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This book aims at providing the readers with a comprehensive overview of the Luxembourg fund industry together with a better understanding of the mechanisms governing the interactions between its different actors. The goal is to enable the readers to better apprehend the functioning of industry as a whole from both a legal and practical perspective and to operate more efficiently within the industry. As a consequence, the book must be distinguished from practitioner-oriented compilations of legal texts and references. The contribution of renowned experts of fund industry in Luxembourg permitted to summarize the operating in Luxembourg. Consequently, this book aspires to become a reference on the topic. Students in Finance, Law and Management considering a career in the fund industry will benefit from this book by gaining a better understanding of fund industry as a whole, wich would improve their employability in this sector. Under the supervision of Danielle Sougn, this work gathers the contributions of Xavier Balthazar, Serge dOrazio, Yves Francis, Claude Hoffman, Mr. Maquil, Stphane Ries, Jrme Wigny and Jean-Charles Wijnandts.

FuNd iNdustry iN LuxEmbourG

his book is to be placed in an unexploited niche in the fund industry literature: It has first to be distinguished from the main strand of the literature on mutual funds focusing on funds selections methods and portfolio management strategies available to funds managers.

Danielle Sougn

FuNd iNdustry iN LuxEmbourG

FuNd iNdustry iN LuxEmbourG


A practitioNEr GuidE
Directed by Danielle Sougn
Preface by Rafik Fisher Foreword by Claude Kremer

Danielle Sougn, Doctor in Applied Economics at HEC, Business school of the University of Lige, Head of Finance, Accounting and Law department, KBL Chair in Fund Industry.

Cahiers financiers

Collection sous la direction de Bruno Colmant

FUNINLUX ISBN 978-2-8044-5692-4 ISSN 2030-9856

www.larcier.com www.stradalex.com

Authors
Mr. Xavier Balthazar, Partner, PwC Luxembourg Mr. Serge DOrazio, Head of Investment Fund Services, KBL Mr. Yves Francis, CEO and Managing Partner of Deloitte Luxembourg Mr. Claude Hoffmann, Member of the Executive Committee, European Fund Administration S.A., Luxembourg Mr. Maquil, Special Advisor to the president, Luxembourg Central Bank Mr. Stphane Ries, Head of Business Development, KBL Ms. Danielle Sougn, Phd, Full Professor, KBL Chair Holder in Fund Industry, HEC-ULg Management School University of Lige Mr. Jrme Wigny, Partner, Elvinger, Hoss & Prussen, Luxembourg Mr. Jean-Charles Wijnandts, Research Fellow, KBL Chair in Fund Industry, HECULg Management School University of Lige

Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

FUND INDUSTRY IN LUXEMBOURG

13

Preface by Rafik Fischer


To Jean-Nicolas Schaus, First Director General of the Luxembourg Banking Supervisory Authority (CSSF) from 1999 to 2009. Easier access to ever more sophisticated saving products can be attributed to a large extent to the Mutual Fund Industry. For the first time, an ever increasing number of individuals with modest savings can benefit from access to numerous investment opportunities and asset classes thanks to the activities of the Mutual Fund Industry. This industry really took off in Western Europe during the 80s and greatly benefited from the development of the Grand Duchy of Luxembourg as a recognized international financial center. Luxembourg is now widely acknowledged as being one of the main pillars of private banking and wealth management. Numerous scientific books dedicated to Undertakings for Collective Investment adopt a largely theoretical approach, whether dealing with mainly legal questions or the fields of applied economics and the mathematics of financial management. The authors of this book have decided to follow an alternative approach by feeding the reader practical information acquired over the years in which they gained their own rich personal experience in the Fund Industry. Contributors to this book have taken an active role in the growth of a new financial industry from its early development to its maturity which profoundly changed the traditional landscape of public savings. In this book, the authors hope to arouse the readers curiosity to discover the different activities linked to UCI and provide a first contact with this fascinating and diverse sector. While being largely focused on the current practices applicable in Luxembourg, contributions to this book nonetheless have a universal applicability and it will constitute a source of inspiration and reference for all readers with an interest in the Mutual Fund Industry. To the students who will read this book hopefully with great interest it will give an initial insight into a potential choice of professional orientation. Having myself followed this path, I hope that students will feel the fascination and enthusiasm which animate the different contributors. Should this book create new vocations, the authors could only congratulate themselves.

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Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

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Foreword by Claude Kremer


Since the implementation of the UCITS Directive in 1988, the Luxembourg investment fund industry has grown substantially to become one of the cornerstones of the Luxembourg financial center. It has built its reputation and is renowned today as the second largest investment fund industry worldwide after the United States. The multitude of foreign and cross-border initiatives demonstrates that Luxembourg has not only succeeded in creating a general environment for investment funds but is also committed to fostering the continuous growth of the fund and asset management industry as a whole. One of the ways of achieving this goal is through attracting young professionals and graduates from various schools worldwide to settle and pursue their careers in the Luxembourg investment fund industry. I am pleased that the programs offered by HEC-ULG Management School of the University of Lige contribute to this development by offering specialized courses that help to train future professionals of our industry. This practitioners guide, as the name suggests, places an emphasis on practical aspects rather than on theoretical developments. It aims at providing students with the knowledge of the key principles of investment fund regulation and practice so that they can successfully pursue their careers in a wide variety of professions offered within the sector. Having the privilege of being a lecturer myself at HEC-ULG Management School of the University of Lige, it is my great pleasure to welcome the reader to this publication and I hope that he or she will find it useful and informative. But above all, I hope that this publication will contribute to the formation of the professionals in the investment funds sector and consequently to the continued growth of the asset management industry as a whole.

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Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

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List of abbreviations
AGM: Annual General Meeting AIF: Alternative Investment Fund AIFM: Alternative Investment Fund Manager AIFMD: Alternative Investment Fund Managers Directive ALFI: Association of the Luxembourg Fund Industry AML: Anti Money Laundering AuM: Asset under Management CCP: Center Counter Party CSD: Center Security Deposit CSSF: Commission de Surveillance du Secteur Financier DB: Depositary Bank EFA: European Fund Administration EGM: Extraordinary General Meeting ESMA: The European Securities and Markets Authority FCP: Fonds Commun de Placement FESE: Federation of European Exchanges KIID: Key Investor Information Document KYL: Know Your Customer LM: Liquidity Management ManCo: Management Company MIFID: Markets In Financial Instruments Directive NAV: Net Asset Value OTC: Over-The-Counter PEP: Politically Exposed Person RM: Risk Management SIAG: Socit dInvestissement Auto-Gre SICAR: Socit dInvestissement en Capital Risque SICAV: Socit dInvestissement Capital Variable SIF: Specialized Investment Funds
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18 TA: Transfer Agent TMF: Trading Member Firm UCI: Undertaking for Collective Investment

FUND INDUSTRY IN LUXEMBOURG

UCITS: Undertaking for Collective Investment in Transferable Securities VaR: Value-at-Risk VAT: Value-Added-Tax WFE: World Federation of Exchanges

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Introduction
This collective book offers a comprehensive overview of the Fund Industry in Luxembourg. The organization of the book follows the different steps of a funds life-cycle from its creation to its distribution. The book starts with an introduction to the different investment vehicles that can be considered for the creation of a fund (chapter1). The legal framework regulating those vehicles is also covered (chapter2). A thorough description of the Undertakings for Collective Investment (UCI) is then made which covers both the steps necessary for the creation of a UCI and the steps of its early-life development (chapter3). Fund administration is studied in the following chapter. The topic is treated via the length of funds main activities: Accountancy (including the risk management function) and funds inflows/outflows management. The role played by supporting organizations such as management firms and depositary banks is presented from both a regulatory and practical point of view (chapter5). The exposition considers then logically the regulatory framework and the supervision authorities surrounding Luxembourg funds together with practical elements regarding those matters (chapter 6). The book concludes with the different elements relative to the distribution of funds to investors (chapter7 and 8).

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Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

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1. The different investment vehicles


1.1 Introduction
In this chapter, we introduce the different investment vehicles which are available in Luxembourg as well as their legal structures. This section is structured as follows. We first give an overview of the main legal structures available and present in a more detailed manner the UCITS Fund, the Specialized Investment Fund (SIF) and the Socit dInvestissement en Capital Risque (SICAR). We then consider the examples of Hedge Funds and Pension Pooling Vehicles to illustrate that specific fund products, considering their goals in terms of marketing and investment objectives, can be set-up under different legal structures.

1.2 Luxembourg Legal Structures


Investment funds in Luxembourg can be classified according to their level of flexibility in the use of target investments, the type of investors eligible and the level of regulation to which funds are subject (see Table1.1). Public funds which are available to the widest range of investors including individual retail investors are characterized by the heaviest regulation. These funds include PartI Undertaking for Collective Investment in Transferable Securities (UCITS) benefiting from the European passport and Part II funds mostly set-up under the form of SICAVs and FCPs1. On the other hand, Private Placement Funds are subject to a lighter supervision and may use a broader and more sophisticated range of investment strategies. They are traditionally characterized by the absence of European passport and are intended for institutional, professional and so-called well-informed or qualified investors. These funds include SIFs and SICARs. The choice of the structure of an investment fund in Luxembourg is consequently mainly driven by the answer to two specific questions: Who are the targeted investors (retail, private, high net worth individuals, institutional or professional)? What kind of investment tools and strategies does the fund plan to use (plain vanilla or alternative strategies, listed or non-listed stocks, possibility of leverage, short selling, derivatives, etc.)?

1. The Luxembourg Law of 17December 2010 on undertakings for collective investment defines which funds fall under part I and II. It was voted by the Luxembourg Parliament on 16December 2010 and entered into force on 1January 2011. The law implements the UCITS IV Directive and introduces a number of other changes to the Luxembourg legislation applicable to investment funds.

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FUND INDUSTRY IN LUXEMBOURG


+ UCI set-up under the 2002 or 2010 Laws Part I UCITS with European passport Part II Other UCIs FLEXIBILITY UCI set-up under the SIF Law of 13 February 2007 SICAR under the Law of 15 June 2004 ++

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SOPARFI

No European passport

SICAV or FCP Umbrella Fund

SICAV or FCP Umbrella Fund for private placement Transferable securities or alternative investments: private equity, futures contracts and options, real estate

Eligible assets as foreseen by the 2002 (UCITS III) of 2010 (UCITS IV) laws Standard s upervision Public Funds

Venture Capital Private Equity Non-regulated

Light supervision Private Placement Funds

Table 1.1 Investment funds in Luxembourg according to their level of flexibility and regulation In the coming sections, we present in more details the characteristic of the 3 most popular structures currently used for launching new investment funds out of Luxembourg. The restrictions which characterize these different types of funds will make clear the link between the answers to the two aforementioned questions and the choice of the fund structure.

1.3 UCITS funds (UCITS III and UCITS IV)


UCITS is the abbreviation for Undertaking for Collective Investment in Transferable Securities. The UCITS I directive was adopted in 1985 to create a harmonized legal framework, facilitate cross-border distribution and establish a defined level of investor protection in Europe. In 1988, Luxembourg was the first country to implement the directive. UCITS funds benefit from the so-called European passport which means that they are freely marketable throughout the European Union and may be sold to both retail and institutional investors with minimum formalities. The principle of home country control prevails meaning that the law of the country of origin of the fund applies to the UCITS. On the other hand, non-UCITS funds are subject to each countrys local distribution rules. In addition to having the European passport, UCITS funds have to invest in transferable securities and liquid assets. They must be open-ended funds allowing investors to redeem at least twice per month.
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UCITS (UCITS I) Dec. 1985 Harmonisation of investor protection rules through regulation of the product Marketing of UCITS in EU Member States through simple notification process Principle of home country control Birth of the UCITS passport and UCITS brand in and outside Europe Luxembourg : Law of 1988

UCITS III Jan. 2001 Widening of Investment powers, of eligible instruments and of investment techniques available to UCITS Increased scope of activities of UCITS Management Companies to individual portfolio management safekeeping of fund units investment advice on an ancillary basis Law of 2002

UCITS IV June. 2009 Five principal amendments to UCITS regime: Management company passport Simplified notification procedures & enhanced supervisory cooperation EU-wide fund merger regime European master-feeder structures entity pooling KIID Key Investor Information Document Law of 2010

Table 1.2 Evolution of the UCITS regulation The range of potential investments for UCITS (UCITS I see Table 1.2) funds includes transferable securities and money market instruments, newly issued securities, bank deposits and some derivative financial instruments. They nevertheless face some investment restrictions and are forbidden to invest largely in other UCIs2, precious metals and other commodities. In addition, they are not allowed to have any significant influence on the management of any issuer, to sell short and borrow as well as to lend and act as guarantor. Regarding diversification, UCITS funds are not allowed to have positions representing more than 10% of the assets under management. In addition, the 5/10/40 rule implies that the sum of the investments made in securities representing between 5 and 10% of the portfolio cannot add up to more than 40% of the total asset under management of the fund. Derogations are nevertheless possible. A UCITS may invest at most 10% of its net assets in unlisted stocks (trash ratio), other UCIs, etc.
Self-managed UCI Management companies under Chapter 13 of the 2002 Law Legal form: S.A., S..r.l., S.C.A. Registered shareholders Minimum capital of EUR 125 000 (+ shareholders equity of 0.02 % of the managed assets in the case those assets > EUR 250 000 000) Minimum 2 conducting officers (CO) with references, professional experience and respectability* Possible delegation of some duties of the CO to third parties under their supervision Appropriate risk management process

Legal form: S.A. (if SICAV) Minimum capital of EUR 300 000 Minimum 2 conducting officers (CO) with references, professional experience and respectability* Possible delegation of some duties of the CO to third parties under their supervision Appropriate risk management process

* not employed by the custodian bank

Table 1.3 Substance requirements under UCITS III


2. This is allowed under UCITS III

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The UCITS I regulation was further amended in 2001 and 2009 to give rise to UCITS III and UCITS IV. UCITS III notably enlarges the scope of eligible instruments. UCITS III authorizes funds of funds to become UCITS funds provided that they do not invest more than 20% of their net asset in the same UCITS, they do not invest more than 30% in non-UCITS funds and that they do not represent more than 20% of the capital of the fund. This last requirement is introduced to avoid influence on the management of the issuer. In addition, UCITS III rules impose that money market instruments be dealt on a regulated market or issued by regulated issuers. Regarding cash and deposits, a UCITS may not invest more than 20% of its assets in deposit with the same credit institution and bank deposits should be repayable on demand or have the right to be withdrawn. Bank deposits must also reach maturity within 12months. Real index tracking UCI may also benefit from the European passport and the use of derivatives is allowed if the underlying is an eligible asset.
Custodian bank (KBL) Auditor

Designates SELF - MANAGED SICAV 2 conducting ocers ("dirigeants") Independent of the day-to-day portfolio management Mission: supervision of the delegation, risk control and general rules of conduct Delegates

Distribution

Administration (KTL/EFA)

Portfolio Management

Table 1.4 Self-managed SICAV under UCITS III UCITS III also introduces a substance requirement. UCITS III does not allow anymore total outsourcing of the different functions of the fund. Substance can be given to a fund on the level of the fund itself - self-managed SICAV - which can delegate some activities but must at least have one conducting officer residing in Luxembourg who supervises the delegations. An example of such a structure is given in table1.4. A second possibility is to appoint a management company in Luxembourg which will delegate the function and provide the required substance to the fund. This solution is illustrated in table1.5. Finally, the main characteristics of both substance models are listed in table1.3.
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Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

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Custodian bank (KBL)

FUND INDUSTRY IN LUXEMBOURG

Auditor

Designates SICAV Board of Directors (min. 3) Management company agreement LUXEMBOURG UCITS III MANAGEMENT COMPANY Minimum 3 directors and 2 conducting ocers Mission: supervision of the delegation, risk control and general rules of conduct Delegation through agreements Distribution Administration (KTL/EFA) Portfolio Management

Table 1.5 Designation of a third party management company under UCITSIII Furthermore, UCITS III introduced the idea of simplified prospectus which should be written in such a way that it can easily be understood by the average investor and may be used in all member states without alteration except the translation. In Luxembourg, this document can be written either in French, German or English. In 2009, UCITS regulation was once again amended and gave rise to UCITS IV. The UCITS IV amendments are largely designed to facilitate a more efficient framework that provides broader access to more cost-effective products and include among others the simplification of the notification procedure which enables the cross-border distribution of UCITS by removing administrative barriers to cross-border marketing (e.g. through the introduction of regulator -home and host state- electronic communication). UCITS IV also requires the use of the Key Investor Information Document (KIID) which replaces the simplified prospectus under UCITS III. The KIID is intended to be a shorter document (2 pages) that provides information about the essential characteristics of the proposed investment to help retail investors make informed decisions. UCITS IV allows master/feeder structures to become UCITS compliant. In a master/feeder structure, the feeders investment policy is exclusively to invest in a single UCITS fund (master) in any European Union country. This may ease fund distribution in a country different from the country of the master fund. Two other major improvements of UCITS IV with respect to UCITS III are the possibility of cross-border mergers and the Management Company Passport. Cross-border mergers target economies of scale. Possibilities should be given to merge similar funds from different jurisdictions. The Management Company
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Passport allows funds authorized in one Member state to be set-up and managed remotely by a Management Company established in another Member state.
Private Banking KBL Espaa (E) KBL Polska (PL)

International

Retail

Institutional

EPERON ASSET MANAGEMENT Ltd. Dublin = Investment-Advisor KBC AM, Brussels = Asset Manager

Pulaetco Merck KBL Brown Dewaay Finck & Richelieu Shipley (B) Co (D) (F) (UK)

Luxembourg

CSSF Luxembourg Authority Auditor

SICAV UCITS III KBC EQUITY FUND (L) North America

KTL & KBL Central Administration & Custody

Target Investments 75% American stocks, cash, others

Table 1.6 Example of a UCITS fund

1.4 Specialized Investment Fund (SIF)


The Specialized Investment Fund is a lightly regulated on-shore structure for all kind of investment strategies. The law on Specialized Investment Funds was designed to replace automatically the Law of 1991 in Luxembourg concerning Undertakings for Collective Investment, the securities of which are not intended to be placed with the public that completed the Law of 1988. The eligible investors for these funds are more restrictive than those of public funds. In particular, eligible investors are qualified investors such as institutional investors, professional investors and well-informed private investors who declare themselves informed. In addition, investors have to invest at least EUR 125000 or have been subject to an assessment made by a credit institution within the meaning of the Directive 2004/39/EC3 or by a management company within the meaning of Directive 2001/107/EC4 certifying their expertise, their experience and their knowledge in adequately apprising an investment in the Specialized Investment Fund. Regarding diversification, SIFs require a lower level of risk spreading as such vehicles are reserved for sophisticated investors.
3. On markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC. 4. Amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management companies and simplified prospectuses.

USA

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In particular, quantitative restriction on the maximum share of any single issuer in the funds total net asset is 30% (instead of 10% in the case of public funds) and leveraging is allowed. SIFs also have much more flexibility with respect to investment strategies and eligible assets. SIFs may be used for the creation of transferable securities funds, money market funds but also of real estate funds, private equity funds, hedge funds or any other alternative strategies. SIFs can be closed-ended which means that the number of shares is limited and that these shares can normally not be redeemed anytime.
International Investment Manager 1 (CH) Investment Manager 2 (US) Investment Manager 3 (UK)

HNWI

Institutional

Professional

SIF Umbrella Structure Initiator XYZ CSSF Luxembourg Authority Auditor

Sub-Fund 1 Long Only Strategy (plain vanilla UCITS-like fund)

Sub-Fund 2 Dedicated to 1 HNWI or its family or to 1 Institutional Investor Pension fund Insurance Cy Re-insurance Cy, etc

Sub-Fund 3 Socially Responsible Investments (Microfinance, etc.)

Luxembourg

Etc.

KTL & KBL Central Administration & Custody

International

Target Investments Equities, bonds, target funds, MFI, cash, others

Table 1.7 Example of a SIF While SIFs have the attractive feature of experiencing a lighter regulation, they are not qualified to obtain the European passport. SIFs present several other attractive characteristics which make them more flexible than UCITS funds. Among them, we can cite the lighter scope of responsibility of the custodian bank, the issuing document which has no minimum content requirement5, a flexible share capital structure6; the possibility to have the valuation of the assets on a fair value basis and a favorable tax environment. To summarize, SIFs are non-UCITS funds restricted to informed investors. They are based on the
5. In contrast with the prospectus for UCITS funds. 6. The minimum authorized subscribed capital of EUR 1250000 must be reached within 12months after the authorization of the vehicle.

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UCITS model but for all asset classes with more legal and regulatory flexibility, tax efficiency, ease of access, implementation and administration.

1.5 Socit dInvestissement en Capital Risque (SICAR)


A Socit dInvestissement en Capital Risque is a private placement fund that can take different legal forms (S.A., S.r.l., SCA, SCS, etc.) and that is subject to the same rules regarding the kind of eligible investors as the SIF (institutional investors, professional investors as well as informed private investors). The biggest difference lies in the fact that a SICAR is an investment vehicle instead of an investment fund which means that risk diversification is not mandatory (a SICAR can invest in a single target investment). A SICAR may invest directly or indirectly (i.e. via special purpose vehicles or via other funds) in all categories of assets issued by companies with a view of their launch, development or listing within the limits as foreseen by the CSSF Circular 06/241 on the concept of risk capital under the Law of 15 June 2004 relating to the investment company in risk capital (SICAR). As a consequence, besides operating traditional investments in private equity or venture capital, A SICAR may also be a vehicle investing in private equity funds, buyout funds, mezzanine funds, pure holding companies, etc. There is really no quantitative investment restriction for SICARs. SICARs are vehicles regulated by the CSSF. The CSSF must approve the constitutive documents, the choice of the persons conducting the activity of the SICAR, the investment manager as well as the choice of the custodian bank and the independent external auditor. The minimum subscribed capital of EUR 1 000 000 must be reached within 12months after the authorization of the vehicle and there is no requirement for legal reserve for SICARs. The custodian bank and the central administration of the SICAR must be performed in Luxembourg. SICARs may be listed on the Stock Exchange and the valuation of the target investments must be based on the foreseeable realization value of the assets estimated in good faith (fair value). The valuation principle complies with the guidelines of professional associations like the European Venture Capital Association. As the SIFs, SICARs face a favorable tax treatment. The specific tax regime designed for the SICAR is extremely favorable and flexible. Combined with the possibility to choose between setting up the SICAR as a corporation or as a partnership7, it offers a wide range of opportunities to optimize the tax treatment for the investors and for the investments into the underlying. In addition, assets and contributions are not subject to any taxation8. The SICAR as a corporation is subject to income taxation. However, all the income of securities held by the SICAR9

7. Labeled as Socit en Commandite par Actions. 8. No annual subscription tax and no net wealth tax. 9. e.g. capital gains, dividend, bond interest, redemption and liquidation proceeds.

