n° 8 i - alfi · luxembourg fund lfr review. ... responsibility to continue to diversify its...

I Bulding long-term savings in Europe through UCITS: opportunities for the Asset

Management Industry

I Mutual recognition and delegation: EU rules enhancing the efficiency of the supervisory

activity

I In valuation, we trust - CESR update on OTC derivative valuation practices

I Aberdeen: a case of discrimination

I Relocation of offshore funds to Luxembourg - Why and how

I Funds investing in insurance policies: understanding the challenges and opportunities

of the US life settlement market

I Consolidation in Private Equity structures

I A short summary of cross border distribution of Collective Investment

schemes into the United States

EUROPEAN AND NATIONAL

REGULATIONS UPDATE

TAX UPDATE

ALTERNATIVE INVESTMENTS

CROSS-BORDER DISTRIBUTION

N° 8 I November – December 09

L U X E M B O U R G F U N D

R E V I E WLFR

1 I L U X E M B O U R G F U N D R E V I E W I N ° 8

Since the early 1960s, the Luxembourg government hasimplemented a vigorous economic development policywhich has made it possible to successfully reshape thecountry's economic structure. From a steel-based economy,Luxembourg has developed into a world-renownedinternational financial centre and prime business location.Regardless of past success the Grand-Duchy has aresponsibility to continue to diversify its economy in orderto reduce its vulnerability to external shocks.

Luxembourg's financial center has a key role to play in thisprocess. Indeed the financial centre's success story bestillustrates to foreign investors the assets and opportunitiesthe country has to offer for doing business in Europe,namely: political and social stability; skilled andmultilingual workforce; state-of-the-art infrastructures;excellent connectivity to markets; favorable legalenvironment; attractive tax climate; and its historicopenness to larger markets. Luxembourg's financial hub, aswell as the vast array of professional services which havedeveloped in its wake, also make a direct, highly valuablecontribution to our diversification efforts. Financialservices have been for instance one of the key drivers forICT related activities, which have become a cornerstone ofLuxembourg's economy. Furthermore the financialindustry constitutes a cardinal asset for attractingheadquarters activities in our country.

It is my hope that the efforts we at the Ministry of theEconomy and Foreign Trade are pursuing to anchor lifesciences based activities in the biomedical andenvironmental areas will entail in turn opportunities for thebanking and financial centre, and more particularly the fundindustry. As a matter of fact the expertise gathered in thelatter domain could be built upon in order to cater for thequite specific financing needs of the biotech industry.

Finally, let me seize the opportunity of this editorial toreinforce Luxembourg government's continued commitmentto preserve a sound macroeconomic framework and toimprove its business environment despite the arduousaftermath of the recent crisis. Indeed, "the future is not someplace we are going but one we are creating.The paths to it are notfound but made, and the activity of making them changes both themaker and the destination." (John Schaar)

Jeannot KreckéMinister of the Economy and Foreign Trade

Contact for all information:

Marthe NOESEN Stéphanie LEROY FARASSECommunications Project ManagerALFI IFE [email protected] [email protected]

EDITORIAL

EDITING COMMITTEE

Isabelle LEBBEChairwoman of the Editing CommitteePartner, Arendt & Medernach

Hermann BEYTHANPartner, Linklaters LLP

Georges BOCKPartner, KPMG

France COLASBusiness Development Director, Caceis Bank

Josée-Lynda DENISVice Président, EMEA Sales & BusinessDevelopment, BNY Mellon Asset Servicing

Gilles DUSEMONPartner, Loyens & Loeff

Rüdiger JUNGMember of the Executive Committee, ABBL

Philippe LENGESPartner, Deloitte S.A.

Renato MORESCHIHead of Shared Services & OperationsContinental Europe, RBC Dexia InvestorServices Bank S.A.

Charles MULLERDeputy Director General, ALFI

Isabelle NICKSPartner, Ernst & Young S.A.

Marie-Elisa ROUSSEL-ALENDAPartner, PricewaterhouseCoopers S.à.r.l.

