The Act is primarily focused on improving the regulation and supervision of the financial institutions that were viewed as triggering the 2008 financial crisis, namely banking institutions, as well as other firms that acted as major players in the derivatives marketplace or were involved in subprime lending and securitization of such loans. Nevertheless, the Act's extremely broad reach leaves very few financial services firms untouched.

The Act's provisions range from high-level structural changes, such as the creation of a Financial Stability Oversight Council and a Consumer Financial Protection Bureau, to detailed requirements for specified participants in the financial markets (including investment advisers, investment companies, broker-dealers and broadly defined "banking entities").

The future regulations and studies, the substance and findings of which cannot be predicted, are likely to impact in a variety of ways, and for years to come, all participants in the U.S. financial markets.

The effects of the Act will be felt by entities beyond those currently registered with the Securities and Exchange Commission ("SEC") as investment advisers, investment companies or broker-dealers. Many unregistered investment advisers that manage private funds will now be required to register with the SEC and, together with currently registered advisers, will be subject to greatly increased regulation and SEC scrutiny. And, the so-called "Volcker Rule" adds restrictions that, with certain exceptions for permitted activities, prohibit a banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in or sponsoring a hedge fund or a private equity fund.

In addition to implementing various new and amended statutory provisions, the Act defers many of the "details" of this comprehensive regulatory initiative to future regulations and studies by a variety of U.S. federal regulatory agencies. In this regard, the SEC has announced a new process to enable the public to comment even before the Commission proposes its regulatory reform rules and amendments, as well as new best practices for SEC staff when conducting meetings with interested parties "in order to ensure full transparency to the public."

There is a clear tension in the Act between the apparent desire to demonstrate Congress' tough stance on Wall Street while at the same time avoiding adverse impact of the reforms on the financial industry and the recovery in the broader economy.

The future regulations and studies, the substance and findings of which cannot be predicted, are likely to impact in a variety of ways, and for years to come, all participants in the U.S. financial markets. And there is a clear tension in the Act between the apparent desire to demonstrate Congress' tough stance on Wall Street while at the same time avoiding adverse impact of the reforms on the financial industry and the recovery in the broader economy.

For an extensive suite of publications prepared by Dechert attorneys regarding the impact of the Act on various financial services entities and products, please refer to those listed below (and future client alerts on U.S. and international legal developments on our website). We will continue to monitor and report on the rule-making process and related developments as provisions of the Act are implemented.

Fund Raising for Alternative Investment Funds in Germany
 By Hans Stamm

Increasing Demand by German Retail and Institutional Investors for Alternative Investment Funds

Notwithstanding the turmoil in the world's financial markets, it is widely expected that German and other European institutional investors will not reduce their allocation to alternative investments (such as hedge funds, private equity funds, real estate funds and renewable energy funds), but rather, will increase their exposure to this asset class in the medium- and longterm. Both the current low interest environment, as well as the growing payment obligations of corporate and public pension plans, have increased the pressure on institutional investors to diversify their investment portfolios beyond established asset classes in the capital markets.

In the German market, the largest institutional investors include life and health insurance companies, corporate pension funds and pension funds for specific professionals (e.g., "berufsständische Versorgungswerke"). The most recently available report on the investment allocation by German life insurance companies provides evidence in this respect. The total investments by such companies in so-called "regulated investments" ("gebundenes Vermögen") amounted to approximately EUR 672.9 billion.1 Their total exposure to so-called "risk assets" (which include stocks, mutual funds, subordinate debt, hedge funds and other private funds) amounted to approximately EUR 108.9 billion (i.e., around 16% of their total assets).

From a regulatory perspective, German life insurance companies may invest up to 5% of their regulated investments in hedge funds. This basket of eligible investments includes both direct and indirect investments in single- and multi-manager hedge funds. With respect to direct investments in hedge funds and other private funds, certain additional investment restrictions exist for German life insurance companies (e.g., investments in non-EEA domiciled hedge funds are not permissible). Under a recent amendment of the German Investment Ordinance ("Anlageverordnung")2 that stipulates the scope of eligible investments for German life insurance companies, in addition to the 5% basket for hedge fund investments, a further basket of up to 5% of the companies' regulated investments may be invested in direct and indirect commodity-based investments.