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is fully tax-exempt without any further conditions. Even income from cash is tax-exempt during a period of 12 months, thus allowing finding appropriate investments in a tax-free environment. Consequently, the SICAR can practically pay no taxes or only minimum taxes. The SICAR can benefit from the favorable Luxembourg double tax treaty network and from the parent-subsidiary EU directive (participation exemption). Finally, the investor himself will not be subject to any Luxembourg taxation10.
International

HNWI

Institutional

Professional

Investment Manager XYZ, Zug (CH)

Luxembourg

CSSF Luxembourg Authority Auditor

SICAR XYZ

KTL & KBL Central Administration & Custody

SPV

International

SPV

PE Funds

Target Investments

PE Companies e.g.: - chocolate producer in B - kids clothing manufacturer in F

Table 1.8 Example of a SICAR On 15October 2008, the Luxembourg Parliament adopted a law modifying and adding some features to the 2004 law on SICARs. These changes have been welcomed by initiators of private equity structures (more than 2740 SICARs up to date) and their investors. The most notable changes to the SICAR law were: the possibility to create an umbrella structure meaning that SICARs with multiple sub-funds and ring-fenced assets and liabilities are now allowed; the extension of the informed investor status to persons involved in the management of the SICAR; the valuation of the assets based on the fair market value rather than on the foreseeable realization value and the alignment of the duties of the custodian with the Specialized Investment Fund Law.

10. i.e. no permanent establishment, no withholding tax on interest earned and no capital gain taxation in Luxembourg.

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To summarize, the SICAR is an investment vehicle aimed for investments in sectors of potential high growth like private equity and venture capital. With the SICAR, the Luxembourg financial center offers both local and foreign promoters an investment vehicle which is regulated, supervised11, flexible, tax-wise advantageous and marketable to a broad public (professional, institutional and informed private investors). SICARs offer investors an adequate alternative to the already available forms of investment vehicles.

1.6 Examples: Hedge funds and Pension Pooling Vehicles


Hereafter well consider the examples of Hedge Funds and Pension Pooling Vehicles to illustrate that specific fund products, considering their goals in terms of marketing and investment objectives, can be set-up under different legal structures

1.6.1 Hedge Funds


A hedge fund is a fund usually used by wealthy individuals and institutions which is allowed to use aggressive strategies that are unavailable to traditional funds, including short selling, leverage, program trading, swaps, arbitrage and derivatives. Hedge funds are exempt from many of the rules and regulations governing other investment funds, which allows them to accomplish aggressive investment goals. They are often restricted to a certain number of investors per fund, and as a result most hedge funds set high minimum investment amounts, ranging anywhere from $250000 to over $1million. As with traditional investment funds, investors in hedge funds pay a management fee as well as a performance fee. Hedge funds are part of the alternative world, i.e. investment strategies that are decorrelated from financial markets aiming to offer investor regular and absolute performance independently from market conditions. Both single hedge funds (HF) and funds of hedge funds (FoHF) are offered.

11. As SICARs benefit from the Made in Luxembourg label.

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Hedge fund units under administration in Luxembourg 700 600 500 400 300 200 100 0 181 182 201 158 158 80.000 180 60.000 40.000 404 Dec 07 376 June 08 424 Dec 08 456 451 Dec 09 380 June 10 20.000 0 48.829

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Assets under management in Hedge funds administered in Luxembourg ( millions) 14.114 12.136 11.999 34.179 14.688 34.638 14.236 32.622 26.202

42.431

29.868

June 09

Dec 07 June 08 Dec 08 June 09 Dec 09 June 10 Administered

Domiciled & Administered

Administered Percentage

Domiciled & Administered Percentage

Increase 6 months to June 2010 15,74% Domiciled & Administered 13,92% Administered Total 8,05% Increase 12 months to June 2010 Domiciled & Administered 16,67% Administered 13,92% Total 8,79%

Increase 6 months to June 2010 8,44 % Domiciled & Administered 84,05 % Administered Total 19,66 % Increase 12 months to June 2010 Domiciled & Administered 13,77% Administered 78,39 % Total 13,67 %

Table 1.9 Evolution of single hedge funds in Luxembourg Luxembourg offers three possibilities to create a hedge fund. First, it can be a public fund under Part II of the 2002 and 2010 Laws. A legal framework appropriate to the creation of hedge funds exists in Luxembourg since 1991 (CSSF Circular 91/7512) allowing the launch of fund products under Part II of the 2002 Law using alternative investment strategies such as derivatives, leverage financing, real estate investments, venture capital funds. However, no fixed rules were laid down and all files were studied by the CSSF on a case by case basis. CSSF Circular 02/8013 aimed at clarifying and explaining the specific rules applicable to hedge funds such as the use of short selling techniques, the use of derivatives and leverage, asset diversification for funds of funds and the use of collateral in relation to borrowing and lending securities. A second alternative is the so-called NewCITS funds which are Alternative investment UCITS funds. Some hedge fund-like strategies are effectively possible under UCITS since UCITS III. Finally, hedge funds can be created as SIFs. Indeed, under the SIF regime all hedge fund strategies are possible with wide flexibility. The CSSF Circular 08/37214 even describes the guidelines for depositaries of Specialized Investment Funds adopting alternative investment strategies, where those funds use the services of a Prime Broker.

12. On Revision and remodeling of the rules to which Luxembourg undertakings governed by the Law of 30March 1988 on undertakings for collective investment (UCI) are subject. 13. On Specific rules applicable to Luxembourg undertakings for collective investment (UCIs) pursuing alternative investment strategies. 14. On Guidelines for depositaries of specialized investment funds adopting alternative investment strategies, where those funds use the services of a prime broke.

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Assets under management in funds of hedge funds administered in Luxembourg millions ( millions) 150.000 57.876 57.446 100.000 722 Dec 09 50.000 0 74.182 75.667 45.521 27.494 51.712 25.033 52.020 37.826 47.646

Fund of hedge fund units under administration in Luxembourg 1600 1400 1200 1000 800 600 400 200 0 758 603 621 590 547 616

498 Dec 07

562 June 08

693 Dec 08

698 June 09

710 June 10

48.432

Dec 07 June 08 Dec 08 June 09 Dec 09 June 10 Administered

Domiciled & Administered

Administered Percentage

Domiciled & Administered Percentage

Increase 6 months to June 2010 1,66% Domiciled & Administered 12,61% Administered Total 4,49% Increase 12 months to June 2010 Domiciled & Administered 1,72% Administered 4,41% Total 2,95%

Increase 6 months to June 2010 8,41 % Domiciled & Administered 51,10 % Administered Total 10,93 % Increase 12 months to June 2010 Domiciled & Administered 7,86 % Administered 37,58 % Total 7,91 %

Table 1.10 Evolution of funds of hedge funds in Luxembourg Luxembourg can be considered the European hub for hedge funds and funds of hedge funds. Since the launch of hedge fund regulation in 2002, Luxembourg has experienced a rapid growth in funds and assets under management. The appealing feature of Luxembourg is its position of regulated hedge fund jurisdiction. Distribution to key markets (Switzerland, Hong Kong, Germany, etc.) is relatively easy from Luxembourg and the flexible regime proposed by the recent SIF law further create an attractive environment for hedge funds in Luxembourg. The emergence of Luxembourg as a domicile of choice for new hedge funds derives from its European continental position, its flexible regulation, the natural synergies with UCITS III developments as well as the full range of services already provided to non-Luxembourg off-shore hedge funds. There are currently more than 1000 hedge funds and funds of hedge funds active in Luxembourg representing more than EUR 140 billion in assets under management. In April 2009, the European Commission proposed a new Directive on Alternative Investment Fund Managers (AIFMD). The proposal aims at producing a harmonized European regulatory and supervisory framework for the alternative investment sector. In return for more regulation, the proposed Directive will introduce passports enabling AIFMs to offer their management services and market their Alternative Investment Funds (AIF) throughout the European Union. Luxembourg will implement this Directive, which is currently drafted and which regulates the investment managers and indirectly all nonUCITS funds such as hedge funds, private equity and real estate funds, Part II UCIs, SIFs, and SICARs. The key objectives of the AIFM Directive are to ensure
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that all AIFM are subject to appropriate authorization and registration requirements, to provide a framework for the enhanced monitoring of macro risk, to improve risk management and organizational safeguards at the individual AIFM level, to enhance investor protection, to improve public accountability for AIFs holding controlling stakes in companies and to develop a single market for AIFs. A detailed comparison of the AIFMD with the UCITS directive will be developed in chapter2.

1.6.2 Pension pooling vehicles


Multinational companies running occupational pension schemes (2ndpillar) in several jurisdictions would ideally like to be able to use one single multinational pension scheme for all their employees. Because of the lack of European harmonization and domestic protectionist legislation, this solution is currently not efficient. A partial solution available today is to pool the assets of the different pension schemes through a so-called pension pooling vehicle. A pension pooling vehicle is a vehicle that pools the investments of several pension schemes. This vehicle is of prime interest for multinational companies or large companies (industrial or other) running several pension schemes and for pensions money asset managers. Pension pooling allows cost savings and increased efficiency though economies of scale on the level of investment, management, administration, custody and taxation (see Table3.11).
Existing pension schemes of one multinational group German pension fund French pension scheme Dutch pension fund UK pension scheme Pension pooling vehicle for all group pension schemes under the form of a Luxembourg UCI German pension fund French pension scheme Dutch pension fund UK pension scheme

Pension pooling vehicle (umbrella structure)

BENEFITS Cost-savings and efficencies through economies of scale on the level of: investment management administration custody tax tion

ts

ts

ts

ts

en t

en t

en

en

en

en

ts

st m

tm

tm

en

es t

st m

st

st

In v

In v

In

In

In

In v

ve

(Bonds, Equities, Cash, Funds, Hedge Funds, Private Equity, etc.)

(Bonds, Equities, Cash, Funds, Hedge Funds, Private Equity, etc.)

Table 1.11 Benefits from pension pooling

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In

In

ve st

es

es

ve

ve

ve

en

ts

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33

Pension pooling allows the outsourcing of administrative and repetitive tasks from an accounting and re-balancing point of view. It enhances reporting from a single local custodian and administrator and creates a greater consistency in the quality of the asset management. The pension pooling vehicle allows the sponsor and their participating pension funds to have a specific asset allocation according to their specific characteristics (e.g. maturity of the liabilities, risk tolerance of the sponsor, etc.). Each pension scheme is able to build up its portfolio by allocating the exposure it wishes to each of the strategies (sub-funds) offered by the pension pooling vehicle. Thanks to a pension pooling vehicle, small pension funds of a larger group have access to a sophisticated structure. In addition, the pension pooling vehicle allows better control and oversight on the range of pension schemes with respect to management and administration and to the fee structure.
Pension Fund 1 Very Large Pension Fund 2 Large Pension Fund 3 Medium Pension Fund 6 Very Small

ESPERIDES Pension Pooling Vehicle under the form of a Sicav with 3 sub-funds Low Risk Medium Risk High Risk

Investments (funds)

Investments (funds)

Investments (funds)

Investments (funds)

Table 1.12 Example of a pension pooling vehicle: the case of SuezTractebel pension pooling vehicle as set-up in 2004 Depending on the needs (targeted investors, investment policy), Pension pooling vehicles could be set-up as UCITS, Part II UCIs or SIFs.

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2. A comparison between UCITS Management Company and AIFM


2.1 Introduction
Chapter 1 introduced the legal framework of the main investment vehicles used in the industry. The UCITS directive regulating part I funds has been introduced together with the AIFMD regulating Alternative Fund Managers. This chapter proposes a comparison of those two directives. The exposition revolves around the main articles of the AIFMD and highlights the main similarities and differences between the two directives.

2.2 Context and chronology of the AIFMD


In April 2009, the European Commission proposed a new Directive on Alternative Investment Fund Managers (AIFMD). The proposal aims at producing a harmonized European regulatory and supervisory framework for the alternative investment sector. In return for more regulation, the proposed Directive will introduce passports enabling AIFMs to offer their management services and market their Alternative Investment Funds (AIF) throughout the European Union. Luxembourg will implement this Directive, which is currently drafted and which regulates the investment managers and indirectly all nonUCITS funds such as hedge funds, private equity and real estate funds. The key objectives of the AIFM Directive are to ensure that all AIFM are subject to appropriate authorization and registration requirements, to provide a framework for the enhanced monitoring of macro risk, to improve risk management and organizational safeguards at the individual AIFM level, to enhance investor protection, to improve public accountability for AIFs holding controlling stakes in companies and to develop a single market for AIFs. On 11 November 2010, the European Parliament approved the Directive in a plenary vote session. The AIFMD is currently in level 1 of the Lamfalussy 4-level process for the creation of new directives in the financial services industry at the European level. This means that the core legislation has been created but has not been transposed yet into laws at the member states level. The structure of the AIFMD in its level 1 form is given in table2.1. Member states are thus to bring the directive into force within 2 years after its publication in the Official Journal (i.e. mid 2013). A timeline of the AIFMD is given in table2.2. As one can see, an EU passport can be granted to non-EU AIFM as of the fourth quarter of 2015 provided the European Securities and Markets Authority (ESMA) issues a positive advice to the European Commission as to the functionality of the passport hitherto.. The Directive applies to all
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AIFMs which are established within the European Union regardless of where the AIFs that they manage are established (inside or outside the European Union). Applicability is also independent from the question whether shares in the AIF can be redeemed by the AIF, the AIF is listed, the legal form of the AIF or the legal structure of the AIFM. In addition, the Directive applies to a lesser extent to all AIFMs established outside the European Union if they manage AIFs established in the European Union (non-EU AIFMs must comply with the transparency requirements, requirements onportfolio company disclosureandasset stripping if applicable).
Art. 6: Art. 1-5: Art. 6-11: Art. 12-17: Art. 18: Art. 19-20: Art. 21: Art. 22-24: Art. 25-30: Art. 31-33: Definitions, exemptions, determination of AIFM Authorisation of AIFM Operating conditions for AIFM Organisational requirements Valuation; Delegation Depositary Transparency Requirements AIFM managing specific types of AIF Rights of EU AIFM to market and manage EU AIF in the EU Rules in relation to 3rd countries Marketing to retail investors. Competent authorities Art. 7: Art. 8: Art. 9: Art. 11: Conditions for taking up activities Application Conditions for granting Initial capital and own funds Withdrawal

Art. 12-13: General principles and remuneration Art. 14: Art. 15: Art. 16: Art. 17: Art. 22: Art. 23: Art. 24: Conflicts of interest Risk Management Liquidity Management Investment in securitisation positions Annual report Disclosure to investors Reporting obligations to competent authorities

Art. 34-40: Art. 41-53:

Table2.1 The AIFMD level 1

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Deadline for transposition into national law Passport introduction for EU AIFMs managing EU AIFs (21 July)

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Publication in the Official Journal (1 July)

Final ESMA advice on Delegated Acts to be submitted to the EC (16 November)

Entry into Force (21 July)

Deadline for authorisation of AIFMs (21 July)

EU passport available for non-EU AIFM

Withdrawal of national PPRs following receipt of ESMAs positive advice

Jul 11

Aug 11

Nov 11

Jun/ Jul 12

Jul 13

Jul 14

Jul 15

Oct 15

Oct 18

Jan 19

1st Draft ESMA Level 2 measures by EU advice on Commission Delegated Acts (consultation 2st Draft ESMA advice on deadline 13 Sep) Delegated Acts (consultation deadline 23 Sep)

ESMA opinion on implementation of the passport regime for nonEU funds and managers

ESMA opinion on withdrawal of national PPRs

Table 2.2 Timeline of the AIFMD

2.3 Definitions, exemptions, determination of the AIFM and authorization of the AIFM (art. 1-11)
2.3.1 Definitions, exemptions, determination of AIFM (art.1-5)
First it is important to recall that the UCITS directive sets up a legal framework allowing funds complying with its requirements to operate across all member states. In this sense, compliance with the UCITS directive will grant a pan-European passport for funds distribution to retail investors. This directive was part of a broader project aiming at creating an EU-wide single market for financial services. More precisely, a fund created in a member state which complies with the legal requirements outlined in the UCITS directive can be distributed in other member states without having to fulfill additional requirements related to this other state regulatory framework. While this directive is only applicable within the European Union, some countries outside the EU also recognize the UCITS directive as applicable15. The UCITS directive differentiates between the management companies that provide collective portfolio management activities (which can be delegated to third-parties) to the funds and the funds managed by these companies.
15. Take for instance the case of Honk-Kong where 97% of foreign funds sold to retail investors are Luxemburgish UCITS funds.

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The greater mobility granted by the UCITS passport comes logically at a price of more stringent requirements on risk management and diversification of the fund. As a result of those stricter requirements, the choice to comply with the UCITS directive will only be made by funds willing to reach retail investors on a large scale. The AIFMD is on the other hand a byproduct of the increased financial regulation following the 2008 financial crisis. Indeed, hedge funds have been pointed out as culprits for making the crisis worse by taking speculative positions exploiting the high volatility created by financial turmoil during the upgrowth of the crisis. The lack of regulation that these funds enjoyed for years has been deemed as no longer acceptable by political authorities and lots of new laws have been designed to correct this situation. Among them, the AIFMD has been designed at the EU level with the aim of regulating activities in the alternative investment sector and monitoring systemic risk. The AIFMD applies to Alternative Fund Managers (AIFMs) of funds which are not falling under the scope of the UCITS directive16. In the same fashion as for the UCITS directive, compliance with the AIFMD will grant a pan-European passport for Alternative Investment Funds (AIFs) distribution to professional investors. Here the distinction between professional and retail investors must be understood in the sense of the MIFID directive. Professional investors thus include all institutional investors, regional, national and supranational institutions and undertakings satisfying some size requirements17. All other investors fall into the retail category. A first noticeable difference with respect to the UCITS directive is that the AIFMD entirely focuses on regulating the management companies which are labeled as Alternative Investment Fund Managers (AIFM) in the AIFMD terminology18. This means that the creation of a fund is left to the discretion of the AIFM and does not require the approval of the regulatory authority as it is the case under the UCITS directive. Thus while both regulatory frameworks share the feature that a fund domiciled in one EU member state can have a management company (or AIFM) domiciled in another EU member state, both the management company and the fund will need the approval of the regulatory authority to obtain their licenses under the UCITS directive while only the AIFM must be licensed under the AIFMD. This feature of the UCITS directive can of course reveal time consuming when you plan on launching a new fund but ensure a higher level of control and thus of protection for retail investors. The fact that the AIFMD is aimed mainly at non-retail clients who are more time sensitive and need less protection because they are more informed is a way to
16. For instance the AIFMD would apply to funds subject to Part II of the Law of 17December 2010, SIFs and SICARs. 17. i.e. they must fulfill two of following criteria: balance sheet total of 20m, net turnover of 40m, own funds of 2m. 18. Those AIFM are responsible for the compliance of the fund with regulation and also for portfolio and risk management.

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explain why this feature is not part of the directive. It is interesting to highlight that the Luxembourg regulation on the creation of part 2 funds is currently focusing on the fund rather than the management company. A transposition of the AIFMD into the Luxembourg law would result in the two levels of control adding up and the regulation of AIFM in Luxemburg would mirror the one for UCITS. This would increase the regulatory burden for the creation of AIF and result in a loss of competitiveness for Luxembourg. The question of how to implement the AIFMD without harming the competitiveness of Luxembourg is thus a crucial question today19. Note however that the requirements contained in the AIFMD are quite close to those outlined in the UCITS directive even though AIFs are more targeted at professional investors. Once again, this higher degree of protection even for presumably more informed professional investors finds its justification in reactions to the financial crisis. It is worth emphasizing that a fund will fall under the scope of the AIFMD if any of the following criteria are met: the AIFM is located in the EU, the fund is located in the EU or the fund is distributed to investors located in the EU. Exemptions are nevertheless granted to AIFM with less than 100 million Asset under Management (AuM). These managers will have to register with the regulatory authorities but they will not have to comply with the AIFMD. Note also that AIFMs located in third countries (outside EU) will have to apply to the regulatory authority of the country in which the fund that they manage is domiciled. It is expected that as of 2015, non-EU AIFMs will have the possibility to benefit from the EU passport as well. The private placement regime for the distribution of AIFs by non-EU AIFMs will not be phased out earlier than 2018.

2.3.2 Authorization of AIFM (art.6-11)


Initial capital and own funds (art.9) Minimum capital requirements if you want to set up an AIFM company are quite close to the capital requirements needed to create a management company under the UCITS directive. An initial capital of 125.000 is required which is topped by additional capital requirements computed based on AuM for which you provide collective portfolio management. These additional capital requirements amount to two basis points of AuM above 250million and with a cap on total capital at 10million. Those AuM exclude portfolios of AIFs that the AIFM is managing under delegation. This basically means the AIFM Company does not have to account for the assets of the AIFs which have delegated the portfolio management to this entity. Moreover, an AIFM will have to maintain capital of 25% of last year overheads (operating costs). The final result will be the highest value obtained. It is worth noticing that in most of
19. Note that the implementation is already underway.

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the cases the relevant method of calculation for the required level of capital will be the first one. Finally, a noticeable difference of the AIFMD with respect to the UCITS directive is that additional own funds will be required in some cases. For instance, if the AIFM does not contract professional indemnity insurance in order to insure against employees misconduct in the AIFM Company or liability risks then additional own funds will be required to cover them. A suitable proposition currently under revision to compute additional funds would to require 1 basis point of AuM to be kept as additional own funds.

2.4 Operating conditions for AIFM (art. 12-17)


2.4.1 General principles (art.12)
The management of the AIFM must be constituted of at least two persons conducting the business. Those persons must be sufficiently experienced and have good repute. The appreciation of those last two elements is left to the regulatory authority. The shareholders must be suitable to the activity (evaluation based on rsums). The location of the activity also matters to the extent that the head office and the registered office of the AIFM must be located in the same member state. Among the main general principles that the AIFMs must embrace in the conduct of their activities, one can highlight: AIFMs must act honestly, with due skill, care, diligence and fairness in conducting their activities They must act in the best interests of the AIFs and respect the integrity of the market They must have and employ effectively adequate resources and procedures They must design relevant policies regarding conflicts of interest They must comply with all regulatory requirements They must treat all AIF investors fairly Note that the UCITS (level 2) provisions serve as model for the conduct of business rules.

2.4.2 Conflicts of interest (art.14)


Concerning the prevention of potential conflicts of interest, the AIFMD is aligned with the provisions of UCITS level 2 and MIFID level. AIFMs will have to identify potential conflicts of interest between herself and the AIF, between two funds managed by the same AIFM, between the AIF and another client of
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the AIFM or between two of the AIFMs clients. This will be implemented by setting adequate procedures and policies at the level of the AIFM to identify, prevent, manage and monitor those potential conflicts of interest. Additional disclosure requirements will be added in order to prevent damages to investors interests in cases where the above arrangements are deemed insufficient. An interesting feature is that the AIFMD stipulates that the investment manager of an AIF must be a different and unrelated entity from the depositary bank. This rule also applies to sub-custodians which must be different entities from the portfolio manager. The level of specificity of the AIFMD on those issues is a direct consequence of the Madoff scandal explained in the section on depositary duties.

2.4.3 Risk management (art.15)


Risk management (RM) is one of the compulsory functions of AIFM Companies. This function must be organized independently to ensure that potential conflicts of interest are avoided (see supra). The RM function must set a system which can identify measure, manage and monitor all risks relevant to AIF investment strategies. The AIFM is also responsible for defining the maximum level of leverage regarding the AIFs. The AIFMD section on RM is close to the one in the UCITS directive but it has a wider scope since AIFs are not restricted to liquid assets as the UCITS funds are. Of course, the RM system must be reviewed at least once a year to assess its relevance to monitor AIFMs activities.

