Olivier Sciales Investments Law Blog on Lawyers.com

Luxembourg is, behind the USA, the world’s second ranking financial centre for the domicile and servicing of investment funds. Since 1959, when the first fund was established, the investment fund industry hugely expanded, counting 3,395 funds in April 2009. This success originated with the authorities' encouraging attitude to foreign capital and investment, and was considerably strengthened by its prime location in the heart of Europe - close to the main markets targeted by investment funds -, by its highly qualified multilingual workforce, as well as by its political, economic and social stability. This unique business friendly environment turns out to be of crucial assistance to mitigate the effects of the financial turmoil the investment funds world is currently going through, and indeed Luxembourg seems to be doing better than most major financial centres. As at 31 March 2009, total assets of undertakings for collective investment and specialised investment funds reached EUR 1,526.563 billion compared to EUR 1,530.291 billion as at 28 February 2009, i.e. a 0.24% decline. The Luxembourg government has implemented innovative fiscal measures and further reforms remain to be seen at the European level (i.e implementation of the UCITS IV Directive). Moreover, the events of the past months have lead the Luxembourg authority and government to take into consideration the security of investors.

I.       Legal and regulatory framework

The 20 December 2002 law relating to undertakings for collective investments (“2002 Law”) shaped the Luxembourg investment fund market, differentiating between Undertakings for Collective Investment in Transferable Securities (UCITS, Part I of such law) and Undertakings for Collective Investment (UCIs, Part II of such law). Further to the 13 February 2007 law relating to Specialised Investment Funds (SIF) (“SIF Law”), the Luxembourg investment funds are now divided into three categories: 

-     UCIs, 698 in March 2009;

-     UCITS, 1,840 in March 2009; and

-     SIF, 858 in March 2009.

A.    UCITS

UCITS are designed for retail investors, and benefit from the European Passport, enabling them to be freely marketable throughout the EU countries with a minimum of formalities. Those funds are open-ended and must comply with stringent requirements set by the EU legislator in terms of eligibility of assets, risk-spreading requirements, and, more generally, in terms of substance and supervision.  

Major changes in this area of the law remains however to be seen, since the proposal of the European Commission for an improved EU framework governing UCITS funds has been approved on 13 January 2009 by the European Parliament. In practice this will mean the implementation of the UCITS IV Directive, which aims to liberalise the regime for cross-border retail funds. 

B.     UCIs

 In contrast, UCIs (Part II) may only market their units in other EU countries after complying with the specific conditions stipulated by the authorities in the country concerned. The criterion defining whether a UCI is subject to Part I or Part II of the 2002 Law is the planned investment objective, as Part I applies only to UCI the sole objective of which is the investment in transferable securities, whereas a UCI may invest in activities such, inter alia, alternative investments (i.e. Hedge Funds), venture capital, and real estate.

C.     SIFs

The SIF Law provides a separate statutory regime specifically designated for investment funds dedicated to sophisticated investors. The SIF is a lightly regulated and tax efficient fund which gives an on-shore alternative to consider (as compared to traditional off-shore jurisdictions such as the Cayman Islands or the BVI) when deciding on the jurisdiction for setting up a fund and the type of fund vehicle to use, and SIF are subject to each country’s distribution rules.

D.    Regulatory body and control

The regulatory body is the Commission for the Supervision of the Financial Sector, (“CSSF”).

If it is subject to a continuous control by the CSSF, a fund set up under the SIF Law does not need its prior approval for being incorporated, while it is still a condition sine qua non for funds set up under the 2002 Law. Directors of a SIF are still subject to the CSSF approval.

The coming into force of the UCITS IV Directive, expected in mid-2011, should somewhat change the rule in this area, since the proposal reinforces the current provisions by providing additional tools to supervisors and enhancing supervisory cooperation.

To comply with the setting-up requirements, investors benefit from the financial facilities offered by the high-profiled Luxembourg economic environment, counting 152 banks (registered on the official list as at 28 February 2009), a broad range of international and local law firms exceedingly qualified in this field, as well as audit firms and tax advisors.   

II.       Constitution of a fund / legal structures available

Investment funds may take the form of an open-ended legal entity (investment company with variable capital, SICAV, 1,452 in March 2009), a closed-ended legal entity (investment company with fixed capital, SICAF, 18 in March 2009), or of a common contractual fund which has a management company (FCP, 1,926 in March 2009). All those different entities may create sub-funds, each with a different investment policy. In this context, each compartment will be deemed to be a separate entity, which implies that the assets of a compartment are exclusively available to satisfy the rights of investors in relation to that compartment.

A.     SICAV / SICAF

 
A SICAV is a limited liability company whose capital is at any time equal to its net assets. Its capital increases and decreases automatically as a result of subscriptions or redemptions, without any formalities required. SICAVs may take different legal forms, depending on the law to which they are subject. In contrast, a SICAF is a limited liability company with fixed capital, open-ended only if the investors can buy and sell shares at their request and at a price equal to the net asset value per share. However, due to its limited flexibility, this corporate vehicle is rarely the choice of investors.