Notwithstanding the turmoil in the world's financial markets, it is widely expected that German and other European institutional investors will not reduce their allocation to alternative investments.

The retail investor market has also seen a growth of interest in alternative investment products in recent years. The substantial part of this investor market is made up of German-domiciled, unlisted, closed-end funds (in the form of German law partnerships, "KG"). Although this segment of the German retail market has seen a fall in investments based on equity raised from retail investors (from approximately EUR 15.4 billion in 2008 to approximately EUR 9.4 billion in 2009), market participants are nevertheless maintaining a positive outlook for this segment of the industry.3 In particular, investments in renewable energy (e.g., solar and wind farm projects), infrastructure and real estate are currently being sought by retail investors.

German Investment Act and Investment Tax Act Restrictions on Offerings to German Investors

For non-German-domiciled sponsors of alternative investment funds, various regulatory and tax rules should be taken into consideration when targeting German investors. Any alternative investment fund targeting German investors has to meet the requirements of the German Investment Act ("GIA") ("Investmentgesetz") that codifies, inter alia, the rules governing the marketing of funds to German investors. Even private placements are affected by the GIA, since most German institutional investors are only permitted to invest in funds that meet the standards set out in the GIA. Furthermore, any non-German fund that falls within the rules of the GIA typically will also be subject to the specific tax regime set out in the German Investment Tax Act ("GITA") ("Investmentsteuergesetz"), which affects the taxable income of any German taxresident investor.

The GIA provides that any foreign investment fund qualifies as a "foreign collective investment scheme" if, notwithstanding its legal structure:

  • It is an open-ended investment scheme (i.e., investors can redeem fund units on a regular basis at least every two years); or
  • It qualifies as a regulated investment scheme (i.e., in its home jurisdiction, it is subject to regulatory supervision comparable to the supervision of German regulated funds);
  • Its business purpose is to make collective investments (i.e., for the benefit of investors holding units in such scheme);
  • It invests (directly or indirectly) in a portfolio of risk-diversified assets; and
  • The assets held by the fund are comprised predominantly of so-called "eligible investments" (including assets that are defined as "eligible investments" in EC directive 2007/16/EC), which includes transferable securities (bonds and shares), derivatives, and both direct and indirect real estate investments.

In the hedge fund industry, various sponsors have recently offered Europeanbased clones of their off-shore hedge funds in the form of so-called "NewCITS".

An explicit safe-harbor exemption from these requirements exists for certain "private equity funds", understood to include any funds that hold more than 20% of their investments in portfolio companies as an "active investor". However, a clear definition to distinguish such "private equity funds" from hybrid funds or hedge funds currently does not exist. As a consequence, many non-German hedge funds, real estate funds, renewable energy funds and commodity funds are subject to the rules of the GIA and GITA.

Even if the regulatory selling restriction regime of the GIA may not apply in the case of a private placement to certain institutional investors or in the case of a reverse solicitation, the specific tax regime of GITA may create a hurdle for attracting German investors. If a non-German fund does not comply with a specific German tax reporting regime as specified in the GITA (which includes preparing and filing German tax returns, calculating various sources of income under German tax law and publication of such taxable income on a regular basis and also upon any redemption or issuance of fund units), German tax-resident investors will be subject to a penalty tax regime. German tax-resident investors in the fund will be deemed to have received per unit taxable income at the year-end of the foreign fund, calculated as the greater of: (i) 6% of the fund's year-end per unit NAV, and (ii) 70% of the increase in the per unit NAV of the fund during the relevant fiscal year. Furthermore, upon any transfer or redemption of fund units, an additional deemed taxable income of 6% of the proceeds will be triggered for the German tax-resident investors. Although some non-German sponsors of hedge funds comply with such tax reporting and tax disclosure rules, many non-German fund sponsors are concerned about the administrative (and cost) consequences of these tax rules.

Alternative Marketing Through Fund-Linked Structured Products

In the hedge fund industry, various sponsors have recently offered European-based clones of their offshore hedge funds in the form of so-called "NewCITS" (i.e., funds set up within the framework of the European Directive on (Transferable) Securities Funds (UCITS) that, subject to a notification in the respective jurisdictions, can be marketed across Europe). However, not all hedge fund and other alternative investment fund strategies can be replicated in such "NewCITS" (due to certain restrictions regarding eligible investments, investment strategies, use of OTC derivatives, etc.). Also, concerns have recently been expressed regarding the application of UCITS liquidity requirements to such hedge funds. Furthermore, the above-described German tax regime (GITA) also applies in respect of such NewCITS.