2.4.4 Liquidity management (art.16)


The RM system must be completed by a Liquidity management (LM) system for all AIFs (except unleveraged and closed-end AIFs). The LM system will ensure compliance of the liquidity profile with the underlying obligations and consistency between the investment strategy, the liquidity profile and the redemption policy. The goal is to allow the regulatory authority to monitor the alignment of the actual activity of AIFs with the information provided to investors in the prospectus distributed to advertise the funds. Indeed, several hedge funds collapsed during the financial crisis due to a sudden drying of the liquidity for assets in which they were invested. There was as a result a mismatch between the redemption policy of the funds and their actual ability to redeem funds which led them to bankruptcy. Stress tests will be regularly carried out to see the impact of alternative scenarios (events) on the liquidity profile and the consistency with the investment strategy or redemption policy.

2.4.5 Remuneration (art.13)


Finally, remuneration policies implemented in the AIFM Company will also interact with the RM function as they must be consistent with an effective RM and avoid encouraging inappropriate risk-taking. In order to achieve this
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goal, a multi-year cycle remuneration policy together with a good balance between variable and fixed components of the remuneration package will have to be introduced to avoid too high short-term risk-taking in the management of AIFs.

2.5 Organizational requirements, valuation and delegation (art.18-20)


2.5.1 Organizational requirement (art.18)
AIFM must be organized around three compulsory functions: compliance, internal audit and risk management (see section 2.4.3). Concerning internal audit, AIFM need to set proper internal control mechanisms allowing for instance to monitor personal transactions by employees, traceability of transactions involving the AIFs or investment compliance of the AIFs assets. Sound administrative and accounting procedures must be established and the data processing must be subjected to control and safeguard arrangements. Those procedures must of course be facilitated by adequate and appropriate human and technical resources together with proper reporting lines.

2.5.2 Valuation (art.19)


Contrary to the UCITS regime, the AIFMD places detailed valuation requirements on behalf of the AIFMD. The proper valuation of the AIF must be carried out at least once a year and when appropriate for open-ended AIF. ESMA tries to identify general principles that should guide the AIFM in developing and implementing policies and procedures for a proper and independent valuation of the assets of the AIF. This valuation can be performed by an external valuer or by the AIFM herself provided that adequate measures are in place to avoid potential conflicts of interest. However, a necessary condition in order to avoid conflicts of interest is that the valuer must be an entity distinct from the portfolio manager or the depositary bank since it is also in charge of the evaluation of the valuation for the AIF. If the portfolio manager or the depositary bank can prove that the department within their entity which is in charge of the valuation is functionally independent from the ones respectively in charge of portfolio management or depositary duties then the valuation task could be attributed to those functionally independent departments of the entities. Note also that an external valuer cannot delegate the valuation task to a thirdparty once the task has been attributed. The use of an external valuer does not abstract the AIFM from its liability vis--vis AIFs but the external valuer is on the other hand liable to the AIFM.

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2.5.3 Delegation (art.20)


The process of delegation is regulated in the following way by the AIFMD: prior notification of the delegation project must be made to the regulatory authority. A justification relying on objective reasons will be made and the good repute and experience of the entity to which the activity concerned is delegated will be highlighted. The delegation will thus be conditional on the approval of the regulatory authority. Sub-delegation is then possible under the same conditions. In the case of portfolio management delegation, which constitutes the majority of the cases in the Luxembourg fund industry, the entity to which the task is delegated must be a regulated entity in its country of origin. While this disposition suffers no exception under the UCITS directive, the AIFMD allows for derogations in cases where the portfolio manager entity proves to have sufficient infrastructure to ensure the task of portfolio manager. Moreover, it is not possible to delegate risk management and portfolio management at the same time.

2.6 Depositary duties (art.21)


This article of the directive is a direct consequence of the Madoff case where a sub-custodian operated under the management of a Madoff entity in charge of the portfolio management on behalf of some funds. This link between the subcustodian and the management entity allowed them to commit embezzlement without triggering any alarm warnings20.Under the AIFMD, the custodian is not allowed to perform any portfolio management duties. Depository duties have been strengthened in cases of assets losses incurred by a fund. The depository company will act as an insurance company in those cases since they will have to reimburse equivalent assets without undue delay. Only external events beyond reasonable control with unavoidable consequences can constitute a reason for the depositary to escape from its liability21. Another way for the custodian to escape from its liability is to transfer it to a sub-custodian but it would entail that the sub-custodian accepts contractually to bear the same level of liability as defined in European legislation vis--vis the fund and investors and irrespective of where this sub-custodian is located in the world. This new insurance mechanism introduced by the AIFMD implies that the custody fees should now include the insurance service provided by depositaries.

20. Readers are referred to chapter6 for additional treatment of custodian bank supervision failure 21. E.g. war, political turmoil in the country where the custodian or sub-custodians are located, etc.

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2.7 Transparency requirements (art.22-24)


A new feature of the AIFMD is to make reporting by AIFMs more regular and complete. The goal is to increase the amount of information transmitted to regulatory authorities and allow them to have a better view on the industry situation and potential problems that might occur. More transparency will also increase the ease with which the regulation can be enforced. First, the audited annual reports for AIFs must be made available within 6 months and include financial statements together with fixed and variable remuneration at the AIFM level. The frequency of the reporting to the regulators will depend on the size and assets under management of the AIFs . Initial and periodical reporting to investors will also be required.

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3. Set up and legal life of the UCI


3.1 Introduction
The first two chapters focused on the legal framework within which funds must operate in Luxembourg and more broadly at the European level. We now concentrate on the legal requirements related to the inception and management of a UCI over its life cycle. In the first part of this chapter, we present necessary procedures and actors in the setup of an investment fund in Luxembourg. More precisely, we explain the role of the promoter, service providers, required documents and agreements. The second part of the chapter lists several events which may happen during the life of an investment fund and their legal implications.

3.2 Part I: Set up of the UCI


3.2.1 The promoter of the UCI: notions
Before summarizing the concept of promoter, it is worth noting it only applies to UCITS and to funds subject to Part II of the Law of 17 December 2010 but not to SIFs and SICARs, which can therefore be launched with no promoter. In addition, the CSSF has released UCITS and UCITS management companies complying with Circular 12/546 from the obligation to have a promoter. It is worth noting in that respect that since all UCITS and UCITS management companies will be compelled to comply with the circular by 30 June 2013, the promoter requirements detailed below will no longer apply after such date. Similarly, the CSSF has released part II funds having designated a compliant UCITS management company from the obligation to have a promoter. The below, which details the situation applying to all UCITS and Part II funds prior to the issue of Circular 12/546 (on 24 October 2012), is therefore evolving and needs to be read in light of the foregoing. Though the promoter is a concept which is not defined in the Luxembourg legislation, the CCSF consider the promoter of an investment fund as being the one who is at the origin of the UCI, who gives the impetus or provokes the creation of the UCI, who defines the orientation of the activities of the UCI and who benefits from its realization. CSSF circulars impose that Luxembourg UCIs submit to the CSSF a file containing among other things information about the promoter such as recent financial reports during the approval procedure of an investment fund by the CSSF. The existence of a promoter ensures the protection of investors notably in case of errors in Net Asset Value (NAV) calculations and in case of corrections resulting from non-compliance with the investment rules applicable to UCIs. In particular, it is the responsibility of the
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UCIs promoters to ensure that any errors are correctly dealt with in strictest compliance with the rules of conduct specified in this circular. Due to the promoters key implication in the creation and management of the UCI, the CSSF considers that the promoter assumes a specific liability. The promoter is therefore responsible for the general organisation and supervision of the activities of the UCI in order to assure its proper functioning. As a consequence, although the law does not comprise any specific reference to the role, duties and liabilities of the promoter, the CSSF considers that the promoter is to be held ultimately liable for loss resulting from possible failures, irregularities or insufficiencies identified in the management and the administration of the UCI, it being understood that the promoter can always take action against the final responsible third parties. In light of the promoters role, the CSSF generally requires the promoter to have a majority representation on the management body of the UCI. The Law of 17December 2010 Relating to UCIs further states that, in order to receive the agreement, the directors of the UCI and of the depositary must be of sufficiently good repute and have sufficient experience in relation to the type of UCI concerned. To that end, the names of the directors and of every person succeeding them in office must be communicated forthwith to the CSSF. Directors shall mean those persons who under the law or the constitutional documents represent the UCI or the depositary or who effectively determine the conduct of the activities of the UCI. Emphasis is placed on the reputation and on the qualifications of Directors to prevent any unfavourable situations for the investors and the Luxembourg financial centre. Sovereign decision rests with the CSSF. In order to be approved by the CSSF, the promoter shall fulfil three conditions: (i) be a regulated entity, (ii) be of good repute and have sufficient expertise and (iii) have sufficient financial resources. In general, minimum own funds of about 7.5million are required. If the main promoter has insufficient resources, it can request the support of a so-called co-promoter, such as a banking institution which will have similar responsibilities to those of the main promoter.

3.2.2 The incorporation documents


Regarding the incorporation documents for investment funds, we can define two cases. First, mutual funds (or FCPs) which are UCIs under a contractual form without any legal personality. The FCP is managed by a Management Company (ManCo). The management regulations determine the rules of the FCP and the relationship between the ManCo and the unit holders. These unit holders adhere to the management regulations by their subscriptions. The ManCo represents the community of the unit holders. Usually, the management regulations are countersigned and may not be modified without the prior consent of the custodian. Indeed, according to art.18 of the Law of 17December 2010, the custodian must ensure that the sale, issue, redemption and cancellation of
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units effected on behalf of the mutual fund or by the management company are carried out in accordance with the law and the management regulations, ensure that the value of units is calculated in accordance with the law and the management regulations, carry out the instructions of the management company, unless they conflict with the law or the management regulations, [], ensure that the income of the mutual fund is applied in accordance with the management regulations. The second case is the SICAV which is an investment company with a legal personality. In this case, incorporation is done through a notarial deed establishing the characteristics and the standard rules of the UCI.
FCP Management Regulations Denomination Duration Investment Policy Investment Restrictions Distribution Policy Management Company Fees Other Fees Public nature Accounting year Procedure and condition for a liquidation Procedure and condition for a modification of the incorporation documents Procedure and condition of the issue of the shares/units Procedure and condition of the redemption of the shares/units Rules for the valuation of the assets Reference currency Specific information relating to the sub-funds Segregation of the sub-funds X X X X X X X X X X X X X X X X X X X X X X X X X X X X X SICAV Articles of Incorporation X X

Table 3.1 Incorporation document: Mutual fund vs. SICAV Note that the lists reported in table3.1 are not meant to be exhaustive. Art.13 of the law of 2010 enumerates the mandatory elements that the incorporation document of mutual fund must contain:
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Denominations of the mutual fund, the ManCo and the depositary bank The duration of the fund together with its investment policy22 The distribution policy consistently with art.16 Expenses and fees that the ManCo is allowed to bill to the mutual fund under management and the mode of computation for those elements Dispositions about fund advertising The closing date for the mutual fund accounting year Dispositions in case of dissolution Dispositions about the modification of the management agreement Emission policy for shares Dispositions about share redemption and conditions under which redemption can be carried out or suspended23 One can notice that no specific disposition in the law concerns the rules for valuation of assets, the reference currency or information pertaining to subfunds segregation. It is however customary to have such elements appearing in incorporation documents.

3.2.3 The sale documents


Subscriptions are not valid unless made on the basis of (i) the prospectus in force and (ii) the most recent annual report and by the most recent halfyearlyreport if the latter is published after the most recent annual report.The Law of 17 December 2010 stipulates that the prospectus must include the information necessary for investors to be able to make an informed judgement of the investment proposed to them, and, in particular, of the risks attached thereto. Necessary information includes the UCI structure, the investment policy and restrictions, the fees, the profile of the typical investor, the type of shares, the directors and the liquidation and merging rules. The prospectus must also indicate the risk profile of the UCI as well as information on the service providers and taxes which are applicable to the fund. In addition thereto, UCITS are required to provide their investors with a Key Investor Information Document (KIID). The KIID is a synthetic and standardized document giving investors key information on investment funds in terms of objectives, risks, performance and costs so that they are able to understand the nature and risks related to the funds that are offered to them and hence take well-advised investment decisions. This document replaces the simplified prospectus for all UCITS funds.
22. The investment policy must be consistent with the goals set by the fund. 23. Note that this disposition does not apply to Part II funds even though it could

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Key Investor Information


This document provides you with key investor information about this fund. It is not marketing material. The information is required by law to help you understand the nature and the risks of investing in this fund.You are advised to read it so you can make an informed decision about whether to invest. 123 Fund, a sub-fund of ABC Fund SICAV (ISIN: 4321) This fund is managed by ABC Fund Managers Ltd, part of the XYZ group of companies

Objectives and Investment Policy Joint description of the objectives and policy of the UCITS in plain language (it is suggested not to copy-out the prospectus) Essential features of the product which a typical investor should know: main categories of eligible financial instruments that are the object of investment a statement that the investor may redeem units on demand, and how frequently units are dealt in whether the UCITS has a particular target in relation to any industrial, geographic or other market sectors or specific classes of assets whether discretionary choices regarding particular investments are allowed, and whether the fund refers to a benchmark and if so which one a statement of whether any income arising from the fund is distributed or reinvested Risk and Reward Profile Other information if relevant, such as: what type of debt securities the UCITS invests in information regarding any pre-determined pay off and the factors expected to determine performance if choice of assets is guided by growth, value or high dividends how use of hedging / arbitrage / leverage techniques may determine the funds performance that portfolio transaction costs will have a material impact on performance minimum recommended holding term

Lower risk Typically lower rewards 1 2 3 4

Higher risk Typically higher rewards 5 6 7 Narrative presentation of risks materially relevant to the fund which are not adequately captured by the indicator: Credit risk, where a significant level of investment is made in debt securities Liquidity risk, where a significant level of investment is made in financial instruments that are likely to have a low level of liquidity in some circumstances Counterparty risk, where a fund is backed by a guarantee from, or has material investment exposure through contracts with, a third party Operational risks including safekeeping of assets Impact of any techniques such as derivative contracts

Narrative explanation of the indicator and its main limitations: Historical data may not be a reliable indicator for the future Risk category shown is not guaranteed and may shift over time The lowest category does not mean risk free Why the fund is in its specific category Details of nature, timing and extent of any capital guarantee or protection

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Charges for this Fund The charges you pay are used to pay the costs of running the fund, including the costs of marketing and distributing it. These charges reduce the potential growth of your investment. One-off charges taken before or after you invest Entry charge Exit charge []% []% The entry and exit charges shown are maximum figures. In some cases you might pay less - you can find out from your financial adviser. The ongoing charges figure is based on expenses for the year ending []. This figure may vary from year to year. It excludes: Performance fees Portfolio transaction costs, except in the case of an entry/exit charge paid by the UCITS when buying or selling units in another collective investment undertaking For more information about charges, please [see pages x to x / section x] of the funds prospectus, which is available at www.ucitsfund/prospectus

This is the maximum that might be taken out of your money [before it is invested] [before the proceeds of your investment are paid out]. Charges taken from the fund over a year Ongoing []% charges Charges taken from the fund under certain specific conditions Performance fee []% a year of any returns the fund achieves above the benchmark for these fees, [insert name of benchmark].

Past Performance The chart will be supplemented with prominent statements which: wam about its limited value as a guide to future performance indicate briefly which charges have been included or excluded state the year when the fund started to issue units indicate the currency in which past performance has been calculated.

10% 7.5% 5% 2.5% 0 2.5% 5% 7.5% 10%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Practical Information Name of the depositary Where and how to obtain further information about the UCITS (prospectus, reports & accounts) Where and how to obtain other practical information (e.g. where to find latest unit prices) A statement that tax legislation of the funds Home State may have an impact on the personal tax position of the investor A statement that [Name of management company] may be held liable solely on the basis of any statement contained in this document that is misleading, inaccurate or inconsistent with the relevant parts of the prospectus for the fund Specific information relating to umbrella funds (e.g. any switching rights between sub-funds) Information about other share classes, if applicable (KII may be based on a representative class) This fund is authorised in [name of Member State] and regulated by [identity of competent authority]. [Name of management company] is authorised in [name of Member state] on and regulated by [identity competent authority].] This key investor information is accurate as at [the date of publication].

Table 3.2 ESMA template of Key Investor Information Document


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Regarding risk management, UCITS must employ a Risk Management (RM) process which enables it to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio; it must employ a process for accurate and independent assessment of the value of Over-The-Counter (OTC) derivative instruments. It must communicate to the CSSF regularly and in accordance with the detailed rules the latter shall define, the types of derivative instruments, the underlying risks, the quantitative limits and the methods which are chosen in order to estimate the risks associated with transactions in derivative instruments. In addition, a UCITS shall ensure that its global exposure relating to derivative instruments does not exceed the total net value of its portfolio. RM may differ from one fund to another and may involve the commitment approach or Value-at-Risk (VaR).

3.2.4 Public nature of the sale and incorporation documents


Regarding the publication of documents related to an investment funds in Luxembourg, the Law of 17 December 2010 imposes several requirements. First, the prospectus and the latest published annual and semi-annual reports must be available for consultation (the prospectus shall be available in a durable medium or by means of a website and the annual and semi-annual reports must be available to the public in the manner specified in the prospectus) and remitted to subscribers free of charge upon their request. In addition thereto, UCITS are required to submit a KIID to their investors prior to their subscription.
UCITS FCP Part I Luxembourg law Board of Directors (conseil dadministration)

Depositary Bank (e.g. KBL) Management Regulation Depositary agreement UCITS III Management Company (ManCo chap. 13 Luxembourg law) (e.g. KTL) Delegation of central administration unless master agreement between ManCo and Fund Administration Fund Administrator (e.g. EFA)

Domiciliation Agent 1. Administration Registrar and Transfer Agent Administrative Agent 2. Asset Management 3. Distribution (= commercialisation)

Delegation of the asset management

Delegation of distribution

Investment Manager

Distributor (e.g. KBL)

Table 3.3 Service providers of mutual fund (FCP)


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In this respect, the question arises whether the above mentioned documents must, before the conclusion of the contract, be supplied to the subscriber only upon his request or whether they must be supplied in any event in the absence of such request. The CSSF considers that the subscription contract may be entered into without the subscriber having actually looked into or, even received, a copy of the prospectus and periodical reports, provided these documents had been offered to him in the prescribed manner. This means the Law does not prohibit that the subscription form is not attached to the prospectus, but to a brief information brochure which includes the offer to subscribers to obtain the prospectus and the periodical reports.The KIID in any case needs to be provided to investors prior to their subscription.

3.2.5 Inscription on the official CSSF UCI list


UCIs must, in order to carry out their activities, be previously authorised by the CSSF. Authorised UCIs shall be registered by the CSSF on an official list. Such registration shall be notified by the CSSF to the UCI concerned. For the UCIs referred to in Art.2 and 63 of the Law of 17December 2010, applications for entry on the list must be filed with the CSSF within the month following their constitution or formation. The said list and any amendments made thereto shall be published in the Mmorial by the CSSF. The inscription and the maintaining on the list referred to above shall be subject to observance of all the provisions of laws, regulations or agreements relating to the organisation and operation of UCIs and the distribution, placing or sale of their units.

3.3 Part II: Legal life of the UCI


3.3.1 Director and conducting officer: notions
The management and direction apparatus of a UCITS includes the board of directors (for a SICAV), the board of directors of the ManCo (for a FCP). The conducting officers of a management company and the conducting officers of a Socit dinvestissement Auto-Gre (SIAG). The management and direction apparatus decides and acts exclusively in the interest of the SICAV or of the unitholders of the FCP within the purpose of the UCI i.e. act with due skill, care and diligence, in the best interests of its clients and the integrity of the market. The directors are held responsible for their management and should act as pater familias i.e. with the care, diligence and skill that a reasonable person would exercise in comparable circumstances. For instance, they should guarantee the accuracy of the mention of the prospectus and the suitability of the conclusion of the various agreements and of the investments. The directors are responsible towards the company, the investors and, to a certain extent, third parties and the responsibility of the board of directors is at the same time personal and collegial. They receive a discharge from the shareholders during
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the annual general meeting. The directors are also legally responsible in case of for instance breach of trust, use of forgeries or absence of submission of the annual report.

3.3.2 Modification of the incorporation documents of the UCI


For a SICAV, the law on commercial companies (Law of 10/08/1915) applies to the modification of the incorporation documents. The modification of the incorporation is decided during an extraordinary general meeting (EGM). The majority during the first EGM is fixed to at least 2/3 of casting votes provided a quorum of 50% is reached. Note that the change of the nationality of the company and the increase of the commitments of the existing shareholders require the unanimous consent of the shareholders. Otherwise, there is a second EGM without any required quorum and with the majority of at least 2/3 of casting votes (except for the change of nationality or the increase of the commitments of the existing shareholders). The agenda of the EGM must contain inter alia the listing of foreseen changes (or the entire text of the changes relating to object or the form of the company). In addition thereto, the convening to the second EGM (if any) shall include the result and date of the first EGM and the date of the second EGM. For FCPs, the procedure is somewhat different since unit holders of a FCP do not (normally) have any decision right unless foreseen by the Management Regulations. The procedure can be specified in the Management Regulations.
Time-line: First EGM

Bearer shares

J-16: first publication in a newspaper and Mmorial

J-8: second publication in a newspaper and Mmorial

J: first EGM

Registered Shares

At least J-8: letter (by register mail if only register shares)

Table 3.4 Timeline for the first EGM

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Time-line: Second EGM

53

J: first EGM did not reach the required quorum

J+1: first publication in a newspaper and Mmorial

J+16: second publication in a newspaper and Mmorial

J+31: second EGM

At least J-16: letter (by register mail if only register shares)

Table 3.5 Timeline for the second EGM

3.3.3 Modification of the sale documents of the UCI


Several reasons may motivate the decision to modify the sale documents of a UCI. For instance, reasons may be the update of general information, the modification of the investment policy, the change of service providers, the fee structure or the launch of a new sub-fund. These modifications may or may not have an impact on the incorporation documents and may be decided by the board of directors or (if they impact the articles of incorporation of the SICAV), during an extraordinary general meeting. These modifications result in the issue of a new prospectus or of an addendum. These changes need to be approved by the CSSF which should be provided with a draft of the prospectus or addendum, the agreement, the notice to shareholders and the revised draft articles of incorporation (should the change require a change of the articles of incorporation). The CSSF may approve orally or in writing (for changes in the incorporation documents, merger of sub-funds and new sub-funds) or send back feedbacks and comments.

3.3.4 The board and general meeting of the UCI


At least one general meeting must be held each year within the municipality and on the day and time indicated in the articles of incorporation. It must take place maximum 6months after the end of the financial year and the first Annual General Meeting (AGM) can be held 18 months after incorporation. The general meeting of shareholders shall have the widest powers to adopt or ratify any action relating to the company such as the nomination, discharge and revocation of the directors or the auditors and the approbation of annual accounts. The agenda of the AGM must contain the approval of the reports of the Board of Directors and the Independent Auditor of the UCI, the approval of the annual accounts accounting year-end and the allocation of the results, the discharge to be granted to the directors and the statutory appointments.
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Physical participation to AGM is exceptional and, most of the time, shareholders delegate a proxy to represent their interest. The board of directors is composed of members whose mandate duration ranges from 1 to 6 years with the possibility of an unlimited number of renewals. It is composed of physical person and of companies which appoint a representative for the board meeting. The board of directors is responsible for the funds representation towards third parties and for the nomination of service providers.
Time-line: AGM

Bearer shares

J-16: first publication in a newspaper and Mmorial

J-8: second publication in a newspaper and Mmorial

J: AGM

Registered Shares

At least J-8: letter (by register mail if only register shares)

Table 3.6 Time line of the Annual General Meeting Unless otherwise provided for in the articles of incorporation of the SICAV, the majority rule of the board meeting is 50% of the directors present or represented with a quorum of 50%. Physical meetings as well as videoconference or conference call can be used for the board meeting provided they are foreseen in the incorporation documents.