B.     FCP

A FCP is a co-proprietorship whose joint owners are only liable up to the amount they have contributed. A FCP is deprived from a legal personality and must therefore be managed by a Luxembourg management company on behalf of joint owners. UCITS are managed by management companies under the conditions laid down in Chapter 13 of the 2002 Law, whereas Chapter 14 of the 2002 Law lays down the conditions under which management companies are ruling UCIs and SIFs.

C.     Choosing a legal structure

The choice of whether to create a fund as a FCP or as an investment company is mainly based on tax considerations, as a FCP is tax transparent. Marketing and operational considerations are also relevant in this vehicle as a FCP, being domiciled in Luxembourg, benefits from the high standard of service provided by managers, custodians, legal and tax professionals present in Luxembourg. In contrast, the two other forms, because of their flexibility, are more often reserved for funds investing in transferable securities or derivatives, and for funds where shareholders/unitholders need to purchase or redeem their shares/units freely. 

D.    Formation expenses

The formation expenses will consist for all funds in a fixed registration duty of EUR 75, notary fees, legal fees, a CSSF filing duty, fixed, for 2002 Law UCIs, at EUR 2,650 for a single market UCI and EUR 5,000 for a multiple compartment UCI. In contrast, the CSSF filing duty has been fixed, for SIF Law UCIs, at EUR 1,500 for a single compartment UCI and EUR 2,650 for a multiple compartment UCI. The formation expenses may also comprise, if a listing to the Stock Exchange is contemplated, its admission fee, fixed at EUR 1,250.

E.     Minimum capitalisation

The minimum capitalisation (EUR 1,250,000) required under both laws must, in case of a SIF, be reached within 12 months from the approval by the CSSF, in contrast with 6 months in case of other investment funds.

III.     Investors' eligibility

Investment funds set up under the 2002 Law are available to public distribution. Hence, no restriction applies upon eligible investors, whereas the SIF Law introduces a qualified investor scheme. In this context, SIFs are reserved for well-informed investors who are able to understand and assess the risks associated with investments in such a fund, well-informed investor meaning either an institutional investor, a professional investor, or any other investor who has declared in writing that he is an informed investor and either invests a minimum of EUR 125,000 or has an appraisal from a bank, an investment firm or a management company certifying that he has the appropriate expertise, experience and knowledge to adequately understand the investment in the fund.

IV.    Investment restrictions

Under the broad principle of risk spreading, all funds are subject to different rules restricting the scope of their investment policy. Those rules are quite restrictive towards UCITS, somewhat lighter concerning UCIs, and much lighter when it comes to SIFs.

A.    UCITS

The 2002 Law provides for numerous restrictions upon investments by UCITS, which have been clarified in recent regulatory developments:

-     Circular CSSF 07/308 lays down rules for the implementation of a risk management framework. Those rules rendered necessary that a UCITS must self-assess itself as either 'sophisticated' or 'non-sophisticated'. A sophisticated UCITS, being in the obligation of entrusting to a developed risk management unit, is able to make a significant use of derivative financial instruments, whereas non-sophisticated UCITS, with a much less developed risk management unit, can make use of derivative financial instruments only for hedging purposes. This Circular also specifies some valuation rules stating, inter alia, that overall risk exposure related to financial derivative instruments should not exceed the total Net Asset Value.

-     The 8 February 2008 Grand-ducal regulation clarifies the notion of UCITS as provided in the 2002 Law, in light of the Commission Directive 2007/16/EC;

-     The Circular CSSF 08/339 displays the guidelines given by the CESR in relation to eligible assets for investment by UCITS, and in this context provides additional clarifications relating to eligible assets for investment by UCITS covered by Directive 85/611/EEC, as amended; and

-     CSSF Circular 08/356 describes in detail the techniques and instruments UCITS may use, including securities lending transactions. The main innovation to be noted refers to permitted collateral and permitted assets in which cash collateral can be reinvested. In this respect, this Circular specifies how collateral and assets acquired upon reinvestment of cash collateral must be safe kept in order to avoid a counterparty risk for the UCITS exceeding its legal limits.

B.    Non-UCITS Part II Funds

If there are no restricted eligible assets for a UCI, its investment policy is subject to the CSSF approval, and specific rules are laid down in Circular IML 91/75 (as amended by Circular CSSF 05/177), whilst others are specifically applicable to UCIs pursuing alternative investment strategies. Those rules are laid down in Circular CSSF 02/80 which states, inter alia, that: 

-     Aggregate commitment in terms of short selling may not exceed 50% of assets, and no more than 10% of the same type issued by the same issuer may be sold short;

-     Borrowings must not exceed 200% of the net assets; and

-     Counterparty risk, defined as the difference between the value of assets given as guarantee and the amount borrowed, cannot represent more than 20% of the UCI's assets per lender.