The specific German tax regime for foreign collective investment schemes (GITA) targeting German tax-resident investors, as well as certain regulatory benefits, may lead to a greater demand for fund-linked notes as a vehicle to raise capital from German investors.

As a consequence of the above-mentioned regulatory and tax restrictions, in recent years an increasing number of funds have raised capital from German investors by using structured products, particularly in the form of so-called "fund-linked notes". In these structures, German investors invest into a bond, whose payout replicates, on a synthetic basis, the performance of the respective foreign fund. Historically, this market arose around ten years ago, with various banks issuing notes that replicated the performance of a basket of hedge funds and marketing such products to German retail investors. Over time, "capital guaranteed notes" were developed that effectively combine a synthetic investment in a zero-coupon bond with an option based on the performance of the respective foreign funds. More recently, similar "Delta 1-" and "capital guaranteed" structures have been developed for German institutional investors. The report by the German regulator BaFin for 2009 refers to the fact that the majority of investments made by German insurance companies were in the form of such fundlinked notes.

Although the German regulatory and tax authorities as a matter of practice accepted these products for many years, the authorities recently each issued an official decree on the rules for accepting such products (BaFin in December 2008 and the German tax authorities in August 2009). Such products will be accepted from a German regulatory and tax perspective if: (i) the issuer of the note is not legally obliged to invest the issuance proceeds into the respective investment fund(s), and (ii) the investor, under the terms of the note, has only a contractual right for a payment that is referenced to the performance of the respective investment fund(s) (i.e., the investor does not have any direct legal recourse or any security right in rem with respect to the foreign investment fund(s)). As a consequence of these decrees by the German authorities, fund-linked notes may also now be issued by entities that are not banks. Since investors in the current financial climate are concerned with the credit risk of the issuer of any such notes, certain Germanand Luxembourg-based service providers have developed structures to use special purpose companies (SPCs) as issuers of these notes.

Outlook

Fund sponsors (particularly large, non-German sponsors) with sufficient administrative resources may make further use of European-based NewCITS structures, typically in Luxembourg or Ireland. In addition, the specific German tax regime for foreign collective investment schemes (GITA) targeting German tax-resident investors, as well as certain regulatory benefits, may lead to a greater demand for fund-linked notes as a vehicle to raise capital from German investors. The administrative resources and timing involved for "wrapping" a hedge fund, or for any alternative investment fund strategy in the form of a fund-linked note, may be less burdensome than for other available structures. And, as with any structured product, these financial instruments offer flexibility in structuring specific pay-out terms (such as a full or partial capital guarantee) as well as beneficial liquidity terms.

Footnotes

1 BaFin Annual Report 2009.

2 3rd Amendment of German Investment Ordinance ("Anlageverordnung"), dated 29 June 2010.

3 VGF Annual Report 2009.

CESR's Advice on Complex Financial Instruments: The Implications and Outlook for UCITS
 By Declan O'Sullivan and Conor Durkin

On 29 July 2010, the Committee of European Securities Regulators ("CESR") delivered its technical advice to the European Commission (the "Commission") in relation to CESR's review of complex and non-complex financial instruments for the purposes of the MiFID1 "appropriateness" requirement. Despite calls (from various parties who made submissions to CESR during its consultation) to classify structured UCITS and UCITS that employ complex portfolio management techniques as "complex financial instruments", CESR did not recommend any change to the current categorisation of UCITS under MiFID as "non-complex financial instruments".

In practical terms, the distinction between complex and non-complex financial instruments matters, because the requirement to assess the appropriateness of a product or service must always be complied with where the investment product or service involves a complex financial instrument. An assessment of appropriateness does not need to be undertaken for "execution-only" (i.e., non-advised) services in respect of non-complex financial instruments.

This article examines how UCITS are categorised under MiFID, discusses the possible impact of any change to such categorisation and considers the future regulatory developments that may affect classification of UCITS under MiFID's appropriateness requirement.