3.3.5 Legal life events


Several legal events may happen during a funds life. The replacement of one of the director because of the end of his mandate, the death of the director, his revocation or resignation or the dissolution of the company, etc. just to name a few. Directors must be at least 3 and the nomination of a new director is subject to the CSSF approval. The nomination usually takes place at the annual general meeting. Auditors may also be subject to changes during the life of an investment fund and also need the CSSF approval. Another legal life event of investment funds is the publication of the financial reports. The annual accounts require the approbation of the annual general meeting.

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4. Fund administration
4.1 Introduction
The previous chapter covered the legal requirements involved in the set up and management of the UCI during its legal life. We now focus on one of the core operational functions in a fund: fund administration. Efficient fund administration allows funds to operate smoothly and to interact properly with the other intervening parties in the life of a fund as well as to provide services to the funds investors. The activities covered under the general heading of fund administration range from essential activities interrelating for example with the asset management function, providing fund valuation, accounting and bookkeeping services or processing shareholder transactions to more valueadded services in the field of Risk Management and distribution support.

4.2 Overview of fund administration


4.2.1 Intervening parties in investment funds
The intervening parties in an investment fund can be split into two parts regarding their relationship with the life of the investment fund. On the one hand, the control functions at the top of which is situated the promoter of the fund (launcher of the fund. See chapter3). Depending on the legal structure of the fund (SICAV or FCP), the fund is represented by a board of directors or a management company which is composed of directors responsible for, among other things, the monitoring of the life of the fund in terms of risk management and compliance. Even though they are responsible for the overall functioning of the fund and for investor protection, they may delegate certain functions to external intervening parties. The depositary bank has an independent controlling and supervisory function on the assets of the investment fund and also on such aspects as investment restrictions breaches or the accuracy of the NAV calculation and the subscription and redemption process. On the other hand, the executing functions include the asset managers who manage the fund in accordance with the investment policy defined in the prospectus in terms of the specific assets in the portfolio, the custodian bank whose function is to process the investment transactions and to keep the assets of the investment fund (safekeeping function) and fund administration i.e. fund accounting and transfer agency. Under UCITS IV, the primary functions of fund administration are defined as follows: The accounts of an investment fund are kept in such a way that all assets and liabilities can be immediately identified and correctly valued. Accounting policy and procedure have to be in line with accounting standards of the Member State of origin of the fund so as to allow the precise
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calculation of the Net Asset Value (NAV) as well as the correct execution of subscription and redemption orders based on such NAV. These requirements can be summarized as in Table 4.2 where the first part about NAV calculation refers to the accounting function of fund administration and the last part about subscriptions and redemptions refers to transfer agency.

Fund promoting Group

Substance provider for the oversight services

Asset Manager

SICAV BoD / FCP mandates Management Company Conducting persons

Custodian Bank

Fund Administrator Core Functions Oversight of risk management process Oversight of delegations and service providers Compliance Oversight / Delegations Transfer Agent and Register

Depository Bank

Other: Paying Agent, Domiciliary Agent, ...

Table 4.1 Overview of intervening parties in an investment fund (UCITS-type)

Value assets portfolio receivables cash

(-)

Value liabilities Payables accruals

NAV

Process Subscriptions / Redemptions

Table 4.2 Primary functions of fund administration

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4.2.2 Fund administration scope


In the previous section, we have highlighted two main functions of fund administration i.e. NAV calculation and subscriptions/redemptions execution. However, the roles of fund administration are not confined to passive bookkeeping and processing of subscriptions. Indeed, fund administration also provides value added services. The scope of fund administration effectively includes among other services risk management, compliance support, performance measurement and attribution, reporting, etc. Table4.3 summarizes services belonging to each of the categories (core and value-added). All these services typically translate into a complete service offering for all potential types of funds involving of course fund accounting services such as NAV calculation, reporting or trade management, transfer agency services such as the processing of subscription and redemption orders or distribution support as well as add-on services such as compliance or valuation services.

CORE

Fund Manufacturing

Asset Management

Fund Acc.

Transfer Agency

Distribution

Depo Bank Custody

Trade Mgmt Value Added Eligibility Compliance Support

Risk Mgt Support Performance Measure Attribution

Indep. Valuation Reporting Fiscal Services

Distribution Support

Table 4.3 Scope of fund administration The fund administration company is interconnected with all the different players (portfolio managers, brokers, distributors and custodian banks and is at the center of all information flows coming from and going to all intervening parties in the operational life of an investment fund.

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Long only funds (UCITS & non-UCITS)

Fund Accounting

Add-on Services

Transfer Agency

Unit linked & pension funds

Trade management, Matching, Daily reconciliation Accounting & reporting

Compliance

Nominee, retail, multi-class

HF & FoHF

Analytics NAV calculation

Sales charge struct., trailer fees

Private equity & real estate funds

Valuation services Pooling, FoF, master-feeder

Saving plans, withdrawals

Man. Cos. & SPVs

Middle office services

Domicile

Distribution support

Table 4.4 Example of a complete service offering

4.2.3 Emergence of the outsourcing model


Outsourcing allows a company to delegate some activities (which are not strategic or core) to an external specialized company. Fund administration is typically a complex function which requires a critical size and which, as a consequence, is frequently outsourced by investment funds and delegated to companies whose main business is focused on fund accounting and transfer agency. A good illustration of this phenomenon is European Fund Administration (EFA) which is a leading fund administration company in Luxembourg. While Luxembourg has no real asset management sector, it has nevertheless developed as an international financial center around high-quality and specialized service providers for investment funds. Two other concepts which are growing in importance are offshoring and smart-sourcing which refer to finding domiciles which are relatively cheap (for instance in terms of labor costs) to outsource part of the manufacturing process.
Functionality + Service Quality + Technology + Cost = Outsourcing

Table 4.5 The outsourcing equation


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4.3 Fund accounting


4.3.1 Fund accounting process
Fund accounting can be broadly defined as the calculation of the Net Asset Value and price per share of an investment fund. Though it may seem relatively straightforward to understand the principle, it is the result of a complex and highly integrated process. The Net Asset Value calculation frequency determines the liquidity of the fund in terms of subscriptions and redemptions24. The main part of the NAV of an investment fund is typically determined by the value of the securities in the portfolio while the rest of the NAV is composed of receivables, payables, current bank accounts, etc. The fund can further be divided into different share classes which may differ in their dividend policy. For instance, distribution funds offer a recurrent dividend while capital gains and income are accumulated in the NAV price in accumulation funds and not distributed on a regular basis. Share classes can also differ on the characteristics of the target investor (retail or institutional). Different share classes may also be subject to different kinds of management fee calculation and commissions. The frequency of the fund valuation is determined by the level of liquidity that the investment fund wishes to provide: i.e. in a daily fund, investors can subscribe and redeem on a daily basis whereas in a monthly fund, investors can only enter or leave the fund once a month on the valuation day.

24. Daily, weekly, monthly or even quarterly.

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Statement of valuation (in EUR) Sample Fund NAV date 12/31/2010 Reports generated by EFA Tel.: (352)48.48.80.200 e-mail:efanet@efa.eu
Cost 374 333 204.99 0.00 151 066.16 - 75 885.72 748.41 - 1 198 371.98 -2 924.73 - 1 372.35 - 3 734.36 - 370.80 1 687 535.48 - 8 221 555.34 476 534.43 - 729 791.20 9 379 293.55 375 794 376.54 410 598.24 - 370.80 1 700 770.99 - 8 221 555.34 475 888.37 - 725 381.45 9 553 956.65 415 702 002.05 - 3 734.36 - 1 372.35 - 2 924.73 - 1 198 371.98 748.41 - 75 774.43 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 - 4 241.01 77.19 0.00 0.00 5 479 196.05 150 782.72 0.00 75 774.43 0.00 413 973 565.92 5 483 359.87 Valuation accrued interests % NAV-1 - 0.47 % 166.73 % - 0.65 % - 166.73 % 0.00 % - 1.05 % - 1.09 % 0.00 % 0.00 % 0.00 % - 0.55 % - 10.92 % - 1.30 % 0.60 % - 0.98 % 0.00 % 100.00 % % NAV 99.56 % 0.02 % 0.02 % - 0.01 % 0.00 % - 0.27 % 0.00 % 0.00 % 0.00 % 0.00 % 0.40 % - 1.94 % 0.11 % - 0.16 % 2.27 %

Designation

Cash/currency instr.

Securities-portfolio

Futures

Receivable dividends

Margins paid

Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

Regularisation account

Commission payable

LARCIER

Fees payable

Taxes payable

Matured fees payable

Matured taxes payable

Guarantee deposits

Current bank accounts

EUR

- 8 221 555.34

GBP

SGD

- 1 241 648.30

USD

12 689 565.22

FUND INDUSTRY IN LUXEMBOURG

NET ASSETS

Data per class of share 12/31/2010


Number of shares repurchased Redemption price 0.000 869.738 EUR 101.49 101.95 - 0.46 - 0.45 % - 738.325 EUR 1 368.19 1 374.45 - 6.26 - 0.46 % 1 436.60 106.56 36.000 EUR 810.39 814.10 - 3.71 - 0.46 % 850.91 810.39 1 368.19 101.49 Change Change NAV per NAV per Subscripin shares Currin NAV Change share share tion out- ency per in % 12/31/2010 12/30/2010 price standing share % Net assets per share class 2.44 % 97.08 % 0.48 %

Net assets per share class

Number of shares outstanding

Number of shares subscribes

classe A (Dist.)

10 268 552.80 12 671.080

36.000

FUND INDUSTRY IN LUXEMBOURG

classe B (Cap.) -

408 882 334.63 298 848.614

131.413

Classe I (Cap.)

2 030 310.67 20 005.294

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Total net assets

421 181 198.10

LARCIER

Table 4.6 Example of a statement of valuation

61

62

FUND INDUSTRY IN LUXEMBOURG

In addition to the overall NAV of the investment fund, the evolution of the value of each of the securities constituting the portfolio is shown in the statement of valuation report as exhibited in table 4.6. Important information shown in portfolio reports are : the precise identifier of the security (ISIN code for instance), the current market price as well as the purchase price, the number of shares, the total value of the security in the portfolio , the currency, etc.
FIP for securities database TKS VDF Bloomberg WM Daten CetrelSecurities Pricing Service Providers Bloomberg Reuters Fininfo WM Daten StatPro TKS VDF Financial Information Providers
Prices + Corporate Actions Portfolio Managers

EFA Sungard Compliance Asset Arena


On-line Access through a dedicated workstation

GAIN Platform Securities Static data Eligibility Status

Fax, Email

Swift, propri etary files Interfaces

Compliance Officers

GAIN Golden Copy


Securities Data Prices

ECM

Global Portfolio Front end Global portfolio Accounting platform


NAV controls & Ex-post calculation Compliance Book Positions keeping matching NXG

Pre-NAV Compliance Checks

Custodian / Management Company Custodian bank

Post-NAV Compliance Checks

Data Warehouse Accounting & fiscal data NAV publication NAV Reports

EFAnet Push Mode Pull Mode

Man. Co Official Authorities Other interested third parties

Fiscal Compliance Risk Official & Performance Reports Reports Reports Web Client Portal

Table 4.7 Overview of the fund accounting process As one can see in table 4.7, the fund administrator receives during the fund accounting process pricing data (price, dividend payments, potential splits, etc.) from financial information providers such as Bloomberg, TKS VDF, Reuters, etc. At the same time, asset managers inform the fund administrator about any movement (purchase or sale of securities) which may affect the structure of the portfolio. The fund administrator also receives and sends information to control organs which check post-NAV and pre-NAV compliance with investment rules. The calculated NAV can then be transmitted through reports generated in the

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63

data warehouse to fund managers, control bodies, Management Company and investors. The pricing step is very critical since any error in pricing leads to a wrong NAV and hence to subscriptions and redemptions processed at a wrong price, which may be very complicated to unwind. Since the process is repeated every day in daily NAV funds, the fund administrator needs to put in place automated controls regarding security prices. These automated controls are illustrated in table4.8. For instance, automated checks are developed to verify if the right security and stock exchange are taken into account25, cross-checks from different data sources are performed, unexpected absolute and relative (with respect to benchmarks) movements in asset prices are also used to detect potential errors during the valuation process. The same kinds of control procedures are applied to the NAV per share. Daily performance is compared to benchmarks. Portfolio information is also compared to the information provided by the custodian bank which holds the assets of the investment fund in order to detect any discrepancies.
Automated input functions Quality checks & plausibility checks Automated Validation rule s Global portfolio Accounting platform Multiple data-sources to maximize coverage and cross-check facilities.

Financial Data provider TKS VDF Bloomberg WM Daten CetrelSecurities

i GAIN Platform Securities Static data Eligibility Status GAIN Golden Copy Corporate Actions Database
Corporate Actions Securities Data

Request for Prices

Pricing Service Providers Bloomberg Reuters Fininfo VM Daten TKS VDF

Prices

Prices and data controls NAV processing NAV controls & calculation Book Keeping

TKS VDF Custodian Bank Information Corporate Actions

derivatives, unlisted securities)

StatPro (OTC

Alternative UCI

Centralised corporate actions processing in order to safeguard correct and consistent book entries.

EFA

Automated price-controls checking day to day fluctuations as well as consistency versus benchmarks.

Alternative UCI prices are gathered by our dedicated UCI Team

Table4.8 Security pricing process

25. And not a similar one with different characteristics.

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64
NAV-controls at different levels (including consistency checks versus benchmarks) in order to minimize NAV-errors.

FUND INDUSTRY IN LUXEMBOURG


Custodian bank
Order Entry
Cash Statement Settlement

ECM Global Portfolio Front end Global portfolio Accounting platform


NAV NAV i controls calculation Book keeping Positions matching Interfaces

Pricing process TA Applications Souscription / Redemption transactions

EFA
NXG Reconciliation

Securities Statement

Data Warehouse Accounting & fiscal data NAV Reports

Reporting Engine EFAnet Compliance Fiscal Risk & Performance Reports Reports Web Client Portal

Our electronic & web-based tools allow us to ensure fast, secure and flexible delivery of produced reports to any interested third party.

NAV publication

Financial & Push Mode Regulatory i Pull Mode Reporting

Man. Co / Custodian / Insurance Company Official Authorities (CSSF, CAA) Other interested third parties

Finesti, ...

Table 4.9 NAV production and reporting

4.3.2 Investor protection rules


Despite the numerous checks which are performed during the Net Asset Value calculation process, errors may nevertheless happen resulting in a wrong NAV per share. Another problem can arise if a portfolio manager invests in a security in proportions which are not allowed by the investment policy of the investment fund. In Luxembourg, the regulator has foreseen a particular procedure to deal with NAV errors which affect investors. However, since calculating Net Asset Values is not an exact science and repairing small and insignificant errors can be very costly, the regulator has set a certain degree of tolerance (materiality concept). This tolerance threshold depends on the investment policy of the fund. It is respectively 0.25% of NAV for money market funds, 0.50% for bond and mixed funds and 1.00% for equity funds. The different thresholds reflect the implicit degree of imprecision in the valuation process based on variable volatility. The materiality concept does not apply to investment restriction breaches i.e. breaches of the investment policy by the portfolio manager. There is a formal notification procedure. The promoter, custodian, auditor and the CSSF have to be notified immediately and an action plan must be submitted. This action plan must describe the measures taken to cure the problem, the improvement implemented in the administration and control structures to prevent a reoccurrence of the problem, the identification of the investors affected by the error. The correct Net Asset Value has to be recalculated for the period during which the error occurred
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65

if subscriptions and redemptions have been processed and the amount which should be injected into the fund or repaid to the investors must be determined. The notification process to impacted investors and supervisory authorities in the distribution countries also has to be described. However, a simplified procedure can be used provided the total indemnification amount is less than 25000 and the amount to be reimbursed to a single investor is less than 2500. In this case, no corrective action plan needs to be submitted to the CSSF and a simple notification and repair is sufficient. The cost of correction and auditor intervention cannot be charged to the fund.
Evolution du nombre des cas derreur de calcul de la VNI et dinobservation des rgles de placement dclares la CSSF au cours des trois dernires annes 2000 Nombre

1500

1000

500

0 2008 Erreurs de calcul de la VNI Inobservations des rgles de placement 714 1.519 2009 858 1.929 2010 411 1.159

Table 4.10 Number of NAV errors and investment breaches in Luxembourg funds source: CSSF

4.3.3 Compliance and risk management


One of the aims of the amendments introduced by the UCITS III Directive was to widen the scope of financial instruments in which UCITS can invest and to enable UCITS to make use of modern investment techniques. At the same time, the same directive and the following legal regulations established an extensive system of risk limitations and risk controls in order to ensure investor protection. The CSSF circular 07/30826 defines the organizational principles for measuring risks, determines rules for calculating and monitoring fund expo26. On Rules of conduct to be adopted by undertakings for collective investment in transferable securities with respect to the use of a method for the management of financial risk, as well as the use of derivative financial instruments.

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FUND INDUSTRY IN LUXEMBOURG

sures to the different types of risk. It also outlines coverage rules applicable to derivatives as well as the valuation principles for OTC derivatives. UCITS management companies and self-managed investment companies must comply with regulations on the use of a risk management process. The management or investment company must employ a risk management process which enables it to monitor and measure at any time the risk of the positions and their contributions to the overall risk of the portfolio. In addition, it must supervise mandates given to third party fund managers. In particular, measures shall exist which enable the persons who conduct the business of the management company to monitor effectively at any time the activity of the undertaking to which the investment mandate is given. Eventually, it must define its risk profile by conducting a self-assessment of its risk based on its investment policy and the use of derivatives. UCITS with less and less complex positions on financial derivative instruments or with financial derivative instruments used solely for hedging purposes can use the commitment approach to risk management. More sophisticated UCITS using, for an important part, financial derivative instruments and making use of more complex strategies or instruments have to develop internal models and be able to calculate the VaR (Value-at-Risk). A management company needs to supervise on a daily basis several kinds of risk. For instance, it must check whether the asset manager complies with the law and the investment policy of the fund described in the prospectus (investment breaches and asset eligibility). Market risk, credit risk, liquidity risk, concentration risk and operational risk are also to be controlled by the management company. All these requirements are reported in table4.11. It is supported in this task by the fund administration company on a daily basis.
Investment Policy Market Risk/ Global Risk Settlement Risk Currency Risk Credit Risk / Interest Risk Liquidity Risk Counterparty Concentration Operational Risk Risk Risk

List of investment Restrictions breaches observed Risk & Performance Monitoring Reports Asset Eligibility Checks Risk & Performance Attribution Reports

UCITS 3/4 Risk Compliance Report

Operational Risk Report Monitoring of delegated functions

Risk Attribution Reports

Table4.11 Risk and performance monitoring


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67

A typical compliance solution is illustrated in table4.12 and consists in first filtering any transaction proposed by the asset manager. The fund administration company checks whether the kind of asset is eligible and if it does not create a breach. This part is referred as pre-NAV check and aims at preventing any breach before the transaction is posted in the funds accounts. It is nevertheless not totally precise since it is based on the last known NAV. It may consequently happen that a purchase or sale of a security (or even no movement at all in case of passive breach due to the relative performance of assets in the portfolio) leads to a breach which is only detected after the new NAV calculation. The fund administration company proceeds to post-NAV checks at the end of the day with correct prices.
Portfolio Managers

Transferable Securities Structured Financial Instruments Bank Deposits


(1)

Financial Derivatives Instruments Money Market Instruments UCITS / UCI

Transaction

Controls based on portfolio positions as prices at the latest calculated NAV, including new transactions received and net flows of subscription and redemptions registered as at control date Ex-Post Compliance Checks Investment restrictions & Eligibility status

Fund Accounting Front end

Compliance PreNAV Checks (1) Investment restrictions & Eligibility status (*)

Accounting platform

NAV Calculation

Compliance system
Request for corrective actions Compliance Officer Alerts in case of transaction generating breaches ...

Actions: Block, release, autorelease of transaction, ...

Launch Compliance controls at any time using the snapshot function (1)

Compliance Post NAV Reporting

Permanent on-line access to all detailed information portfolio positions, details of breaches, Custodian Bank / Mangement Company / Insurance Company (*) Eligibility controls will be operated as part of Pre-NAV controls as long as the Eligibility status is available for the instrument on time of control.

Table4.12 Compliance solution

4.4 Transfer agency


In addition to fund accounting, transfer agency is the second main activity of fund administration. The transfer agent deals with the subscriptions to and redemptions out of an investment fund. Traditional transfer agents sit between the fund and the investors and help the distributor to process subscriptions and redemptions. Among other things, the transfer agent is responsible for shareholder identification and maintenance of the investors static data (address,
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FUND INDUSTRY IN LUXEMBOURG

etc.), anti-money laundering, transaction processing, settlement and cash management, reporting and commissions/fees management.
Funds Asset Management Fund Admin Distributors Investors

Custody

Transfer Agent

Distribution

Order Entry

Shareholder Maintenance

AML & Legal

Transaction Processing

Settlement and Cash Mgt.

Recon.

Reporting Mgt.

Commission and fees

Table4.13 Traditional transfer agent model Regarding shareholder register keeping, the transfer agency must determine who the investors of the fund are in order to be able to inform them of any event related to the funds life such as general meetings. Shareholders can be divided into two main groups. The first one consists of registered shareholders whose name and address are formally recorded. The other group covers bearer shareholders whose identity is not disclosed. This might be problematic among other things to calculate some specific types of commissions and fees and to determine who actually controls the fund. The sum of registered and bearer shares constitutes the total number of shares outstanding in the investment fund. Another important function of the transfer agent is to support the distribution of the investment fund. In this respect, the management of commission calculation is very important since without commission there would not be any distributor willing to distribute the investment fund. Commissions can take many different and complex forms such as redemption fees based on the number of years the investor spent in the fund. Of course, this requires keeping track of the dates at which the investors bought the shares.

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FUND INDUSTRY IN LUXEMBOURG

69
Fund Administrator Investors

Shareholder register keeping

Shareholder 1

Custody of the clearing or Clearing

Legal framework of shareholder register of commercial companies is applicable

The investors holdings are grouped in an account wrapper, the register account

Registered holdings

Bearer holdings
Fund accounting

Holding in share class A of sub-fund 1 Holding in share class B of sub-fund 1

Holding in share class A of sub-fund 1

Shareholder register Sub-fund 1

S / R after NAV /fees / Equalization

Sub-fund 1 Reconciliation of shares outstanding Sub-fund 2

NAV

Holding in share class A of sub-fund 2

Shareholder register Sub-fund 2

NAV

Holding in share class A of sub-fund 3

Holding in share class A of sub-fund 1

Shareholder register Sub-fund 3

Sub-fund 3

NAV

Table4.14 Shareholder register keeping In Luxembourg, UCITS funds are designed to be exported, which requires highly-skilled fund administrators and transfer agents27. More than 70% of funds in the world which are sold in at least three countries (including home state) are Luxembourg funds.