Jérôme WIGNYPartner, Elvinger, Hoss & Prussen

We are pleased to announce that from October 2009 on the Luxembourg Fund Reviewbenefits from the combined support of the Association of the Luxembourg Fund Industryassociation, ALFI, and IFE Benelux (InternationalFaculty for Executives), a provider of professionaltraining and editorial services.


EUROPEAN AND NATIONAL REGULATIONS UPDATE

Bulding long-term savings in Europe through UCITS: opportunities for the Asset Management Industry

Jean-Baptiste de FRANSSU .......................................................................................................................................3

Mutual recognition and delegation: EU rules enhancing the efficiency of the supervisory activity

Rafael AGUILERA.........................................................................................................................................................5

In valuation, we trust - CESR update on OTC derivative valuation practices

Laurent DENAYER........................................................................................................................................................7

TAX UPDATE

Aberdeen: a case of discrimination

Gilles DUSEMON ........................................................................................................................................................9


Relocation of offshore funds to Luxembourg - Why and how

Benoît DUVIEUSART & Myriam MOULLA ............................................................................................................12

Funds investing in insurance policies: understanding the challenges and opportunities

of the US life settlement market

Christine GILLET ........................................................................................................................................................15

Consolidation in Private Equity structures

Olivier COEKELBERGS .............................................................................................................................................21


A short summary of cross border distribution of collective investment schemes into the United States

Stuart E. FROSS ........................................................................................................................................................24

SUMMARY



BULDING LONG-TERM SAVINGS IN EUROPETHROUGH UCITS: OPPORTUNITIES FOR THE ASSETMANAGEMENT INDUSTRY

In the midst of the credit crisis, Invesco supported

an industry "Think Tank" which gathered a group of

eight senior industry leaders from the asset

management industry. This group issued a 'call to

arms', putting forward a series of thought-provoking

recommendations as to what the stakeholders of

the asset management industry should do to meet

the pressing challenge of building long-term

savings in Europe. These recommendations have

been actively shared with industry representatives

and regulators since then and have opened the way

for practical solutions to be put forward in a

number of critical areas, which include distribution,

product proposition for long-term savings and

pensions, and industry representation at a

European level. Getting the right mix of regulation

and self-regulation, as well as the commitment

from all key stakeholders of the asset management

industry will be vital to see concrete results for

European investors in the coming years.

I A CALL TO ARMS FROM THE ASSET MANAGEMENTINDUSTRY

The European asset management industrydid not help trigger the market crisis, butits impact has nonetheless been severe.Six quarters in a row of outflows totallingover €400bn (with a higher magnitude inEurope than in any other regions) andsevere drops in assets under managementwere the most visible signs of troubledtimes. But more profoundly Europeaninvestors have been shaken. And morethan ever our industry needs to re inspirethem with confidence.

To that extent, the crisis has called intoquestion the strategic direction taken bythe industry over the past few years.The focus of European efforts in previousyears had been much on promoting cost-efficiency and the competitiveness ofEuropean retail funds. But the crisis has

raised questions as to whether the industryis optimally structured throughout theentire value chain to serve long-terminvestors, particularly if it is seeking toposition itself as the custodian of their private retirement needs. Some fundamental issues such as the increasingvolatility of flows, the growing gapbetween the industry and end-investors,product suitability and the lack of a coherent system to channel long-term savings became even more apparentthroughout the crisis.

Recognising that the post credit crunchenvironment would be a time for actionand leadership, the Think Tank reviewedthe key challenges faced by our industry tosupport the development of long-term savings in Europe. With €12tn of assetsunder management - about the size of theEuropean GDP -, the asset managementindustry already plays a key role inEurope's economy and long-term savingsprovision. However the industry needs totake further steps into helping investorsbuild their financial security - and notablyrevisit how UCITS can further serve long-term investors. To that extent theThink Tank came up with several recommendations which have implicationsin three key areas, respectively distribution,the need to enhancing the industry'sproduct proposition for long-term savingsand the need to strengthen industry representation in Europe.