Classification of UCITS Under MiFID

MiFID introduced a conduct of business regime whereby investment firms are required to assess the "suitability" or "appropriateness" of a service or product offered to clients. In broad terms, the purpose of the suitability and appropriateness assessments are to ensure that clients have the necessary experience and knowledge to understand the risks associated with an investment service or product— in particular, MiFID aims to prevent complex financial instruments from being sold on an execution-only basis to retail investors. Complexity of the service or product is the main criterion to be taken into account when assessing the suitability or appropriateness of such service or product for a client.

Suitability and Appropriateness Requirements

Whenever an investment firm provides investment advice or discretionary portfolio management only, the investment firm must obtain all necessary information regarding the client, its knowledge, experience and financial situation, in order to enable the investment firm to recommend only investment services or products that are suitable for the client.

With the exception of the provision of investment advice or discretionary portfolio management, an investment firm is required to obtain information regarding its clients, their knowledge and experience, so as to enable the investment firm to provide only those services or products that are appropriate for the client.

An investment firm is permitted under MiFID to provide products or services without having to comply with the suitability or appropriateness obligations, if the product or service consists of execution-only services, or the receipt and transmission of client orders relating to non-complex financial instruments.2 This is known as the "execution-only exemption".

Article 19(6) of MiFID sets out a non-exhaustive list of financial instruments that are categorised as noncomplex. Such instruments include, among others, shares admitted to trading on regulated markets, money market instruments, bonds or other forms of securitised debt and UCITS. By definition, UCITS are classified under MiFID as non-complex instruments and therefore fall within the execution-only exemption.

Financial instruments that are not defined as noncomplex instruments under MiFID are subject to an in-depth risk-based analysis for the purpose of determining whether the instrument should nevertheless be categorised as non-complex for the purpose of the appropriateness requirement. Article 38 of the MiFID Level 2 Directive3 sets out criteria for determining whether or not an instrument should, on a risk-based assessment, be classified as complex.

CESR's Review of Complex and Non-complex Instruments Under MiFID's Appropriateness Requirement

On 14 May 2009, CESR issued a Consultation Paper that set out CESR's analysis of how various types of financial instruments, including UCITS, should fit within either the complex or non-complex categories of instruments for the purposes of the MiFID Directive's appropriateness requirement.

Since CESR commenced its consultation in May 2009, an increasing number of UCITS alternative products have been offered that pursue investment strategies usually associated with hedge funds. Many commentators have noted that some UCITS can be complex products and queried whether complex UCITS should be sold to retail investors. In these circumstances, the proper classification of UCITS under MiFID's appropriateness requirement has become a topical issue.4

In its consultation, CESR queried whether there should be any change to the treatment of UCITS under MiFID. Many correspondents argued that UCITS should not automatically be categorised as non-complex instruments given the underlying assets in which UCITS can invest in or to which they may have exposure. Fund associations, on the other hand, overwhelmingly supported no change to the current treatment, arguing that UCITS are conceived as retail products, strictly regulated and subject to stringent risk management rules, provide a high degree of investor protection and are well diversified liquid investments that do not involve liability exceeding the acquisition costs. Financial regulators in the European Union have indicated that they are generally open to a review of the treatment of UCITS under MiFID.

Response of European Regulators

The Autorité des Marchés Financiers ("AMF"), the French Financial Regulator, has commented that UCITS can be very complex products, and has called for the re-examination of the way UCITS are sold, in the context of CESR's review of MiFID's appropriateness requirement. The AMF would prefer UCITS to be placed in the category of financial instruments whose complexity is first assessed by an investment firm under Article 38, before determining whether the UCITS should be classified as complex or non-complex.

The Irish Financial Regulator has also acknowledged that there has been a rapid rise of UCITS using hedge fund strategies, and has indicated that if the matter is raised by the Commission, it would be happy to reconsider the treatment of UCITS under MiFID.

Impact of Changes

Changes to the categorisation of UCITS as noncomplex instruments would be likely to cause UCITS significant difficulties in relation to sales and distribution activities. In particular, distributors, execution-only brokers, operators of fund supermarkets and other providers of execution-only services, would be required to obtain detailed information in relation to the strategies employed by UCITS for the purpose of assessing on a risk-basis whether a UCITS is a complex financial instrument. If the UCITS is assessed to be a complex instrument, a further assessment would need to be made regarding the appropriateness of the UCITS for the client.