27. Requiring reporting in different languages, knowledge of different fiscal laws, etc.

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FUND INDUSTRY IN LUXEMBOURG

Sweden 71% France 70% Germany 67% Switzerland 70%

Japan 61% South Korea 100%

Bahrain 76%

Taiwan 75%

Hong Kong 73% Singapore 71% Peru 64%

Chile 73%

Table4.15 Luxembourg market share of foreign funds registered for sale source: PwC Global Fund Distribution 2010

4.4.1 Transfer agency operational flows


A very important concept related to transfer agency is that of cut-off time representing very precise daily deadlines by which different operations must have been performed. First, in the standard order process, the order transmission must occur before a cut-off time. Then the transfer agency opens a new account for the investor (if the investor is new) and clearly identifies the investor. Once the account is open, the order is input in the system and the transfer agency ensures that the subscription money has been paid before the order is processed. As soon as the order is processed, the investor becomes a shareholder. There are certain rules within UCITS which protect the fund in case of a large redemption with respect to the size of the fund. Such redemptions may be gradually redeemed over a larger time span in order to protect the investors who remain in the fund. Another important cutoff time is related to the determination of the exact amount of new money invested in the fund once all the subscriptions and redemptions have been taken into account. This must be reported before market closing time in order for the asset manager to make investment decisions with the knowledge of the amount of money at his disposal. Eventually, the instruction is given to the bank to pay redemptions proceeds to the shareholders who have sold their shares.

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FUND INDUSTRY IN LUXEMBOURG

71

The transfer agent also manages commissions and fees. There exist a potential conflict of interest between the fund manager and the distributor of the fund. While the former has an interest in having as much invested money as possible, the latter may have an interest in having as many transactions as possible in the fund if the distributor is paid on the basis of the number of transactions. Trailer fees allow reconciling the interest of both the fund manager and the distributor. Trailer fees are based on the money that stays in the fund. The transfer agent is also responsible for processing and instructing the payment of the fees on behalf of all the intervening parties.
Cut-off for Estimation report Market closure NAV Time-line

Custodian Bank/ Fund Administration


NAV calculation and sending / Fiscal data computation and sending Forex trade

TA Production department
FOREX requests

Reception of NAV and Fiscal Data

Order batching and business events Processing of all orders

TA Administration
Automatic generation of estimation reports Automatic dispatching of estimation reports

Disinvestment Portfolio Managers Information on cash flow forecast

Investment /

Electronic Trade confirmation for interfaced orders (ieSWIFT MT 515)

Investor or Distributor

Table4.16 Standard order processing (1/3)

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Funds order cut-off or specific order cut-off

FUND INDUSTRY IN LUXEMBOURG

Time-line

Cash correspondent Payment instruction bank for Payment instruction to fund Account statement or collecting bank account (MT101) and SWIFT MT 940 accounts possible Direct Debit from
Investor account

Investor or Distributor

TA Shareholder Services department


Cash reconciliation (no order) 2) Cash reconciliation (with order) Information to UCITS in case of excess Decision by UCITS

Order Transmission

Order reception, preparation and routing

Order Input

Order Validation

Control of transactional Volume for the UCITS

Order simulation +Business event Complete Order Book

Identification + AML Controls

TA Production department

Interfaced static data and orders SWIFT Interfaced Orders (MT502)

Reception of Client and Account referential

Investor and account opening Reception of Order

Controls against AML Black Lists

Comment/ Explanation: Notification of rejected swift interfaced orders (ie SWIFT MT 509)

Standard Process Alternate/Specific Process Technical process

1) Processes are bearing the color the system they are executed onto (cf. slide TA Platform ). 2) Only for private investors in pre-paid mode.

Table4.17 Standard order processing (2/3)

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FUND INDUSTRY IN LUXEMBOURG


Sattlement date

73
Time-line

Custodian bank or cash correspondant

SWIFT MT 101, 298, 210, 541, 54x

Account statement or SWIFT MT 940

TA Production department
Automatic generation of payment instruction and/or securities settlement instructions Cash reconciliation

Order settlement

Automatic generation of all reports

Automatic sending of all reports

Confirmations and reports Promoter and Portfolio Manager Investor and Distributor Custodian Bank

Table4.18 Standard order processing (3/3)

4.4.2 Late trading and market timing


The transfer agent also participates in the protection of the fund and its shareholders against among other things late trading, market timing and dilution. These concepts are related to the cut-off time corresponding with the time before which orders must be placed (typically 12.00 p.m.). The correct process requires that subscriptions and redemptions are made at an unknown price which means that the investor cannot know in advance the price at which he will buy or sell shares of the investment fund. In the example illustrated below the NAV is calculated using price information at 3.00 p.m. Late trading, which is prohibited, consists in waiting until the Net Asset Value is available and subscribing after the NAV has been released. This may allow the investor to use information which was available only after the pricing time and to harm the fund. Market timing is more complex and is a kind of arbitrage based on frequent and repetitive subscriptions and redemptions taking advantage of imperfection in the way the fund is priced. These imperfections may be due to the geographical scope of the investment strategy which may include stock exchanges which are open at different times of the day.

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74
12:00 15:00

FUND INDUSTRY IN LUXEMBOURG


17:00 Time-line

Cut-off time S/R at unknown price

Correct process

NAV Pricing point

Event influencing price

Late Trading

NAV Pricing point

S/R at known price

Market Timing

Arbitrage method: Systematic S/R within short time period to take advantage of pricing imperfections

NAV Asian + US portfolio pricing imperfections

Table4.19 Late trading and market timing

Process Activation

Transaction fees in favour of the fund Always

Bid and offer (dual) pricing Always

Anti dilution levy (ADL) Always or Transaction threshold test: Transaction amount>= % of fund net assets or Net in/ outflow threshold test: Net in/ outflow amount>=% of fund net assets

Swinging single price (SSP) Always (=Full SSP) or Net in/ outflow threshold test: Net in/ outflow amount>= % of fund net assets (= Partial SSP)

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FUND INDUSTRY IN LUXEMBOURG The ADL will be calculated by the TA individually on each single transaction and will be provided as a commission revenue to thefund accounting. Different dilution levy rates maybe defined by transaction type. Dilution levy rates could be periodically reviewed by thefunds board. Fund pricing Single pricing, Dual pricing: Single pricing, method however BID price and however comparable to OFFER price comparable to dual pricing: dual pricing : NAV price NAV price +/+/-commission dilution levy rate * NAV price rate * NAV price Price NAV only Bid and offer NAV price only publications prices for trading Eventually NAV price for valuation / statistical purposes only Investor CN NAV price Commission amount Covered Yes byEFA Bid / offer price NAVprice Dilution levyamount Yes Yes Description Pre-defined transaction fee levied by the TA in favour of the fund on any specified transaction type. Bid and offer spread calculated on each NAV. Subscriptions are traded at offer, redemptions at bid price by theTA.

75
The NAV will be increased (if net inflow) or lowered (if net outflow) by a pre-defined swinging factor. Different swinging factors may be defined for net inflows or outflows. Swinging factorscould be periodically reviewed by the funds board.

Single pricing: NAV price or Swung NAV price (NAV price +/swinging factor* NAV price) Swung NAV price or NAV price for trading Eventually NAV price for valuation / statistical purposes only Swung NAV price / NAVprice Yes

Table4.20 Anti-late trading and market timing mechanisms

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Since such a fund has to be priced at a specific point during the day, there will always be a part of the portfolio for which the underlying prices are known at the time of subscription. Market timing is also not authorized. There exist several mechanisms which act to restrain late trading and market timing such as bid-offer pricing which is the spread between the price at which an investor can buy and sell an investment fund. Examples of anti-late trading and market timing mechanisms are given in table4.20.

4.4.3 Anti-money laundering (AML)


The Transfer Agent (TA) has to know who the investors are. The international nature of the Luxembourg financial center is such that the investors are located all around the globe and the fund administrator has probably never seen directly the different shareholders of the investment fund. Consequently, fund administrators have designed a system in which the Know Your Customer rule and investor identification can be delegated to the distributor of the fund. Indeed, since the distributor is in charge of selling the shares of the fund, he is the most likely counterparty to have met the customer physically. Delegation is based on a strict system of rules and more particularly the transfer agent can only delegate to an entity which is itself properly regulated. The Know Your Customer (KYC) identification process is generally performed at two levels at the time of the account opening28 for client and beneficial owner i.e. at the distributor level or at the investor level. If the distributor is considered as an intermediary allowed to execute AML/KYC controls which are equivalent to Luxembourg standards, the TA may consider investors linked to this particular distributor as AML compliant and does generally not perform any additional or specific KYC controls. In the context of retail distribution networks, the TA informs the regulated distributor specifically of its anti-money laundering obligations, if not already specified within a dedicated distribution agreement in place with the fund. In case of direct investors or if the distributor linked to the investor is not considered as equivalent to Luxembourg standards, the TA has to directly identify the investors in the fund. Once the identity of the investor is known, the name is screened. New clients are systematically screened. All clients are re-screened on a regular basis against defined watch lists. All clients are screened against Politically Exposed Persons (PEP) lists once a month. Official watch lists are automatically updated. In addition, suspicious transactions are controlled through automated queries based on TA data. The number and amount of transactions linked to investors qualified as nonequivalent are regularly checked in order to detect any unusual movement. If the TA detects something, it has to cooperate with the authorities. Any suspicious elements when opening an investor or distributor

28. Tanks to ID / Passport, signature check; articles of incorporation, authorized signatories, etc.

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or during the investment period are immediately reported to the compliance officer who is the contact person for the authorities.
Return to investor or distributor

NO

The account opening request received by EFA is acceptable ?

Low risk Investigate potentially high risk 2

YES 1 YES
The account opening request has been received through a distributor ?

The distributor is domiciled in an equivalent country ?

The investor is a physical person ?

YES
The distributor is NO regulated by an authorized financial supervisory authority ?

NO

NO

YES
The investor executes its payment through direct debit ?

NO
The investor is a financial institution ?

The distributor is part of an authorized financial group domiciled in an equivalent country ?

YES
KYC process

NO
The distributor acts based on valid externalisation contract ?

YES
KYC process

NO

YES
KYC process

NO
KYC process

YES
The investor is domiciled in an equivalent country ?

NO
KYC process

YES
KYC process

YES
The investor it regulated by an authorized financial supervisory authority ?

NO NO
The investor is part of an authorized financial group domiciled in an AML equivalent country ?

YES
KYC process

YES
KYC process

NO
KYC process

Table4.21 The Know Your Customer decision tree

4.4.4 New distribution patterns and fund supermarkets


Typically, funds are sold through banks and financial intermediaries (independent financial advisors). Very often banks only sell their own products but, over the last years, there has been a trend to what is called open architecture which means that banks do not only sell their funds but also funds of their competitors to be credible. As a consequence, the investor has access to a larger range of funds. This nevertheless creates a problem since connections must be created between multiple funds and multiple transfer agents. Supermarkets and platforms were created as a solution to this problem. They support transfer agents and distributors to access multiple funds. Another recent trend is the creation of centralized transfer agent (global transfer agent) which deals with large variety of investment funds based in several locations.
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Investor Investor Investor Investor Investor Investor Investor Bank/ Institutionals (Open Architecture) Fund Desk IFA Supermarket/ Platform

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TA TA TA TA TA TA TA Fund Fund Fund Fund Fund Fund Fund

Table4.22 Back office position of transfer agents in investor servicing chain

Call Center Investor Investor Investor IFA

Decentralised local marketing IFA Support Gateway Spain

Fund Italy Centralised Middle Office TA Engine Fund Fund

Call Center

Germany

Investor Investor

Bank/ Institutionals (Open Architecture)

Table 4.23 Transfer agency evolution: from back office to value-added middle office

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5. Depositary bank and Management Company


5.1 Introduction
In this chapter, we present two main intervening parties in the everyday life of an investment fund i.e. the depositary bank and the management company. We define their missions as well as the regulation to which they are subject. First part of the chapter is concerned with the Depositary Bank while the second part is devoted to the Management Company

Depositary

Distributor

Management Company

Investment Fund

Investment Manager

Promoter

Authorities

Table 5.1 The depositary bank and the management company: 2 key intervening parties for an UCI

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5.2 Part I: Depositary bank


5.2.1 Historical overview
In the Grand-Ducal decree of 1972 concerning the supervision of investment funds, there was originally no obligation to nominate a Depositary Bank (DB) in Luxembourg. However, the role of the DB increased during the 1970s, specifically for mutual funds. The main missions of the DB were the safekeeping of the investment portfolio and of the stock of bearer shares/units of the UCI not yet issued, the execution of current administrative tasks of a portfolio (such as encashment of coupons and dividends, execution of subscription rights, purchases and sales of securities on the market) and the subscription and redemption of bearer shares/units along the respective encashment/payment from/to share or unit holders. The Law of 1983 on fiduciary assets further clarified the rules which should apply to DBs. In particular, it stated that all cash and securities of a mutual fund have to be held by a financial establishment (the Depositary Bank) appointed by the Management Company and authorized by the financial supervisory authorities. The Law also imposed minimal capital requirement for the DB. In addition, the management team has to be recognized as being honorable and having the necessary professional competences and the shareholders of the bank have to be recognized as being honorable too. Generally speaking, the Law of 1983 was inspired by and based on the recommendations of the European Council. However, only mutual funds had the obligation to nominate a depositary bank to protect the unit holder but the scope of the tasks of the DB was already widened. A few years later, the Law of 1988 transposed into Luxembourg law the directive 85/61129 by which the nomination of a DB was required as well for UCIs under contractual as well as statutory form and by which a given number of tasks was imposed upon the custodian. In the 2002 Law relating to UCIs, the safekeeping of the assets of a UCI have to be entrusted to a DB whatever the legal form of the UCI (statutory or contractual). The DB has specific missions of control. Eventually, the Law of 201030 did not significantly change the regulatory framework but imposed some further requirements between the DB and the ManCo domiciled in another country than the UCI and between the depositary bank of a feeder fund and the depositary bank of the master fund.

29. On the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS). 30. Transposing the EC directive on UCITS IV into Luxembourg Law.

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5.2.2 Access conditions for being Depositary Bank of a UCI


The Directive 85/611 specifies that the DB has to be established in the country of origin where the UCI is domiciled or has to be present there through a branch when it has his statutory domicile in another member state. The DB has to show the necessary professional and financial guarantees to exercise in an effective manner its mandate and be able to bear the responsibilities resulting from its mandate. The type of establishments enables to exercise the mandate of a depositary bank is delegated to each member state. In Luxembourg, the DB has to be a bank established under Luxembourg law or be a subsidiary of a foreign bank. In the latter case, the subsidiary can only be DB of a UCITS if its mother company is established in another member state of the European Economic Area. However, a bank is not as such automatically authorized by the Luxembourg regulator to exercise the function of DB. Indeed, the bank also has to demonstrate that its management disposes of the necessary professional experience and that it has the necessary human and technical resources in place to correctly exercise the tasks assigned to a depositary bank. In addition, the regulator further imposes the independence of the DB. Under the Directive 85/611, the DB and the investment manager cannot be for a given UCI (whatever its legal form) a single entity as the two functions (management and control) are incompatible. While the day-to-day management of the assets of the UCI is executed by the management company or the board of directors of the UCI, the safekeeping of those assets and the control of the legal conformity of the day-to-day management is entrusted to the Custodian or Depositary Bank. For obvious reasons, investment manager and DB have to act independently from each other. However, this independence is limited to a legal separation of entities but not extended to an economical or financial independence, which means that a mother company and one of its subsidiaries may perform both tasks. In the case of mutual funds (FCP), the Directive 85/611 expressively stipulates that the DB has exclusively to act in the interest of the unit holder. In the Luxembourg law, the requirements under this section have been transposed in the laws of 1988 and 2002, as well as in the law of the specialized investment funds (SIF).

5.2.3 Missions of a Depositary Bank


A DB mainly fulfills three different missions i.e. the custody of the assets, the supervision of certain operations and the current administration of the assets of the fund (specifically specified for FCPs).

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Depositary Bank

Custody of the assets

Current administration of the assets of the Fund (specifically specified for FCPs)

Supervision of certain operations

Table5.2 Missions of a depositary bank Under the Law of 2002, the custody of the assets of any UCI has to be entrusted to a DB. The meaning of custody is twofold and includes both the physical safekeeping of the assets and the supervision over these assets. Regarding physical safekeeping, the DB is in charge of taking into deposit the cash, the securities (equities, bonds, derivatives, etc.) or any other asset belonging to the fund. It is supposed to preserve those assets as if they would be its own and to be able to return them at any moment. The safekeeping can also be delegated to a professional designated by the depositary or by the UCI in agreement with the DB. The professional designated by the depositary and who keeps the assets to the order of depositary is part of the depositary international network of correspondents or sub-custodians. Delegation is particularly used by mutual funds which invest in several different regions of the world. For instance a European fund investing in securities in Latin America could delegate the safekeeping of Latin American assets to a Brazilian DB. The supervision of the assets implies that the DB must have knowledge at any time of how the assets of the fund have been invested and where and how these assets are available. In particular, the DB must know with which counterparty the assets are deposited. Obviously, the supervision is easier when the counterparty is keeping the assets in the name of the depositary rather than in the name of the fund. Indeed, if the assets are held by a third party in the name of the fund, there is no contractual link between the depositary and the counterparty. The depositary must ensure that the third counterparty informs it directly and on a permanent basis of the situation of the assets of the fund. In addition, the supervision encompasses the verification by the depositary of the qualification and the solvability of the correspondents and counterparties where the assets of the fund are kept. This means that the depositary generally fulfills due diligence on the given correspondents and counterparties. In this respect, preference is generally
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given to rated companies belonging to big banking groups. The selection is usually based on several criteria such as the analysis of the financial situation and of the operational and professional competences of the correspondent, verification of the sufficient insurance against fraud, errors and omissions and on the separation in the books of the correspondents proprietary assets and those deposited by the fund. The duty of supervision implies for the DB a responsibility for its wrongful failure to perform its obligation or its wrongful improper performance thereof. In case of damage, the depositarys negligence with respect to its duty of supervision and the correspondence between cause and effect must be proved. The depositary has discharged its duty of supervision when it is given that, from the start and during the whole duration of the contract, the correspondent with which the assets of the UCI are on deposit are reputable and competent and have sufficient financial resources. The duty of supervision of the assets of the UCI cannot be delegated and consequently the liability for such supervision always resides with the DB. It cannot release itself from his duty of supervision, even if it has been assisted by a third party in the execution of its tasks or if he has entrusted the execution thereof to its representative.

Local custodian
3. Placement of the order in the Market / Instructs Local Custodian

Clearing system
9. Settlement (swift)

KBLs local subcustodian


10. Report of the settlement of operations (swift)

Broker
2'confirmation of transaction 1. Investment order YES 2. Confirmation of transaction 8. Settlement Instructions (swift MT 54X)

KBL / AO
11. Bank statements 12. Daily securities statements (MT535)

EFA / OE

EFA/Accounting 13. Daily reconciliation (7-11+12) between system & securities statement from KBL (any discrepancy is notified to KBL)

Investment Manager 1' matching (c)

NO

4. Matching (c) 2-2' OK?

YES 5. A priori 7. Booking in the control NAV

4' Incorrect Matching corrective action 6' notify the breach - Trade process suspended untill further decision / corrective action

6. Notification of breach NO

OK?

YES

EFA

YES

KTL OPC Advisory & NO Compliance Analyse OK?

Table5.3 Investment in transferable securities via external broker


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Regarding the supervision of certain operations related to the subscription and redemption of shares or units of a UCI, the depositary bank must ensure that the sale, issue, repurchase and cancellation of units made on behalf of the UCI are carried out in accordance with the law or the constituting documents of the UCI. It must also ensure that, for transactions involving the funds assets, any consideration is remitted to it within usual time limits and that the funds income is applied in accordance with management regulation. In addition, in the case of FCPs and only in this case, the DB must ensure that the value of units is calculated in accordance with the law and the management regulation and carries out the instruction of the ManCo31. Eventually, the depositary bank also has a mission regarding the current administration of the assets of an FCP. In particular, the DB must carry out all operations concerning the day-to-day administration of the assets of the FCP such as encashment of coupons and dividends, encashment of capital reimbursement and execution of corporate actions (exercise of rights, conversions, splits, etc.). These tasks in fact do not defer from the obligations of the custody contract under Civil Law applicable to any DB of UCIs under statutory form.

5.2.4 Responsibility of the depositary bank under theCivilCode


Where the assets of the UCI are on deposit with the depositary itself, its liability is governed by articles of the Civil Code applicable to deposit agreements. The DB assures the safekeeping of the object that has been entrusted to it. If the object represents securities, the DB has to keep those securities safe and encash for its owner the revenues linked to those securities. The DB has to return upon simple requests the assets in deposits to its owner. This represents an obligation of result and the DB cannot wave its responsibility unless it can prove that it cannot return the assets due to the fault of a third party, the client himself or a case of absolute necessity. In Luxembourg, there exist three liability regimes which applies to a DB of a UCI: liability for the tasks foreseen in the Directive 85/61132, liability for the tasks foreseen by the Civil Code when assets are directly held by the depositary bank and liability for tasks that are specifically foreseen in the depositary agreement where such tasks are not expressly referred to by the Directive 85/611.