I DISTRIBUTION: THE NEED TO FOCUS FURTHER ONINVESTORS' NEEDS

Ensuring greater investor outcomes whenstructuring and distributing retail investment products is one of the criticalareas which has been highlighted in theThink Tank report.

Indeed asset managers have a responsibilityto ensure that investors are adequatelyinformed, receive qualitative advice, andthat an overall alignment of interests is inplace along the value chain. In the light ofgrowing distribution intermediation inEurope, asset managers should thereforeaddress the gap that exists between themand investors. This means notably that theindustry should engage in a strategicreview with retail distribution, encouragebetter information flows up the valuechain, and reach out more proactively tobanking and insurance federations.

In conjunction with this effort of gettingcloser to investors, it is important for theindustry to ensure further strengtheningof investor protection at the point of salelevel, notably through improved suitability,transparency and labelling standards.One of the practical outcomes of theThink Tank group was the idea to developa 'best practice' charter for distributors,which would focus on enhancing qualityof advice and treating customers fairly aspart of the collective fiduciary responsibilitythey share with product manufacturers.

At an investor level, the asset managementindustry should take vigorous stepstowards the common goal of enhancingfinancial education and developing a long-term savings culture in Europe.As pointed out in the Commission's GreenPaper on retail financial services in thesingle market in 2007, numerous surveyshave demonstrated the low level of financial literacy among European retailinvestors. Taking action would mean forinstance considering the possibility of creating an industry foundation to lobbyfor and initiate investor education programmes. There are a lot of initiativesand ideas which have been developedacross countries in that area, and a lot ofbest practices could be shared at aEuropean level in a common framework.



I PRODUCT: ENHANCING THEINDUSTRY'S PROPOSITION TOMEET THE CHALLENGES OFPENSIONS

To best position the UCITS product as a

key building block for pensions in the

future, the Think Tank has identified

several areas where the industry should act.

First the asset management industry

should take action to protect and promote

the UCITS brand. UCITS has given the

European fund industry a robust

framework on which to build a service that

satisfies the needs of long-term savers

across Europe, and UCITS have

demonstrated their resilience throughout

the crisis. Going forward, it is important to

clarify the investment rules pertaining to the

UCITS investment vehicles, ensure an

adequate development of the UCITS

framework and a clear positioning towards

alternative investment vehicles.

Second, at an operational level, the

industry should develop best practices to

continue strengthening the UCITS

container, such as in the field of risk

management procedures, product

development, valuation rules and custody.

The industry should also speak out more

forcefully and more systematically for the

buy side, such as for instance calling for

further rationalisation of the credit and

OTC derivatives markets.

In parallel, the industry needs to continue

improving its efficiency to address the

issue of relatively high fees prevailing in

Europe (notably compared to the US).

The European industry is in particular still

characterised by its relatively high number

of funds of relatively low size (funds are

typically six times smaller than in the US,

with an average fund size of about €100m).

The fund industry should notably seek

economies of scale and efficiencies

through further pan-European integration

thanks to the UCITS IV framework, or

though the implementation of industry

initiatives such as in the field of fund

processing.

Finally, looking at the need for pensionproducts in Europe, the Think Tank hasrecognised the need overall for a morecoherent pan-European framework forprivate pensions and an infrastructure toencourage long-term savings. Pensionssolutions in Europe - where an ageingpopulation forms the backdrop to calls ongovernments to act - are fragmented andoften inadequate. Our industry thereforehas a duty to play a leading role in thedebate about the future of pensions.Pension savings would in turn bring further stability to our industry: for example;in the United States, over 60% of the netflows in long-term funds since 2000 originated from retirement accounts.

I THE NEED TO STRENGTHENINDUSTRY REPRESENTATIONIN EUROPE

Beyond the challenges identified in thefields of distribution and product provision, the Think Tank recognised thatit is important for the industry to furtherstrengthen its representation in Europe.