C.     SIFs

SIF are not required to comply with any detailed investment restrictions or leverage rules; the SIF Law merely stating that a SIF should apply the principle of risk diversification. This principle provides that the collective investment of funds must be made in assets 'in order to spread the investment risks'. The CSSF clarified in its Circular 07/309 that: 

-     A SIF may not invest more than 30% of its assets or commitments to subscribe securities of the same type issued by the same issuer;

-     Short sales may not result in the SIF holding a short position in securities of the same type issued by the same issuer representing more than 30% of its assets; and

-     When using financial derivative instruments, the SIF must ensure, via appropriate diversification of the underlying assets, a similar level of risk-spreading.

However, the CSSF may, upon appropriate justification, grant exemptions to these rules on a case-by-case basis. 

V.     Reporting and audit requirements

A.    Prospectus

Funds are in the obligation to issue a prospectus containing information concerning the fund and its management company. The 10 July 2005 law on prospectus for securities specified that the obligation to publish a full prospectus shall not apply to units issued by UCI other than the closed-end type. Such a fund shall publish a simplified prospectus. Offers to the public of securities representing units issued by UCI other than the closed-end type shall be subject to the sole provisions of the laws on UCI. According to the 2002 Law, both the simplified and the full prospectus must include the information necessary for investors to make an informed judgment of the investment proposed to them, and especially of the risks attached thereto. Investors should note that when the UCITS IV Directive will come into force, the simplified prospectus is expected to be replaced by a ‘key investor information’ document.   

B.     Issuing document

Funds subject to the SIF law are only required to produce an 'issuing document', displaying, with no minimum content, the information necessary for investors to be able to make an informed judgment about the investment proposed to them. The issuing documents and any modifications thereto must be communicated to the CSSF. 

C.     Financial statement

A difference to draw between the 2002 Law and the SIF Law is that the obligation to publish a financial statement is only annual in the case of a SIF, whereas an investment fund subject to the 2002 Law must publish such an audited financial statement annually and semi-­annually.

Such financial statement(s) must be audited by an authorised independent auditor, member of the Luxembourg Institute of Auditors. This auditor is in the obligation, if any information provided to investors does not truly describe the financial situation of the fund, to report promptly to the CSSF. The same obligation applies if the auditor becomes aware during the audit that any fact or decision is liable to constitute a material breach of the law or regulations, or to affect the continuous functioning of the UCI. 

VI.     Taxation of funds

Luxembourg funds are essentially tax-exempt vehicles, and indeed Luxembourg UCITS, UCIs and SIFs do not pay Luxembourg income and capital gain taxes, nor is a stamp duty on share issues or transfers to be paid.

The Luxembourg authorities are currently working on a wide range of fiscal reforms. The first main changes have been the abolition of the fixed capital duty and of the withholding tax on dividends paid to recipients resident in countries that have concluded a tax treaty with Luxembourg as from 1 January 2009.

Under the SIF Law an annual subscription tax has been fixed at 0.01% of net assets, compared to 0.05 % for funds under the 2002 Law. It is however only of 0.01% for UCIs whose exclusive policy is the investment in money market instruments or deposits with credit institutions. Other funds, such as certain institutional cash funds and pension pooling funds, are exempted from this subscription tax, no matter under which Law they are set up under. It should be noted that investors may invest in a SIF by means of equity or debt, hence benefiting from an effective tax optimisation, and that there is no debt-equity ratio to be respected in the case of a SIF.

In order to avoid double taxation, Luxembourg has signed double taxation treaties with 52 countries, and 21 others are under negotiation or awaiting approval of the Luxembourg Parliament or the foreign country. However, it has to be emphasised that only 27 of these treaties are applicable to SICAVs and SICAFs. 

VII.    Stock exchange listing

A fund may be listed on the Luxembourg Stock Exchange (LSE). A few conditions have been imposed for a foreign fund to be listed on the LSE, mainly that the fund promoter must be of good repute, have adequate professional experience, and that the functions of investment manager, management company, custodian and transfer agent must be carried out by a separate entity.

 
The Stock Exchange maintenance fee has been fixed at EUR 1,875 for the 1st line of quotation, EUR 1,250 for a 2nd one, EUR 875 for a 3rd one, and EUR 500 for the 4th and the following lines of quotation.

Conclusion

The Luxembourg investment fund industry, largely benefiting from its location in a strong financial centre, is now an internationally recognised on-shore label for investment funds. The greatest asset of Luxembourg is undoubtedly political voluntarism, demonstrated by a constant anticipation of the need of investors - either in the transposing of European legislation or in the shaping of national legislation - in order to create a stable, protective and favourable environment according to the expected development of the market. This pragmatism on the part of the Luxembourg authorities, exemplified by the recent fiscal exemptions and by the way the CSSF dealt with the global financial turmoil, is decisive to shepherd investors in days of global uncertainty. Lastly, the increasingly important issue of transparency is covered by national and European regulations and provides new investors with an especially protective framework as compared to traditional off-shore jurisdictions such as the Cayman Islands or the BVI. For instance, the European Commission has proposed a Directive on Alternative Investment Fund Managers (AIFMs) with the objective to create a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level.