31. Unless they conflict with the law or the management regulations. 32. Assets held with third parties.

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J.P. Morgan Bank State Street RBC Dexia BNP Paribas Brown Brothers Harriman (BBH) UBS DekaBank Deutsche Girozentrale BNY Mellon Societe Gnrale CACEIS Pictet & Cie KBL European Private Bankers DZ Bank International Crdit Suisse Citibank Other

50; 2% 50; 2% 52; 2% 53; 2%

467; 17%

468; 17% 266; 10%

77; 3% 96; 4% 108; 4% 114; 4% 123; 5% Assets in USD bn

228; 9% 138; 5% 164; 6% 219; 8%

Table 5.4 Ranking of Luxembourg depositary banks: market shares by assets


RBC Dexia BNP Paribas State Street KBL European Private Bankers CACEIS J.P. Morgan Bank Brown Brothers Harriman (BBH) UBS DZ Bank International Banque de Luxembourg DekaBank Deutsche Girozentrale Socit Gnrale Banque Private Edmond de Rothschild ING Pictet & Cie Others

3074; 25%

1241; 10%

1171; 10% 984; 8%

283; 2% 285; 2% 315; 3% 330; 3% 358; 3% 434; 4% 438; 4%

801; 7% 685; 6% 484; 4% 520; 4% 638; 5%

Table 5.5 Ranking of Luxembourg depositary banks: market shares by number of funds/sub-funds

5.3 Part II: Management Company


5.3.1 The role of a Management Company under UCITS III
Under UCITS III, a ManCo is mandatory only for FCPs. A SICAV can assure itself the daily management of the fund but it can also appoint a ManCo. ManCo are regulated under chapter 13 of the 2002 law. The appointment of a ManCo requires prior authorization from the CSSF before starting business. Such authorization is valid for all member states of the European Union i.e. a ManCo authorized in another member state may carry out its activities in Luxembourg. The establishment of a branch does not require any additional authorization. The main legal forms taken by ManCos are traditionally those
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of Public or Private limited Company or Partnership limited by shares. The permitted activities of the ManCo are investment management, administration, distribution and as a derogation discretionary portfolio management, investment advice and safekeeping and administration in relation to shares or units of UCIs.
Custodian bank (KBL) Auditor

Designates SICAV Board of Directors (min. 3) Management company agreement LUXEMBOURG UCITS III MANAGEMENT COMPANY Minimum 3 directors and 2 conducting ocers Mission: supervision of the delegation, risk control and general rules of conduct Delegation through agreements Distribution Administration (KTL/EFA) Portfolio Management

Table5.6 Management Company under UCITS III Chapter 13 of the 2002 Law imposes several requirements on the structure to ManCos. ManCos are supposed to meet certain capital requirements. Initial capital must be at least 125000 and the required capital increases with the size of the portfolio under management. When the value of portfolios exceeds 250million, the ManCo is required to hold an additional capital of 0.02% of the amount of the portfolio value exceeding 250 million with a maximum of 10million in capital. Regarding its structure, the ManCo must nominate 2 conducting officers of sufficiently good repute and experience. In addition, the CSSF must be able to contact those persons directly and in principles one of the conducting officers must be based in Luxembourg (substance requirement). The conducting officers must have at their disposal all technical and IT equipment necessary to enable them to assume their responsibilities and perform the functions imposed on them by the 2002 Law. To ensure independence between the ManCo and the DB, conducting officers of the ManCo cannot be employed by the depositary of a UCITS under their management. Besides the conducting officers, the ManCo has to provide a business plan to the regulator. Especially, the application to set up a ManCo must indicate the organizational structure of the ManCo, the scope of services planned for the next 3 years, the investment policy (financial instruments and markets) and the risk management process.
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In addition, the CSSF must be informed of the identity of the shareholders and the members as well as of any qualified holdings (>10%). The head office and registered office must be located in Luxembourg. The central administration must also be in Luxembourg. Central administration must be understood in the broadest sense and includes the areas of infrastructure, accounting and information systems. For instance, necessary human resources must be in Luxembourg but can be outsourced under specific authorization by the CSSF. The CSSF also requests the communication of the persons in charge of the monitoring of certain aspects of the day-to-day management like risk management, internal audit, etc. Regarding IT equipment control, the CSSF must receive a description of computer hardware and software and data sources in use and the ManCo must demonstrate that it has sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing and internal control mechanisms. The ManCo can nevertheless delegate some of its functions but the delegation does not affect their responsibilities in any way. Before delegation, the CSSF must be informed upfront of the tasks that are delegated, the identity of the entity to which the functions are delegated and the procedures put in place to monitor the delegated activities. The management of the ManCo has to receive regular reporting on the delegated activities and must be able to access the accounting data for the managed UCITS. In addition, the mandated entity must be qualified and capable of undertaking the delegated functions. It must also produce evidence that it has the appropriate human and technical resources. The delegation of the investment management duties are only authorized for supervised entities and should in principle be disclosed in the prospectus of the UCITS. The ManCo must also follow several rules of conduct such as to act honestly and in the best interests of its clients, to act with due skill, care, diligence, to try to avoid conflict of interest and where they cannot be avoided to ensure that its clients are treated fairly and finally to comply with all regulatory requirements so as to promote the best interests of its clients. Management companies also have to send financial reports to the CSSF on a quarterly basis. As already mentioned, the ManCo also has to follow risk management procedures. The RM process must be implemented to enable to monitor and measure at any time the risk of its positions. The CSSF Circular 07/308 provides guidelines for the implementation of a RM framework covering international requirements, the scope of RM relating to each type of risk identified and details of risk limits. The circular focuses on financial risks namely global risk (market, liquidity and credit risk), counterparty risk and concentration risk. A UCITS must self-assess itself as sophisticated, i.e. making significant use of financial derivatives or complex strategies and instruments, or non-sophisticated, i.e. making limited use of financial derivatives and mainly for hedging purposes. All or part of the RM process may be delegated to a third party recognized in this type of activities but the ManCo remains responsible for ensuring the correct implementation of an adequate RM process.
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5.3.2 The management company of a non-UCITS


Chapter 14 of the 2002 law applied to ManCo of non-UCITS. These management companies can only manage UCIs that are not UCITS. The limitation comes from former directive 85/611 on UCITS stipulating that the scope of a ManCo should be limited to the management of UCITS, the aim being to protect the interests of the share or unit holder by assuring a maximum specialization of the ManCo and avoiding conflicts of interests with other activities. This limitation has been extended to non-coordinated UCIs under the Law of 1988. Activities generally cover the intellectual management of the UCI but can also encompass all the tasks linked to the central administration of a UCI and may be extended to the keeping of the register of the share/unit holders and the distribution of those shares or units. Under certain conditions, the CSSF permits under chapter14 management companies of managed UCIs which are subject to EU-equivalent supervision. The same rules as for chapter 13 management companies apply to chapter 14 ManCos regarding authorization, legal form, central administration and registered office.

5.3.3 Management companies under UCITS IV


Some changes were introduced by UCITS IV to the management company legislation. The main change is undoubtedly the ManCo passport. The objective of the ManCo passport is to allow a ManCo domiciled in one country in the European Union to set up and manage funds domiciled in other European countries. This allows remote fund administration by management companies located in another member state that the UCITS. The ManCo is supervised for its organization (risk management, conflicts of interests, delegation arrangements, etc.) by its home member state authority. The authority of the home member state of the UCITS is only authorized to supervise the constitution and functioning of the UCITS. More details about UCITS IV management company passport are reported in Tables 5.7 to 5.10.

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Method of service Delegation rules Additional tasks and duties

Applicable laws in case of remote Management Companies

Authorisation procedure and powers

Under UCITS III ManCo and UCITS have to be domiciled in the same country and despite passporting possibilities foreseen, this possibility was not accepted by EU supervisory authorities A ManCo may provide the services in the Home Member State of the UCITS (UHMS) through the establishment of a branch, or the use of freedom of services Delegation possibilities of a ManCo will be subject to the regulation in the Home Member State of the ManCo (MHMS) ManCo needs to ensure that: It deals correctly with investor claims and investors may exercise their rights without restrictions (ever if the ManCo is using freedom of services) Information requests of the public or the UHMS authority are answered If MHMS not equal the Home Member State of the depositary, ManCo and depositary need to sign an agreement in which the depositary is authorised to receive all information necessary for the performance of its functions Changes in programme of operations, organisation, address or management needs minimum one month prior notice to MHMS and UHMS authority to allow them to take a decision on those changes Each ManCo providing its services to UCITS through the provisions relating to freedom of services, needs to: Comply with the UHMS rules in relation with constitution and functioning of the UCITS Comply with the MHMS rules in relation with the organizational measures (risk management process, rules of conducts and conflict of interest procedures) during the administration of the UCITS More details have been issued on the level 2 measures UHMS Authority: Fund rules, choice of the ManCo and the depository (Verification of suitability of Risk Management Process + Delegation Arrangements by UHMS Authority) MHMS Authority: ManCo to be approved by its MHMS authority and MHMS authority to inform UHMS authority about any changes in approvals and licenses

Table5.7 Management company passport (1)

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Fact overview

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Regulators MHMS authority to inform/deliver to UHMS authority: communication Any request by ManCo to offer asset management by freedom of requirements services, including a description of organisation of ManCo and obtained licenses (initially and ongoing) and any disciplinary steps Any approved delegation arrangements for services rendered by ManCo to UCITS The Certificate of Compliance for ManCo regarding requirements of the MHMS Within ten days by clarifications on licenses and authorisation if requested by UHMS authority UHMS authority to inform MHMS authority Fund rules, choice of the ManCo and the depository In case of breaches and required actions, MHMS authority to instruct ManCo and report to UHMS authority Breaches UHMS authority should be able to impose appropriate administrative sanctions and measures for violation of the rules which fall within its exclusive remit, independent of MHMS Claims against a UCITS and a remote ManCo in relation to the management of a UCITS should be lodged by investors with a judicial authority established in the UHMS in accordance with the law applicable to the UCITS Timelines Establishment of a Branch for collective ManCo HMS authority within two months after receipt of portfolio complete file to object or to submit to UCITS HMS authority (no management authorisation if no reaction) activity UCITS HMS authority within two months after receipt of notification of ManCo HMS authority (automated authorisation if no reaction) Changes in programme of operations, organisation, address or management needs minimum one month prior notice to ManCo and UCITS HMS authority Freedom of services ManCo HMS authority within one months after receipt of complete file to inform UCITS HMS authority (including risk management description, compensation scheme description and information on license and eventual restrictions) UCITS HMS authority within two month after receipt of notification of ManCo HMS authority (automated authorisation if no reaction) Changes in programme of operations, organisation, address or management needs notice to ManCo and UCITS HMS authority

Table5.8 Management company passport (2)

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ManCos should set up independent compliance and internal audit functions; These functions can be delegated under certain conditions ManCos should establish, implement and maintain effective procedures in relation to complaints handing, personal transactions and record keeping (portfolio transactions, subscription and redemption orders) Level 2 measures also provide detailed rules regarding the identification, prevention, management and disclosure of conflict of interests ManCos have the duty to act in the best interest of UCITS and investors. This should imply accurate asset valuation, market timing and late trading prevention, transparency and duty to prevent undue costs for investors ManCos should implement documented and effective arrangements to ensure that investment decision on behalf of the UCITS are carried out in compliance with the investment policy and the risk limits of the UCITS In the case of direct sale of fund shares, ManCos should act honestly, fairly and professionally in accordance with investors interests. ManCos should test if investment is appropriate for the investor (Appropriateness Test), handle client orders according to the fund prospectus and provide detailed reporting on subscriptions and redemptions to investors ManCos should take all reasonable steps to obtain the best possible result when executing transactions for the UCITS (Best Execution) Inducements are seen as one of the main sources of conflicts of interests in the context of portfolio management and have received specific regulation All payment (or non-monetary benefits) received or made in relation to the activities of investment management and administration to the UCITS must satisfy three conditions: 1. they are adequately disclosed to the UCITS (and the unit holders via durable medium) before rendering the service. 2. they are designed to enhance the quality of the relevant service. 3. they do not impair compliance with the ManCos duty to act in the best interest of the UCITS Exceptions: Fees, commissions or non-monetary benefits paid or received by the UCITS Fees which are necessary for the provision of the relevant service and which by nature do not generate conflict of interests (proper fee)

MiFID conduct of business rules

MiFID inducement rule

Table5.9 Management company passport (3)

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Fact overview Additional non-MiFID provisions

FUND INDUSTRY IN LUXEMBOURG UCITS improvements ManCos senior management is responsible for approving and monitoring periodically the general investment policy of the UCITS ManCos should implement basic principles regarding the organisation of the accounting to ensure permanent identification of UCITS assets and liabilities and accurate valuation of assets and NAV calculation ManCos should implement policies in relation to the remuneration of staff whose activities materially impact the risk profile of the UCITS managed by the ManCo ManCos should, to the exclusive benefit of investors, apply strategies for the exercise of voting rights attached to the instruments held by the UCITS The distinction between sophisticated and non-sophisticated UCITS is abandoned. The labelling had been replaced by a selection of the most appropriate methods for market risk analysis based on the risk profile of the UCITS The assessment of all risks and their materiality will be evaluated within the overall risk profile of the UCITS. Liquidity and operational risks are explicitly designated to be material The global exposure (market risk) will need to be monitored on a daily basis An initial validation of the VaR model will need to be performed by an independent third party Leverage will need to be monitored independently from the method chosen for global exposure computation The netting hedging opportunities when using the commitment approach are more advanced and more specific Back testing of VaR models must be performed on a monthly basis. Reporting to senior management should be done at least on a quarterly basis if the number of overshooting over the last year (250 business days) exceeds four Counterparty risk is measured on the basis of the positive Markto-Market value of contract (the add-on for future credit exposure will be abandoned). Initial margin posted to and variation margins receivable from brokers should be included in the computation of the counterparty limit Disclosure requirements will increase for the prospectus and the financial statements (VaR levels, leverage, etc) A reporting function should be appointed which informs the Board as well as the senior management (i.e. conducting officers) on a regular basis. The reporting should be specific to the different recipients (i.e. different reporting contents for BoD and senior management)

Focus Risk Management

Table5.10 Management company passport (4)

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6. Organization and supervision ofinvestmentfunds


6.1 Introduction
In this chapter, we present the basic principles of the organization of the supervision of investments funds especially focusing on Luxembourg. We also enlarge the analysis started in previous chapters by giving additional details on the different parties which are involved in the life of investment funds. A specific focus is given on the mission of the auditor of the investment fund as well as the role and responsibilities of the custodian banks. These two actors are playing an active role in the protection of the interest of the investors and have seen their duties and obligations significantly enlarged recently and are expected to continue to evolve in the coming years.

6.2 Context
At the end of 2011, the total net assets worldwide of the investment fund industry amounted to around EUR 18580 billion with almost half this amount managed in the United States. Table 6.1 highlights that Luxembourg is the largest fund services market in Europe and the second largest in the world after the United States. The top 10 players represent a market share of almost 90% of the total investment fund industry in 2011, a value which is almost unchanged with respect to the situation in 2005. It is however worth noticing that Luxembourg has seen its market quite stable during the period where the United States lost 2%. Besides the United States and Luxembourg, this top 10 is composed among other by France, Australia, the United Kingdom and Ireland. In addition, table6.2 shows that top 50 worldwide asset managers account for more than 70% of the market with Black Rock, State Street and Allianz at the top of the list.

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Top 10 countries by net assets of the global investment fund industry in 2005, EUR billion
Total Market share

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Top 10 countries by net assets of the global investment fund industry in Q3 2011, EUR billion
Total Market share

USA Luxembourg France Australia UK Ireland Canada Japan Hong Kong Italy

7,548 1,386 1,155 593 463 463 415 398 390 382

50% 9% 8% 4% 3% 3% 3% 3% 3% 3%

USA Luxembourg France Brazil Australia Ireland Japan Canada UK Germany

8,900 1,709 1,078 1,059 1,003 762 743 650 595 223

48% 9% 6% 6% 4% 4% 4% 4% 3% 1%

Table6.1 Evolution of the global investment fund industry from 2005 to 2011 source: EFAMA, Deloitte analysis

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Asset Managers
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 13. 14. 16. 17. 18.

Assets in EUR billion, 2010


Blackrock 1,332 1,178 1,031 873 777 698 670 530 525 505 499 496 476 466 438 393 387 387 355 345 343 297 295 293

Market share, %

Asset Managers
26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50.

Assets in EUR billion, 2010


293 289 281 280 273 272 261 261 261 239 223 200 196 193 193 193 176 173 168 167 166 166 160 158 156

Market share, %
1.0 1.0 1.0 1.0 0.9 0.9 0.9 0.9 0.9 0.8 0.8 0.7 0.7 0.7 0.7 0.7 0.6 0.6 0.6 0.6 0.6 0.6 0.5 0.5 0.5

2,335 8.0

Generali Investments TIAA-CREF Aviva Investors Credit Suisse T.Rowe Price Federated Investors BNP Paribas AM BNY Mellon Cash Wells Capital Mgt APG Group Columbia Mgmt MFC Global Inv Mgt M&G Investments Aegon AM Morgan Stanley IM Pioneer GAM Nomura AM UK Eurizon Capital Schroders New York Life Inv Union Investment Scottish Widows KBC AM Standard Life Inv

State Street Global Inv. Allianz Global Investors Vanguard Group JP Morgan AM BNY Mellon AM Int PIMCO Amundi Group BNP Paribas Inv Partners Goldman Sachs AM Int Natixis Global AM DB Advisors Legg Mason Northern Trust GI UBS Global AM Franklin Templeton Inv

4.6 4.0 3.5 3.0 2.7 2.4 2.3 1.8 1.8 1.7 1.7 1.7 1.6 1.6 1.5 1.4 1.3 1.3 1.2 1.2 1.2 1.0 1.0 1.0

12. AXA Investment Managers

15.Pramerica Investment Mgmt

40. MEAG Munich Ergo AM

19. Wellington Mgt Company 20. Legal & General Inv Mgmt 21. 22. 23. 24. 25.
AllianceBernstein ING Investment Mgmt HSBC Global AM Invesco MassMutual FG

Table 6.2 Top 400 worldwide asset managers source: 2010 summer investment & pensions Europe

6.3 Organization of an investment fund: basic principles


As we have already explained, a UCI must satisfy several conditions among which the use of the savings for the purpose of collective investments, the collection of these savings from the public (not restricted to specific investors) and the management of the fund in accordance with the principle of risk spreading. Among the UCIs, there exist two different legal forms: FCP and SICAV. FCPs are not a legal entity but an investment vehicle run by a management company on behalf of joint owners who are liable only up to the amount contributed by them and whose rights are represented by units intended for placement with the public by means of a private offer. As a consequence, investors are not shareholders but unit holders and there is no General Assembly of unit holders and no Board of Directors meetings other than the Board of Directors of the Management Company. On the other hand, SICAVs are legal entities which must have their registered offices in Luxembourg. Investors are shareholders of the company and their rights are represented by their shareholdings in the
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SICAV. As for any incorporated entity, there is a General Assembly of shareholders and there are meetings of the Board of Directors. As indicated by its name, a SICAV has a variable capital. Its capital is always equal to its Net Assets. Consequently, unlike for other companies, a change in its articles is not required each time the level of capital issued changes. Among these two types of funds, we can further distinguish within the legal framework Part I and Part II funds33. Part I funds (or UCITS funds) are openended funds (i.e. funds in which subscriptions and redemptions are possible at any time) which benefit from a European Passport34 which allows them to be sold all across Europe. They face more restrictive investment policy and higher investor protection. Part II funds are more flexible funds which do not qualify under Part I. This may be due among other things to the fact that they are closeended (restrictions on redemptions), that capital is raised outside the European Union, or that they have special investment policy and invest in assets which are not eligible under the UCITS framework. Within an investment fund, different sub-funds for instance focusing on different investment policies in terms of assets (equity, bond or money market subfund, etc.) can be created. The rights of the investors or debtors toward one sub-fund are exclusively limited to the assets of this sub-fund. Each sub-fund has its own separate subscriptions, accounting, investment objectives and portfolio of investments. No compensation of losses is possible between sub-funds of the same fund. Within sub-funds, there can be different asset classes which may be sold to different kinds of investors (i.e. retail or institutional investors). They may differ by the specific expenses charged to the investors. Lastly, shares can be split in terms of their distribution (dividends) or capitalization and currency denomination characteristics.

33. See also chapter3 34. See also chapter8.2 and 8.5 relating to the distribution of investment funds

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Legal framework

UCI

Assets in EUR billion, 01/2012

FCP

SICAV

Legal form

623.1

1,523.4

Contractual form No legal personality managed by a management company

Corporate form Own legal personality managed by shareholders and BoD

Part. I (UCITS)

Part. II

Part. I (UCITS)

Part. II

Legal regime under Lux law 17 December 2010

437.4

80.1

1,272.1

121.8

Table6.3 Legal framework of UCIs under the 2010 law source: Fitzrovia, December 31, 2011: team analysis

Sub-fund

Retail shares

Institutional shares

No load shares

DIS $ $

CAP $

DIS $

CAP $

DIS $

CAP

Table6.4 Sub-fund structure


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6.4 The investment fund industry in Luxembourg


Luxembourg is a relatively small country with around 500000 inhabitants. GDP growth over the last few years has been significant (average annual increase of 2.1% over the last 5 years) with an unemployment rate of 8.3% at the end of 2011. Luxembourg has been largely affected in 2009 by the financial crisis because of the huge concentration of the Luxembourg economy around financial services. Regarding investment funds, there are more than 13 000 sub-funds active in Luxembourg at the end of 2011. Among those sub-funds, 80% are vanilla funds (traditional investment policies and assets), 15% are funds of funds and the remaining part is divided into hedge funds, real estate and private equity funds. Detailed breakdowns per funds types are given in tables 6.5 through 6.7
Luxembourg Financial Centre Categories Data 143 Date 9 Feb. 2012

Number of banks
Luxembourg Economic Data

Balance sheet total Employment Number of SICARS

EUR 793.98 bn 31 Dec. 2011 26,695 persons 31 Dec. 2011 273 10 Feb. 2012 31 Jan. 2012

Population :

511,840 inhabitants (Jan. 2011) 2.9% (Jan. 2012) EUR 34.256 bn (2010)

Inflation : GDP (in value) :

179 Number of Management Companies (Chapter 15 law 2010)

Employment Total net assets under management Number of PSF Balance sheet total Net profit Employment Number of custodians Number of management companies

2,516 persons 31 Dec. 2011 EUR 2,096 bn 31 Dec. 2011 205 EUR 397 m 10 Feb. 2012 31 Dec. 2011 31 Dec. 2010 31 Dec. 2010 31 Jan. 2012

GDP in % of growth : 6.6% (2007) 1.4% (2008) -3.7% (2009) 3.2% (2010) 3.1% (2011) Unemployment rate : 8.3% (Dec. 2011)

EUR 10.328 bn 31 Dec. 2011 11,806 persons 31 Dec. 2011 69 200

Number of central administrations 122

Table 6.5 Luxembourg economic data source Statec, CSSF and Deloitte

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Percentage of subfunds by type of fund in Luxembourg

100%

3.02%

2.40%

1.30% 16.50%

1.50% 15.53%

3.83%

90%

16.98%

17.40%

15.30%

80%

70%

60%

50% 80.80%

40%

80.00%

78.50%

79.80%

80.87%

30%

20%

10%

0% 2007 Total (nb 10,671 of subfunds) 2008 11,913 2009 11,989 2010 12,937 2011 13,294

Table 6.6 Percentage of sub-funds by types of funds in Luxembourg source: ALFI

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Luxembourg statistics Number of UCI by type, Dec. 2011

1,937

514 289

1134 1,867 3837,0 846

299

722

33 Other

27 6

Total

FCP

SICAV

Sub-Total

Total

Part I

Part II

SIF

Table6.7 Number of UCIs by type, Jan 2011 source: Deloitte

6.5 Parties involved in the life of an investment fund


There is a large number of parties involved in the life of a fund among which the promoter who has the idea to launch the fund, the investment manager who manages the financial assets, the investors and the distributors, the regulator, the external auditor and the depositary bank (see Table6.8). The CSSF must first approve and then supervise any existing fund in Luxembourg. In practice, when a fund promoter wants to launch a fund, he has to provide the CSSF with document for their approval. These documents include the articles of the incorporation, the prospectus (commercial document for investors
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describing the investment fund), the Key Information Document (summary of the prospectus)35, all the contractual agreement between the fund and all the intervening parties in the life of the investment fund, the proof that the central administration is located in Luxembourg, the name and resume of the directors and the marketing strategy. Once the fund is launched, the CSSF supervises the fund on a continuous basis. In practice, every change to the documents and information which are submitted for authorization are to be submitted to the CSSF. A copy of the fund annual reports is to be forwarded to the CSSF in addition to financial reporting. The CSSF also has the right, either directly or through intermediaries, to examine the books and records of a fund. All these requirements are intended to protect investors.