Several practical issues would arise if UCITS are not automatically permitted to avail of the execution-only exemption. For example: (i) should the UCITS itself, or its distributor, be required to make the determination as to whether or not an instrument is complex; (ii) should national regulatory authorities have any role in approving the categorisation of UCITS; (iii) how should information regarding the classification of UCITS be communicated to clients and should such information be included in the Key Investor Information document (that will replace the simplified prospectus); and (iv) how should firms involved in selling and distributing UCITS review, and possibly adapt, their procedures to map and classify their clients, as well as the UCITS transactions of their clients and, on the basis of such information, assess the appropriateness of UCITS for their clients.

Further Regulatory Developments

On 29 July 2010, after completing its consultation, CESR delivered its technical advice to the Commission. Although CESR's function was to carry out a review of the classification of various financial instruments under MiFID, CESR noted that UCITS are subject to a separate regulatory regime and indicated that recommendations for reform regarding the classification of UCITS would be outside the scope of its review.

On the same day, CESR also replied to the Commission's request for information regarding technical criteria to distinguish among UCITS as complex and non-complex instruments. On this subject, interestingly, CESR stated it "believes that there is a case for considering treating structured UCITS and UCITS that employ complex portfolio management techniques as complex financial instruments for the purposes of the appropriateness test (this is a concept that would need to be elaborated possibly through binding technical standards)" and invited the Commission to determine whether additional work should be undertaken by CESR in considering this question.

The Commission will now review CESR's technical advice before recommending changes, if any, to MiFID. It is expected that Commission will make its recommendations in early 2011.

Packaged Retail Investment Products

On a related topic, the Commission is currently preparing legislative proposals in relation to Packaged Retail Investment Products ("PRIPs"), and its work in this field is related to CESR's review of financial instruments (including UCITS) under MiFID. PRIPs are defined by the Commission as investment products that are broadly comparable for investors and can take a variety of forms. For example, PRIPs would include investment funds (including UCITS), structured securities, unit-linked life insurance products or structured term deposits. At present, retail PRIPs, such as those listed above, are regulated under separate Directives and there are inconsistent rules in relation to disclosure, selling and investor protection. The Commission's goal is to create a common basis for the regulation of key investor disclosures and selling practices at a European level, irrespective of the form in which a retail investment product is packaged or sold.

Based on its work to date, the Commission has proposed to develop a framework in relation to pre-contractual disclosures and selling practices. For selling practices (including the sale of UCITS), the Commission intends to use MiFID provisions on conflicts of interest, inducements, appropriateness, suitability and client disclosures, as the basis for developing a common PRIPs sales regime.

Conclusion

The question of the future treatment of UCITS under MiFID and the associated issue of how UCITS are distributed will be revisited in the context of the PRIPs reform that is being developed by the Commission. Investment firms providing execution-only services in respect of UCITS, particularly distributors, executiononly brokers and operators of fund supermarkets, should be aware that a change to the classification of UCITS under MiFID may mean that UCITS will no longer automatically benefit from the execution-only exemption. If the PRIPs reform results in a change to the classification of UCITS, investment firms would be advised to review their operating procedures so that the firms can either make a determination as to whether or not specific UCITS are complex financial instruments, or alternatively, assess the appropriateness of particular UCITS for their clients.

Footnotes

1 Directive 2004/39/EC of 21 April 2004 on Markets in Financial Instruments Directive ("MiFID"), which is a European Union law that provides harmonised regulation for investment services across the European Union. MiFID applies to all business firms that provide investment services in respect of financial instruments.

2 The service should be delivered at the initiative of the client, the client should be advised that the investment firm is not required to assess the suitability of the services and the investment firm should have in place an appropriate policy to manage conflicts of interests (ref. Article 19(6) of MiFID).

3 Directive 2006/73.EC of 10 August 2006 as regards defined terms, and organisational requirements and operating conditions for investment firms.

4 Although UCITS IV will result in significant changes to the UCITS regime, it does not touch upon the classification of UCITS under MiFID.

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