Management Company

Promoter Investment Manager

Broker

Advisor/ Lawyer

UCITS

Investors/ Distributors

External Auditor Regulator Transfer, Domiciliary, Administrative Agent

Depositary Bank

Table6.8 Parties involved in the life of an investment fund In practice, the supervisor heavily relies on the external auditor for the day-today supervision of the investment fund after that it has been initially approved. Every fund in Luxembourg has to appoint an external auditor approved by the CSSF. The auditor will audit the annual accounts. The auditor has the obligation to notify the CSSF when it notices any irregularities in the investment fund. Irregularities can entail for instance incorrect valuation, non-conformity to investment restrictions and policy, etc. The auditor can also ask for corrective actions from the investment fund.
35. Readers are referred to Chapter 1 and 3 for additional details.

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The role of the Custodian Bank is to ensure the safe-keeping of investments. It must have knowledge at any time of how the assets of the fund have been invested and where and how these assets are available. It also has to ensure the regularity of the operations and make sure that the sale, issue, purchase of shares or units are made in accordance with the investment policy. Registrar and transfer agents36 also play a role in supervising the activities of the fund. They notably perform anti-money laundering checks relating to investors. They also hold the register of shareholders of the fund and manage capital call and commitments. Lastly, the domiciliary agent provides the registered office and fulfills several responsibilities among which the provision of office accommodation and other facilities to the fund, the payment of bills on behalf of the fund, the provision of assistance with the funds legal and regulatory reporting obligation including shareholders and board of directors meeting and the safeguard of the funds prospectus and related documents.

6.5.1 Organization of investment fund supervision


In this section, we present in more details the organization of the supervision of the investment fund and of the three main players of the supervision i.e. the regulator or the CSSF, the external auditor and the Custodian Bank. The scope of the regulator intervention is defined in the Law of December 2010 relating to undertakings for collective investments. It defines the functions carried out by the CSSF, the purpose of the supervision, the authorization process and the other missions of the regulator. The main functions of the regulator are the general organization, management and operation of databases and information systems, the macro-prudential supervision of UCIs, the review and management of particular situations of UCIs, the analysis of specific economic aspects and the instructions and supervision of UCIs. The purpose of the supervision of UCIs is to verify the compliance with the regulations and constitutive documents. Furthermore, the prudential supervision is based on the analysis of financial reporting transmitted by UCIs, the on-site inspections and the scrutiny and follow-up of reports provided by the approved statutory auditor. The CSSF is also in charge of reviewing the authorization requests to exercise UCI activity. As regards UCIs, these conditions mainly concern the legal form of the entity, the central administration, the quality of the promoter, the repute of the members of the administrative, management and supervisory bodies as well as that of the shareholders, the financial bases and the custodian and the control of annual accounting documents by the auditor with adequate professional experience. At the international level, the CSSF ensures the follow-up of all the international files in relation to UCIs and participates in the analysis and

36. See also chapter4.4

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drawing-up of advice to EU working documents. The CSSF has in 2011322 staff members to ensure these functions.
Questions ? Portfolio of investments Capital Subscriptions Redemptions Retained reserves Result of the period Payables Investments Redemptions Expenses Net Assets

On which areas the auditor has to focus? Where are the (higher) risks? How to obtain evidences?

Bank deposits Receivables Sold investments Subscriptions Interest Dividends Prepaid expenses Formation expenses Other Assets ASSETS Number of shares outstanding NAV per share

= Currrent Liabilites

Other Liabilities LIABILITIES

Table 6.9 Net Asset Value Calculation of an investment fund and auditors risk-based approach to NAV checks. The auditor of an investment fund is appointed by the general meeting of shareholders of the fund (SICAV) or by the board of directors of the management company (FCP). It issues an opinion on the truth and fairness of the financial position of the fund as presented in the annual report. It is required to report to the CSSF all material breaches of the Law or regulations every problem affecting the continuous functioning of the UCI and/or leading to a refusal to certify the accounts. It must also inform the CSSF when it becomes aware that the information given to the CSSF and/or unitholders is incomplete or incorrect. It issues a review report on any material NAV computation error or breach of investment restrictions and their correction and attests the effective payment of the resulting compensation of the UCI and the unit holder. The auditor also provide a Long Form Report whose purpose is to report on the finding of the auditor in the course of its audit concerning the financial and organizational aspects of the UCI comprising inter alia its relationship with the head office, the custodian and the other intermediaries (investment managers, transfer agents, distributors, etc.).

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Classes of Transactions and Events for the Period under Audit All transactions are input and processed once (i.e., transactions such as purchase/ sale on investment, corporate actions, subscriptions/ redemptions ...) Recorded transactions or events are not valid (i.e. transactions are not booked on relevant UCI) Transactions or events are inaccurately recorded (i.e. wrong number of shares purchased, wrong price, wrong currency....). Transactions or events are recorded in the wrong accounting period (i.e. dividend recorded at pay date instead of ex-date). Assets, liabilities, ... are not valued correctly (i.e. UCI portfolio is not valued correctly) Transactions or events are inappropriately classified or presented in the financial statements (ie. Cash and receivable or portfolio).

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Potential error Completeness

Account Balances at the Period End Assets, liabilities, or equity interests are not recorded (i.e., portfolio, capital, income, ... are missing).

Disclosures Relevant transactions, events, or other matters are not disclosed (i.e., matters required to be disclosed are missing). Disclosed transactions, events, or other matters are not valid. Transactions, events, or other matters are inaccurately disclosed.

Validity

Recorded assets, liabilities, or equity interests are not valid. Assets, liabilities, or equity interests are inaccurately recorded.

Recording or accuracy

Cutoff

Maybe not impact Or NAV impact

Potential misclassification (i.e. between cash and portfolio)

Valuation

NAV is misstated

NAV is misstated

Presentation

Assets, liabilities, or equity interests are inappropriately classified or presented in the financial statements.

Transactions, events, or other disclosed matters are not classified and presented in the financial statements in an understandable manner.

Table6.10 Six audit objectives

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Regarding Net Asset Value calculation, the auditor is responsible for verifying the validity of the calculated NAV. In practice, auditors apply a risk-based approach which consists in identifying for all kinds of funds what are the main kinds of risk regarding NAV calculation errors (investment portfolio composition, exchange rate, over-the-counter financial assets, etc.). This approach is illustrated in table 6.9. The main audit objectives reported in table 6.10 are summarized below. The main audit objectives can be generically summarized as: Completeness: to make sure that every transactions have been recorded Validity: to make sure that recorded transactions are valid Recording or accuracy: to make sure that the accounting treatment followed is the right one Cutoff: to make sure that every transaction is booked in the correct financial year Valuation: to make sure that assets and liabilities are valued correctly Presentation: to make sure that transactions are appropriately classified in the financial statements
Audit of financial statements Opinion (true and fair view) on the FS (reserves, qualification, ...) FS presented in accordance with accounting standards (i.e. IFRS) The audit is performed in accordance with audit standards (i.e. ISA 700A) Special audit assignments When FS in accordance with other accounting standards Review of specific accounts only On simplified financial statements (i.e. ISRE 2400) Agreed upon procedures Specific tests and procedures with report on the result (i.e. ISRS4400) i.e. Compliance with investments restrictions and policies Limited review Analytical procedures and information requests Limited assurance Contribution in Kind, Liquidation

Table6.11 Audit types and conclusions The auditors objective is also to verify whether an investment fund complies with its investment objective and restrictions. The auditor must check the eligibility of the assets held by the investment fund. In the case of UCITS, eligible assets are transferable securities, money market instruments, recently issued securities, units of UCITS and UCIs, cash and deposits, derivatives and government and public securities (ancillary liquid assets are also allowed). These
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assets must be traded in a regulated market i.e. a market that is regulated, operates regularly, is recognized and open to the public. The maximum share of other assets in the investment portfolio of a UCITS is limited to a maximum of 10% (trash ratio). Furthermore, physical real estate and precious metals are prohibited. The auditor must also check the diversification limits imposed to investment funds (UCITS). Especially, a UCITS must not invest more than 10% of its total net asset in instruments issued by one corporate body and the value of all corporate investments which exceed 5% of its total net asset must not, in aggregate, exceed 40% of total net assets. Other investment restrictions concern the weight of government and public securities (maximum 35%), the bonds issued by an EU credit institution (maximum 25%), the counterparty exposure by over-the-counter derivatives (maximum 10% by counterparty if a credit institution or 5% otherwise) and the amount invested in cash balances and companies appearing in the same consolidated accounts (maximum 20%).

Madoff 1 Billions of assets lost (Ponzi scheme) that were managed by a SEC-registered company, B. Madoff Investment Securities LLC Three activities performed in the US by Madoff: broker-dealer, investment manager and depositary (for individuals and several investment funds, including Luxembourg) Luxembourg investment funds appointed Luxembourg financial institutions as depositaries that delegated the safekeeping of certain assets to B. Madoff Investment Securities LLC 2 Conflicts of interest (asset management vs depositary) Responsibility to return assets unclear and varying practices in EU under UCITS framework (hierarchy of the potential liabilities) Many actors in the investment value chain in multiple jurisdictions

Lehman Brothers 1 Some French investment managers using LBIE (Lehman Brothers International Europe) as prime broker for 3 hedge funds, with two financial institutions acting as depositaries September 2008: default of Lehman Brothers no segregation of client assets by LBIE expected lengthy, uncertain process after the bankruptcy for the return of the client assets 2 The French supervisory authorities AMF requested the two financial institutions to restitute the assets; the request was refused. AMF filed case in the French courts to require restitution. In April 09, French courts demanded full and immediate restitution of assets with Lehman Brothers as prime brokers, by the fund depositaries (Socit Gnrale and RBC Dexia Investor Services) of the hedge funds

Table6.12 Custodian Banks duties The custodian (or depositary) bank duties derive from the law of 201037 and the EU UCITS directive. The core responsibilities of the depositary bank are the safekeeping and supervision of assets. Regarding safekeeping, the depositary bank takes care of the investment fund assets under management and returns them upon demand of the beneficial owner. From the supervision perspective, the depositary bank need to know at any time where and how the clients assets are kept in custody and how the clients assets are invested. The DB also needs

37. See also chapter5.2

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to ensure that its sub-custodian network meets the required quality standards and financial soundness. Custodian banks also have control responsibilities. For FCPs and SICAVs, the custodian has the duty to ensure that subscriptions, redemptions and cancellations of shares or units comply with the law and the UCIs constitutive documents. It also has to ensure that the fund receives investment proceeds within acceptable timeframe and that income is distributed to the share- or unit holders in line with the constitutive documents. There are two additional control responsibilities for the custodian bank of FCPs. First, it must process and validate instructions of the management company with respect to the law and the FCP management regulations. In addition, it has the duty to ensure that the NAV is calculated according to the law and the FCP management regulations. A custodian bank can delegate the safekeeping of assets but cannot delegate its supervision mission.
Supervision duties of a depositary can not be delegated
Safekeeping Main responsibilities Return assets upon demand Take care of assets Ensure segregation of assets Supervision and safekeeping are complementary Supervision Main responsibilities Know where and how assets are in sub-custody How the assets are invested

Actual safekeeping of assets

Oversight of assets

Concept of Safedeposit box for the assets Is, in practice, often delegated to third parties

Supervision can not be delegated by the depositary Depositary is not discharged of its responsibility

Depositary may delegate the safekeeping of assets to counterparties, but remains in charge for supervision Responsibility of the depositary on the UCIs assets is not affected by the delegation of safekeeping During the entire relationship, the depositary must be satisfied of the delegates reputation (honorability), professional competence and credit worthiness (financial resources), as well as operational capabilities The depositary will have to carry out adequate measures to fulfill supervision duties on its delegates (e.g. due diligence, withdrawal right, ensure assets segregation, etc.) Market trends on UCIs have driven the necessity for Depositaries to work with counterparties other than their usual correspondents, these trends have a strong impact on the supervision complexity for Depositaries (e.g. Prime Brokerage)

Table6.13 Supervision duties of a custodian bank. The role and responsibilities of the custodian banks is under scrutiny by European regulator. The main objective of the review of the current regime is to ensure a common interpretation of the responsibilities within all EU countries and enhance investor protection
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Result of work undertaken by ESMA (previously CESR)* CESR mapping 1 Following the Madoff scandal, the CESR (Committee of European Securities Regulators) was requested in February 2009 to advise the European Commission on the measures to be taken by EU depositaries dealing with cross border management situations. Conclusions and recommendations 1 Need for clarification and harmonisation in the duties and responsibilities of UCITS depositaries Member States take diverging approaches to the depositarys liability in the case of loss of assets by the sub-custodian. The key issue for CESR is the conditions under which a depositary may delegate the custody function to a sub-custodian. 2 Introducing due diligence requirements covering the selection, appointment and periodic review of the sub-custodian and criteria on which the selection may be based (such as supervision by a public authority, verification of existence of assets by an independent auditor, organisational structure, and adequate record keeping by the depositary itself on the delegation) Review the definition of safekeeping in the UCITS directive that would be based on two broad elements: overall control of assets and segregation. Assets could not be transferred by the management company without prior knowledge or consent of the depositary. Segregation would include specific controls on rehypothecation and would clarify that sub-custodians should be obliged to put in place proper segregation arrangements.

As it appeared that the liability regime for UCITS depositaries was not consistently interpreted and implemented in the different Member States, the CESR carried out a mapping exercise including the requirements in place in each CESR member in the following areas: General criteria on the depositary (eligibility prudential organisational requirements) Liability of the depositary in case of custody activity delegation to a third party Obligation of means vs obligation of result Legal framework Requirements on depositaries when delegating

* ESMA (previously CESR) is the European Securities and Markets Authority. ESMA is an independent EU

Authority that contributes to safeguarding the stability of the European Union's financial system.

Table6.14 Possible next steps Recently, the concept of corporate governance has evolved in terms of requirements for the fund board of directors. The directors and conducting officers now have obligations of day-to-day supervision of some contractual arrangements (see Tables 6.15 and 6.16).

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What is corporate governance? A process and structure used to: direct and manage a business enhance shareholder value ensure financial viability
Shareholders

109
Purpose of corporate governance Specific to funds Fund directors oversee the management and operations of a company (the fund) but the focus of fund directors, however, is slightly different because of the structure of funds. Typically a fund has no employees and relies on the management company (where appointed), the investment manager and other service providers to run the funds day-to-day operations, the board focuses on the performance of these entilies under their respective contracts and monitors potential conflicts of interest determined at board level.

To build and strengthen Accountability Credibility Transparency Integrity Trust

Board of Directors Other Customers Day-to-day Management Other Regulators

Good governance protects all stakeholders: Shareholders Employees Customers Public Supervisors

It should inspire the confidence of shareholders and other stakeholders!

Table6.15 Introduction to corporate governance

Directors

... of sufficiently good repute and have sufficient experience, also in relation with the type of UCI concerned. Need prior authorisation from the regulator Obligations determine the funds strategy, risk profile and targeted investors determine investment policies and investment restrictions approve prospectus appoint custodian choose Management Company and other services providers and approve relevant contracts designate the conducting officers approve the risk management process may delegate the management (supervision) Conducting officers are "directors watchdog" Duties conduct the funds day-to-day activities overview the compliance of the investment strategy and policies define, continuously assess and overview the risk management process (independent from the fund management) monitor accounting and analytical reports liaise with services providers and supervise their activities oversee Anti-Money Laundering, market timing prevention and fair valuation procedures and practices keep abreast of legal/regulatory requirements and fund industry issues report to the board & others (CSSF, auditors, etc.) etc

Conducting officers

Table6.16 Fund directors and conducting officers

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7. Admission to trading of a UCI


7.1 Introduction
Mutual funds are fundamentally long term investments and are not designed to day trading. They can nonetheless be traded on stock exchanges as any other investment vehicle. In this chapter, we present the advantages of mutual fund trading on stock exchanges as well as the regulatory environment related to the admission of mutual funds to official listing and trading.

7.2 Exchanges and regulated markets


Historically, stock exchanges in Continental Europe were created mainly under the principles of the Code Napoleon and followed originally a monopolistic model with unity both in terms of time and location. The trading took place in a particular place (the exchange) and was done at given time by professionals who published binding prices. Stock exchanges developed during the 19th century following this framework all over Europe. The main function of the exchanges were to provide a regulated capital market whose primary role is to help finance the economy and to provide a meeting place of demand and supply of securities and for price information. Nowadays, the Napoleonic Code model has come to an end. The development of new technologies (mainly Information Technology) has led to a gradual shift to the Regulated Market and Market Undertaking models. The recent Markets in Financial Instruments Directive (MIFID) defines the European framework related to regulated markets. Under this directive, a Regulated Market means a multilateral system operated and/or managed by a market operator, which brings together of facilitates the bringing together of multiple third-party buying and selling interests in financial instruments in the system and in accordance with its nondiscretionary rules in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorized and functions regularly. The modern exchange acts as a market undertaking with highly diversified business fields. This includes admission to the market (primary market), trading (secondary market), market surveillance, provision of market data, exchange indices publication, information technology services, education of the public and, in certain cases, central counterparty, clearing and settlement. In a modern exchange, a Trading Member Firm (TMF) first brings in orders to be executed on the exchange. However, if we assume a TMF willing to sell 1000 shares, it will probably not (except in extreme cases) find a unique buyer for exactly the same number of shares but for instance 5 different counterparties
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buying 200 shares each. Because of the complexity of all the deals involved, the payment and delivery of the securities only take place two days after the moment the transaction was made on the exchange through a Central Security Deposit (CSD) which keeps an electronic record of all securities held by investors (in book entry-form) and of all the transactions between intermediaries in these same securities. At the end of the two days, the single position of 1000 shares is replaced by 5 new positions of 200 shares each in the records. In addition, major exchanges have introduced the concept of the Central Counter Party (CCP) which allows the TMF to deal with a single central counterpart instead of 5 different ones. The advantages of the CCP are depicted in Table7.2.
Infrastructures Trading
Margins

Members

Exchanges CCP CSD Central Bank

TMF CMF Settlement Agent Payment Agent

Clearing CCP Settlement Banking

Table 7.1 The modern exchange market infrastructure source: LCH Clearnet central counterparty March 2011

AAA 30 20 BBB 30 60 40 DDD 40 EEE 25 10 25 CCC 35 novation BBB

AAA

30 5 LCH.CLEARNET 10 DDD EEE 45

CCC

45

Reduction of credit risk: reduction of the number of exposures towards several different counterparties ??? only one exposure towards a good rating counterparty Reduction of the number of instructions sent to the settlement & delivery platforms (On the cash market, Ratio > to 97 %) Reduction of operational risk: reduction of the number of manual operations handled by the Back-offices, Optimisation of the guarantee deposits: reduction of risk exposure on positions.

Table 7.2 Multilateral netting source LCH Clearnet central counterparty March 2011
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Regarding the legal framework, the MIFID outlines the rules which regulate the carrying out of market activities in Europe (see Table 7.3). It defines a very broad scope for exchanges and harmonized transparency rules which are supposed to protect investors. In particular, the investor must have the best execution of his order which requires that all transactions be reported to the central authorities. MIFID also imposes that market data be published as close to real time as possible in a format that facilitates consolidation with a real time monitoring to ensure data integrity.
Must obtain best result for client based on wider criteria than price Must regularly monitor effectiveness of execution policy

EXECUTION Mandatory quoting in liquid shares for Systematic Internalisers No price improvement for retail trades Limit orders should be displayed MARKET DATA Published, as close to real time as possible, in a format that facilitates consolidation Real time monitoring to ensure data integrity PRICE FORMATION REPORTING

Blanket reporting obligation in all EU listed securities Obligation to transaction report to competent authority

Table7.3 Main requirement of MIFID source: London Stock Exchange However, MIFID unexpectedly created several adverse consequences such as a decrease in transparency due to the increased variety of trading modes, an increased resort to Over the Counter Markets (which also decreases transparency) and a fierce competition between the different types of markets or market venues. As a consequence, MIFID is currently being revised. Tables 7.4 and 7.5 show an example of how the introduction of MIFID led to more complex interactions between market players.

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LSE BIT NYSE Euronext Nasdaq OMX

113

Training

SWX

DB

BME

2 Clearing/ CCP CC&G LCH SIS x-clear Eurex

Link Up Markets Settlement NC SD M.Tit. Euroclear SIS Sega Clearstream Iberclear ISD VP SS EE CSD

LT CSD LV CSD

Table7.4 European equity landscape before MIFID source: FESE

NYSE NYX Turquoise Euronext Arca 2 3 3

LSE BIT 2

SIX BB Chi-x Group Equiduct 2 2 2

Nasdaq OMX2 3

Nasdaq OMX Europe 2

Training

BATS 2

DB 2

BME

Clearing/ CCP

Euro CCP LCH1

Code of conduct INTEROPERABILITY AGREEMENTS EMCF SIS x-clear

Eurex

Citi Link Up Markets Settlement

NC SD VP SS Euroclear M. Tit. SIS Sega European CSDs ISD EE CSD Clearstream Iberclear

LT CSD LV CSD

Table 7.5 Fragmentation of European equity market after MIFID source: FESE

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SHARES FIXED INCOME 5% On-Ex

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DERIVATIVES 20 % On-Ex OTC** 80 %

40 % On Ex 60 % OTC* OTC* 95 %

Table7.6 Exchanges and OTC markets source: FESE

7.3 Advantages of listing a UCI at the exchange


Now that we have briefly introduced the basics of the functioning of exchanges in general, we can focus on the advantages of mutual fund listing on exchanges.
Legal structure Part I (law 2002) Part II (law 2002) Law 22 March 2004 Law 15 June 2004 SIF Non-LUX UCIs Total Nr. of Share Classes 27042 4413 21 10 3788 1470 36744 % 73.60% 12.01% 0.06% 0.03% 10.31% 4.00%

Table7.7 Share classes by legal structure in Luxembourg Table7.7 displays the distribution of share classes in Luxembourg. Most share classes (almost all Part I funds) perform their NAV calculation every day while more sophisticated funds can have NAV Calculation on a less frequent basis (weekly, monthly or even quarterly). Although it may seem unnecessary to list on an exchange mutual funds which are valued on a daily basis, there exist several reasons related to share distribution, redemption and commission which can make the listing of mutual funds on exchanges advantageous. Luxembourg mutual funds are sold all over the world, which requires setting up a distribution network. Mutual funds can either have their own distribution network or rely on networks of banks and of specialized and independent distribution agents. If mutual funds are not traded on exchanges, investors have to go through a lengthy process which includes banks, distributors and order agents (see Table 7.8). In addition, the purchase or redemption price is calculated
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only once a day (for mutual funds with daily NAV Calculation) and depends on the order being placed before or after the cut-off time. Lastly, subscription and redemption are subject to commissions which may be a function of the investment size and/or the duration of the investment.

Investors orders buy sell

Banks

Distributors

Funds

OrderAgent Cut off time call out NAV

Table7.8 Traditional process for investment in a mutual fund The advantages of listing mutual funds are threefold. First, some institutional investors are required to exclusively invest in listed securities. As a consequence, they cannot invest in mutual funds unless these are traded on an exchange. In addition, the existence of a secondary market for mutual fund shares allows for a shorter required period of time to buy or sell mutual fund shares as they can be directly traded on the market. The secondary market also allows the investors of closed-end funds (funds with a limited number of shares which are not redeemable before fund maturity) and investors of funds with less-frequent NAV calculations and redemptions to sell their shares on the market at any time. Moreover, the transaction price is an immediate price (the market price) instead of the next NAV if the shares are to be redeemed by the mutual fund. Other advantages of the existence of a secondary market can be lower transaction costs (subscription and redemption commissions), the immediate and best execution of the order, the possibility of using various techniques related to execution of such orders such as limit orders and the transparence of the execution conditions. Lastly, with respect to the international distribution of mutual fund shares, intermediaries can be avoided through the direct purchase or sale of mutual fund shares on the exchange and the network of its international trading members.

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Evaluation of statistical analysis of correlation for all funds in order to determine a benchmark with the highest correlation. Example: cominvest Fondak P DAX Index: Correlation 0,94267 Example: cominvest Fondak P DAX Index: Beta coefficient 0,77937 Last NAV +/- continuous real-time change of the benchmark * Beta coefficient Simplified example: cominvest Fondak NAV yesterday 1pm DAX Index today compared to yesterday 1pm Adjustment according to beta coefficient Expected increase of NAV today Bid cominvest Fondak today + Spread 0,5 % (max. 1,5 %) Ask cominvest Fondak today 100 Euro +1,54 % (1,54 % * 0,77937) +1,20022 % 101,20 Euro 0,506 Euro 101,71 Euro

1. Benchmark evaluation 2. Beta coefficient evaluation

3. Quotation

Table7.9 Example of mutual fund quotation source: Clearstream In order to have a continuous quotation for mutual funds which are by definition not valued more than once a day, market makers use statistical approaches. For instance, they select a benchmark38 whose performance is highly correlated to that of the mutual fund of interest. They can then calculate a measure called the beta which can be defined as a measure of how the Net Asset Value of the mutual fund and the value of the benchmark move with respect to each other. For instance, if a fund has a beta of 0.8 with respect to its benchmark, the Net Asset value of this fund is 0.8 times the value of the benchmark. Thanks to this measure, it is possible to make estimations of the value of the mutual fund based on the performance of the benchmark which is known on a continuous basis and propose binding bid and ask prices during the opening hours of the exchange. This process is illustrated in table7.9.

7.4 The stock exchange in Luxembourg and Brussels: some key figures
The Luxembourg stock exchange was created in 1928 as a for-profit organization and is still an independent stock exchange whose shareholders are principally Luxembourgish, Belgian and French banks. Though it is a medium-size stock exchange, it is internationally recognized as a leader for listing of international securities. It employs 136 persons (all in Luxembourg) and signed a partnership with NYSE Euronext in April 2006 following a cross-membership agreement in 2000. It is a founding member of the World Federation of Exchanges (WFE) in 1961 and of the Federation of European Securities Exchanges (FESE) in 1974.
38. Which is usually an index representing a given geographical market, security type and/or sector for instance.

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With regard to listing, the Luxembourg stock exchange is an international center with 3500 issuers coming from 100 countries. Among these issuers, there are 60 sovereign states and 11 supranational institutions. The Luxembourg stock exchange is the European leader in the listing of international bonds and second after NYSE Euronext for the listing of Depositary Receipts. Those figures are summarized in tables 7.10 through 7.12

Euronext 5.37% London SE Group 9.43%

Others 2.61%

Luxembourg Stock Exchange 41.49%

Deutsche Brse 17.39%

Irish Stock Exchange 23.71%

Table 7.10 Distribution of the listing of international bonds by stock exchange

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61.46% 12.07%

9.60%

0.42%

15.76% 0.69%

Table7.11 Issuers by region

Quotation lines (28 February 2010) Bonds Warrants Shares/DRs Luxembourg Foreign UCITS Luxembourg 29,694 7,794 327 33 294 6,539 6,384

Table7.12 Number of quotation lines by type of instruments The Luxembourg stock exchange can be further split into two different types of markets. The BdL Market (since May 1929) and the EURO MTF (since July 2005). The BdL market is governed by European Union rules which imply that securities traded on this market have a European passport and can be listed and traded in any other European exchange. Next to this market, the EURO MTF market is mainly for non-EU issuers of listed securities and is less tightly regulated. These two markets share several characteristics such as the absence of restriction to market access (any type of investor of any size), the trading platform and the mechanism for investor protection via MIFID, the market abuse law, the CSSF as regulatory authority and the use of multi-language regime. They mainly differ in the disclosure policies and rules. For the BdL market, European rules apply regarding prospectus approval, information to be
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published and disclosure requirement while on the EURO MTF market, standards of the issuers country can be used instead (see Table7.13).
European regulated market (BdL Market) Authority for prospectus approval and regulatory framework Pan-European passport Information to publish Disclosure requirements Exchange regulated market (Euro MTF)

Commission de Surveillance The Luxembourg Stock du Secteur Financier (CSSF) Exchange Propectus law and EU Prospectus law plus Rules regulations and Regulations of the Exchange Yes Transparency law Market abuse law No Rules and Regulations of the Exchange (consisting of former requirements regarding the official list) IFRS obligations, US GAAP or obligation of the country of the registered office

IFRS or equivalent obligations

Table7.13 Differences between BdL and EURO MTF markets In 2005, the Luxembourg stock exchange in association with the Association of the Luxembourg Fund Industry (ALFI) and 30 Luxembourg financial institutions launched a subsidiary dedicated to UCIs called Finesti. In 2002, it became a 100% subsidiary of the Luxembourg stock exchange. Its goal is to provide the industry with a unique tool to enhance access and distribution of Luxembourg data and documents. Finesti operates as a communication hub between the producers and the consumers of investment fund data. It collects information from varied sources and transmits it to the investing public and to the Luxembourg supervisory authority (CSSF). It also guarantees the quality of the available information on Luxembourg mutual funds. The functioning of the hub is reproduced in table7.14.
NAV data Documents Descriptive data FPPs Data control & quality Regulatory reporting Collection Management Dissemination Finesti Fund Hub Supervisors Custodians Distribution Platforms Transfer Agents & CSDs Data Vendors Analysts Media

Table7.14 Finesti as a communication hub


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The Brussels stock exchange was created in 1801 on the French model. It progressively grew throughout the 19th century and supported industrial development in Belgium. During the 20th century, it experienced several reforms and a gradual liberalization. In 1999, the Brussels Exchange SA was created and merged one year later with Paris and Amsterdam exchanges to create Euronext. Brussels exchange is mainly focused on equities and especially on gold mines. In 2002, Euronext acquired LIFFE (London future market) and merged with Lisbon. They further merged with NYSE (New-York Stock Exchange) in 2006 but tried unsuccessfully to merge withthe Deutsche Brse in 2011.

7.5 Admission to official list and trading and continuing obligations


Before explaining the procedure to be admitted to the official list and trading, we must emphasize the difference which may exist between admission to the official list and admission to trading. The notion of admission to the official list dates back to the Code Napoleon under which only securities on the official list were given an official price. This notion remains in many regulation. When the European regulation was introduced, it was no longer question of admission to the list but of admission to trading, which may have created some confusion. Some exchanges (mainly Anglo-Saxon ones) have kept this notion of admission to the list and allow securities to be on their official list although they cannot be traded on their trading platforms (but only through other intermediaries). They nevertheless fall under the regulatory framework of the exchange (e.g. MIFID in Europe). In Luxembourg, both concepts coexist but admission to the list automatically encompasses admission to trading so that all securities admitted to the Luxembourg stock exchange list can be traded through its trading platform. The Luxembourg exchange is second in Europe in terms of the number of mutual fund listed (see Table7.15) after Dublin. The main difference between the Luxembourg and the Irish exchanges lies in the fact that the former mainly lists domestic funds while the latter mainly lists foreign mutual funds.
Exchange Luxembourg SE Irish SE BME Spanish Exchanges Deutsche Brse NYSE Euronext (Europe) London SE Group 2008 December 8 9 3 3 133 217 360 056 206 27 2009 December 7 7 3 2 285 960 270 771 204 26 2010 December 7 7 3 2 445 633 152 833 189 25 2011 February 6 7 3 2 539 378 124 858 190 25

Table7.15 UCI listed on European stock exchanges


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Theoretically, the fund admission procedure starts with introduction of a file by the central administration of the fund. In practice, this function is usually delegated to a listing agent (member of the Luxembourg stock exchange) or to specialized law firms. The competent authority for the approval of public offer and marketing is the CSSF while the Luxembourg exchange is in charge of the approval of admission to the official list and to trading. The regulatory aspects related to admission to trading are governed by the Article 36 of Regulation EC 1287/2006 of the European Commission which implements the Article40 of MIFID. The Luxembourg stock exchange applies the same principles to the case of admission to EURO MTF market. The regulatory aspect related to the admission to the official list and trading in Luxembourg is dealt with in the Grand Ducal Regulation of 13 July 2007 on the holding of an official list. Closed funds are subject to a specific regulation which is comparable to that applied to ordinary share companies. Luxembourg UCIs, UCIs with the European passport and authorized (by the CSSF) non-European UCIs automatically fulfill the requirement for listing and trading on the Luxembourg exchange. In these cases, the fund prospectus is complete enough to be used as the listing/trading prospectus. One of the most important issues for a fund to be listed is that it has to be registered in an international central security depositor (ICSD) since to be listed a funds shares have to be freely transferable. There are currently two ICSD which are recognized by the Luxembourg stock exchange i.e. Clearstream (Luxembourg) and Euroclear (Brussels). The creation of a Luxembourg national CSD is currently under discussion. The Luxembourg regulation defines the required files which have to be filled by a mutual fund to be considered for admission to the official list and trading. These files include, among other things, the application form, a copy of the prospectus, the articles of incorporation of the fund, the security code assigned by a recognized ICSD and the confirmation of the eligibility of the securities by the ICSD as well as the latest financial reports. Once listed, mutual funds are obliged to provide to investors a certain amount of information (for instance changes in the legal structure of the fund). The definition of the continuing obligations is provided in the regulation. Corporate actions such as share splits, amount of dividends paid, payment date, paying agent, etc. must also be reported by the fund on a continuous basis. The market abuse directive and law obviously apply to listed mutual funds. In particular, all mutual funds are concerned by insider trading and market manipulation. Mutual funds also have the obligation to publish any price-sensitive information. Transparency rules apply to closed-end and non-European mutual funds.

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Exchange Irish SE Luxembourg SE Exchange Irish SE Luxembourg SE 2008 Foreign 4 868 172 2010 Foreign 3 483 152

FUND INDUSTRY IN LUXEMBOURG 2009 Foreign 3 951 159 2011 Foreign 3 204 155

Domestic 4 349 7 961 Domestic 4 150 7 293

Total 9 217 8 133 Total 7 633 7 445

Domestic 4 009 7 126 Domestic 4 174 6 384

Total 7 960 7 285 Total 7 378 6 539

Table7.16 Domestic and foreign UCIs listed

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8. Distribution of investment funds


8.1 Introduction
This final chapter investigates the distribution of investment funds in Luxembourg. The chapter covers the basic facts about distribution of funds in Luxembourg, statistics, public/private offer, the notification procedure, distribution networks and the remuneration scheme of placement agents.

8.2 Distribution
The ease of distribution of investment funds in Luxembourg is an increasing function of the regulation which applies to each specific kind of funds. For instance, UCITS funds are the most regulated types of investment funds in Luxembourg but, at the same time, they are also the investment funds which are the easiest to distribute (least restriction). Because of the stringent guidelines imposed to UCITS, it is not only easier to sell them but also to convince investors to buy UCITS shares. At the other end of the spectrum, funds from non-regulated jurisdiction (such as the Cayman Islands) represent the most difficult kind of investment fund to sell and can only be distributed on a private placement basis. SIFs and Part II funds lie in-between. In particular, outside Luxembourg, UCITS funds can normally be sold on a private or public placement basis while Part II funds which do not benefit from the European Passport are usually sold on a private placement basis and SIFs are only available on a private placement basis.
Key criteria Investment restriction (eligible assets) Risk diversification Ease of public distribution Supervisory framework Time to establish Target investors UCITS Restricted High High UCI Flexible Medium Medium SIF Flexible Low Low More flexible Very low Institutional / HNWI

Targeted to retail Targeted to retail investor protection investor protection Low Medium Medium All All

Table 8.1 Comparison of the three main investment fund regimes in Luxembourg

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The distributors of a SICAV are appointed by and under the supervision of the board or directors of the SICAV (or by its management company if the SICAV has designated a management company). The distributors of the FCP are appointed by and under the supervision of or the management company of the FCP. In addition to the supervision of the board, distributors of a UCITS are also supervised by the conducting officers of the fund or of its management company (if any).. In practice, the decision of the target investors and distribution network rests on the fund initiator.

8.3 Statistics
Luxembourg is the first financial center for the distribution of global funds (cross-border distribution) thanks to, among other things, its economic and political stability. Luxembourg is also characterized by an outward looking and collaborative approach between government, regulator and fund industry. The flexibility of the regulator makes it receptive to propositions arising from the fund industry which can enhance the efficiency of the investment fund industry while not being detrimental to investors protection. The quality of the infrastructure, support and experience in global fund distribution also make Luxembourg a recognized brand and the first financial center for cross-border fund distribution.

Sweden 81% France 74% Germany 73% Switzerland 76%

Japan 78% South Korea 99%

Bahrain 79%

Taiwan 74%

Hong Kong 79% Singapore 74% Peru 61%

Chile 72%

Table 8.2 Luxembourg share of cross-border funds for public distribution


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FUND INDUSTRY IN LUXEMBOURG Countries of sale at group level 50 42 40 38 33 33 32 30 30 29 28 28 28 28 27 27 26 25 24 24 24 24 23 23 23 First choice Fund domicile / Countriesofsale Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Ireland Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Ireland Luxembourg Ireland Luxembourg Luxembourg Luxembourg Luxembourg Luxembourg Jersey Luxembourg 48 39 36 25 32 32 30 22 30 29 27 20 22 28 27 22 26 21 24 24 23 24 22 10 22

125

Management group name FRANKLIN TEMPLETON HSBC HOLDINGS BLACKROCK SCHRODER BNP PARIBAS FIL INTERNATIONAL SOCIETE GENERALE BARCLAYS JPMORGAN CHASE & CO INVESCO LTD ALLIANZ GROUP DEUTSCHE BANK SWISS & GLOBAL ASSET MANAGEMENT UBS FORTIS GROUP LEGG MASON PIONEER INVESTMENTS BNY MELLON / WESTLB MELLON ABERDEEN ASSET MANAGEMENT CREDIT AGRICOLE CREDIT SUISSE GROUP ING GROEP HENDERSON GROUP PLC LLOYDS TSB GROUP MORGAN STANLEY

Table8.3 Leading cross-border management group

8.4 Public offer/ Private offer


An offer is the invitation made to someone to subscribe to a fund. A public offer is an offer made to the public. Each country has its own criteria to determine what a public offer is. In Luxembourg, the rule is based on the methods used to advertise the fund. Public offers can be done for instance through the media or through the public distribution of information. On the other hand, if the distributor directly contacts institutional investors and has meeting face to face with potential investors, this is considered as a private offer. In Luxembourg, this distinction is not clear-cut. In many other countries, the distinction is made on the basis of the number of investors which are approached by the distributor
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(beyond a certain number of investors, the offer is considered as being public), the type of investors which are targeted i.e. retail investors for public offers and institutional investors for private offers - or the number of investors who actually invested into the fund. For the time being, there is no harmonization on the definition of public vs. private offers even at the European level.

8.5 Notification procedure


This section describes the procedure which must be followed when a distributor wants to sell a Luxembourg fund abroad. A UCITS (benefiting from the European Passport), has to tell the regulator of its country of origin that it wants to distribute its fund in a foreign country. The home regulator is responsible for informing the foreign country regulator. Translation of documents is no longer required (if they are in English) except for the Key Investor Information Document (KIID). Distribution in the foreign country is then authorized on the day following the notification to the foreign regulator. This new process only applies in the European Union even if some countries outside the European Union (such as Hong Kong, Singapore and Bahrain) also facilitate the distribution of a UCITS in their jurisdiction. Part II funds (no European Passport) are usually sold on a private placement basis but some countries such as the Netherlands, Switzerland, etc. accept that Luxembourg Part II funds be registered for public distribution. However, in this case the foreign regulator scrutinizes the documentation in more details (investment policy, risk diversification, service providers) to ensure that the mutual fund is similar to a national fund. If they conclude that the Part II fund is equivalent to their national funds, they may accept the distribution of the Luxembourg Part II fund in their country. Because of the absence of the European Passport for Part II funds, this process is much longer than for UCITS funds. SIFs cannot be sold on a public placement basis outside Luxembourg. In case of private placement (for UCITS, Part II and SIFs), the fund has to comply with the private placement rules of the jurisdiction in which it places its shares. It is worth noting here that certain countries, including Luxembourg, do not allow foreign UCITS to be distributed on a private placement basis.

8.6 UCIs marketed in Luxembourg


This section deals with the case of funds which are intended to be sold in Luxembourg. Luxembourg UCIs can always be distributed on public placement basis in Luxembourg as they have been subject to Luxembourg regulation. Even Luxembourg SIFs can be publicly distributed in Luxembourg even if they can
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only be sold to well-informed investors i.e. the characteristics of the investor must be checked but the way through which investors are contacted can be public. Foreign European UCITS can obviously apply the same procedure as the one described in Section8.5. Other foreign funds could be sold to the public in Luxembourg provided that they are regulated. In this case, Luxembourg regulator verifies the characteristics of the fund. A non-regulated fund cannot be sold to the public in Luxembourg. Regarding private placement, open-ended non-UCITS can be sold on a private placement basis. Closed-ended fund are subject to clear criteria for distribution. Surprisingly, UCITS cannot be sold on a private placement basis in Luxembourg.

8.7 Distribution network


The first possibility is to sell fund shares on a private placement basis. The fund promoter can sell the shares within its own group (internal network). Alternatively, it can have an agreement with several foreign banks and be sure that these banks will sell the fund shares to clients on a private placement basis (third party distributors). Large promoters usually use the internal network alternative. Regarding public placement, funds usually appoint an entity (the distributor) that will itself go to the public. When a fund decides to appoint one or more third party distributors, it has to negotiate distribution agreements. Of course these distributors require to be remunerated and one difficulty may arise from the need to reconcile the interest of both parties in the agreement. The role of distributors and nominees is defined in the IML Circular 91/7539. A nominee is also someone in charge of placing fund shares with his clients but the nominee is considered as being a client of the fund. In other words, the nominee is supposed to be the one who buy the shares of his clients. As a consequence, the names of the clients do not appear in the funds shareholder register (the name of the nominee does) so that their identity is kept secret and confidential. The role of the nominee can be twofold. One possibility is that the nominee is appointed by its client to buy shares in a fund. In this case, this is purely an arrangement between the nominee and its client which does not directly concerns the mutual fund. Another reason why a nominee can intervene is due to the desire of the fund to appoint the nominee as an agent and request investors to subscribe through the specified nominee. In this case, it is an agreement between the fund and the nominee. Nowadays, distribution of UCITS funds is usually done through nominees.

39. Revision and remodeling of the rules to which Luxembourg undertakings governed by the Law of 30March 1988 on undertakings for collective investment (UCI) are subject.

LARCIER
Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

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FUND INDUSTRY IN LUXEMBOURG

8.8 Remuneration of placement agents


There are three ways through which distributors can be remunerated: the sales charge, distribution fees and retrocessions. The sales charge is a remuneration which is based on a certain percentage40 which is added to the price (NAV) of the fund share when the investors subscribe to the fund and is kept by the distributor as remuneration. While these charges may be applied to retail investors, institutional investors generally refuse to pay this kind of subscription charges. Distribution fees are taken on the values of the shares on an annual basis. The most commonly-used remuneration scheme is the retrocession. The manager of the fund receives management fees. The manager then pays a part of these fees to the distributor (up to 50% of the management fees). Management fees are a percentage of the total assets of the fund. Consequently, the interest of the distributor is to increase the size of the fund as much as possible which is in line with interest of the manager.

40. Maximum 5% in Luxembourg.

LARCIER
Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /

FUND INDUSTRY IN LUXEMBOURG

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Index
Alternative Investment Fund Managers AIFMD, 17, 31, 32, 34, 35, 36, 37, 38, 39, 40, 41, 42, 43 Alternative Investment Funds AIF, 17, 31, 34, 35, 38, 39, 40, 41 Annual General Meeting AGM, 17, 53, 54 Asset under Management AuM, 17, 38, 39 Central Security Deposit CSD, 17, 111, 121 closed-ended funds, 26 Custodian Bank, 26, 27, 42, 55, 63, 102, 106, 107 Depositary Bank, 17, 40, 41, 47, 55, 79, 80, 81, 82, 84, 100, 106 DB, 17, 80, 81, 82, 83, 84, 86, 106 European passport, 20, 21, 23, 26, 36, 37, 96, 118, 119, 121, 123, 126 Extraordinary General Meeting EGM, 17, 52, 53 Fund Accounting, 47, 55, 57, 58, 59, 62, 67, 75 fund structure, 21, 98 Hedge Funds, 20, 26, 29, 30, 31, 34, 37, 40, 98 Key Investor Information Document KIID, 17, 24, 47, 50, 51, 126 Know Your Customer identification process KYC, 76 Management Company, 17, 24, 25, 34, 45, 46, 63, 79, 80, 85, 86, 95 ManCo, 17, 45, 47, 51, 80, 84, 85, 86, 87, 88, 89, 90, 91, 92 substance requirement, 23, 86 Markets in Financial Instruments Directive MIFID, 17, 37, 39, 110, 112, 113, 118, 120, 121 Net Asset Value NAV, 17, 44, 55, 56, 57, 59, 60, 61, 62, 63, 64, 65, 67, 73, 75, 92, 103, 104, 105, 107, 114, 115, 128 NewCITS, 30 open-ended funds, 21, 96 Part II funds, 20, 47, 96, 123, 126 Pension Pooling Vehicles, 20, 29, 32, 33 Portfolio Management, 36, 38, 41, 42, 86, 90, 91 portfolio manager, 40, 41, 42, 64 Private Placement Funds SICAR, 17, 20, 27, 28, 29 SICAV, 17, 23, 46, 51, 52, 53, 54, 55, 85, 95, 96, 103, 124 Risk Management RM, 17, 40, 50, 87 VaR, 18, 50, 66, 92 Specialized Investment Fund SIF, 17, 20, 25, 26, 27, 30, 31, 81, 123 Statement Of Valuation, 60, 62 Trading Member Firm TMF, 18, 110, 111 Transfer Agency, 55, 56, 57, 58, 67, 68, 70, 78 Transfer Agent TA, 18, 75, 76 UCI FCP, 17, 45, 46, 50, 51, 52, 55, 81, 84, 95, 103, 107, 124 SICAV, 17, 23, 46, 51, 52, 53, 54, 55, 85, 95, 96, 103, 124 UCITS Undertaking for Collective Investment in Transferable Securities, 18, 20, 21 Undertaking for Collective Investment in Transferable Securities. SeeUCITS cross-border mergers, 24 Management Company Passport, 24 UCITS, 15, 18, 20, 21, 22, 23, 24, 25, 26, 27, 30, 31, 32, 33, 34, 36, 37, 38, 39, 40, 41, 42, 44, 47, 50, 51, 55, 56, 65, 66, 69, 70, 80, 81, 85, 86, 87, 88, 89, 90, 91, 92, 96, 105, 106, 118, 123, 124, 126, 127

LARCIER
Fund industry in Luxembourg Larcier - Groupe De Boeck s.a. Universit de Lige - Bibliothque Lon Graulich- Accs sur campus /