At a regulatory level, the crisis highlightedthe need to increase supervisory cooperationacross Europe, notably when emergencyresponses are needed. The independentHigh Level Group on financial supervisionset up by the European Commission (1) hasacknowledged the need to move towards aEuropean System of Financial Supervision,recognising the current absence of aframework to facilitate supervisors in making uniform and urgent decisions.Thebanking, insurance and asset managementindustries should all be supportive of thisgreater level of integration and cooperationin order to protect long-term savings andmaintain investors' confidence.

Looking at the need for further integrationand coherence in the European market,the lack of a level playing field for substitute long-term savings and retirementproducts is a key issue. Investors should beable to compare and choose between substitute savings products based on theirintrinsic merits in order to access theproducts that are best suited to their

needs. The asset management industryshould notably continue to build on thework done by the European Commissionin the field of packaged retail investmentproducts to ensure comparable conditionsbetween UCITS funds and other savingsproducts.

More generally the crisis demonstratedthat the industry needs to upgrade itscommunication of what it stands for andto better articulate the key economic andsocial role it plays.

I CONCRETE RESULTS NEEDEDFOR INVESTORS

To meet the challenge of building long-term savings in Europe, the industryneeds an approach which is driven by acommitment to serve the end investor.The successful development of retirementsolutions lies in the security of the investment solutions as well as the qualityof distribution and selling practices.

The coming years are going to be criticaland finding solutions to the long-term savings challenges in Europe requiresaction by all stakeholders, including manufacturers, distributors, legislatorsand regulators. The way forward is notonly about new regulation and the industry needs to be more proactive thanever. Ultimately this will help to restoremuch needed investor confidence infinancial services.

Jean-Baptiste de Franssu

President of the European Fund and Asset

Management Association (EFAMA)

(1) The independent High Level Group on financialsupervision, chaired by Jacques de Larosière,was set up by the European Commission inNovember 2008 in order "to make recommendationsto the Commission on strengthening Europeansupervisory arrangements covering all financial sectors, with the objective of establishing a moreefficient, integrated and sustainable European system of supervision and also of reinforcing cooperation between European supervisors andtheir international counterparts". The groupreleased its final report in February 2009.



MUTUAL RECOGNITION AND DELEGATION: EU RULES ENHANCING THE EFFICIENCY OF THESUPERVISORY ACTIVITY

In its communication "Driving European Recovery" of4 March 2009, the European Commission committeditself to introducing proposals for reform of the EUframework for financial supervision. The Commission'saction in this area builds on the report of the "deLarosière" Group of 25 February 2009 on Financialsupervision in the EU, which recommended a newEuropean financial supervisory framework for supervision of individual institutions (micro-prudentialsupervision) and supervision of the stability of thefinancial system (macro-prudential supervision). In light of this there is an increasing need to re-inforce cooperation and coordination among competent authorities in the financial sector withregard to mutual recognition and delegation.Luxembourg as a centre of competence in the cross-border distribution of UCITS under the mutualrecognition requirements of UCITS I and UCITS IIIshould play a primary role in the integration of EU financial markets for UCITS through the delegationof tasks and/or responsibilities.

I INTRODUCTION: FRAGMENTEDEU SUPERVISION

The current organisation of financialsupervision in the EU is characterised by amismatch between the approach taken at aEuropean level with respect to financialsupervision and that at a national level.An integrated EU financial market, includingcompanies operating on a cross-borderbasis, cannot work properly if supervisionremains fragmented along national lines.

I THE NOTION OF "MUTUAL RECOGNITION" AND "DELEGATION"

Mutual recognition is the current standardin European law for the coordination ofsupervisory action in cross-border super-visory matters. It is useful to compare thisstandard with other similar approachessuch as delegation of tasks and delegationof responsibilities.

The delegation of responsibilities differsfrom the delegation of tasks: although in bothcases, the delegation may include certainmaterial or intellectual tasks, delegation ofresponsibilities results in a change wherethe decision making power rests.

According to the CEBS paper on delegation,delegation of task means that tasks are carried out by another supervisory authority(the delegate) instead of the responsibleauthority, and the findings reported back tothe delegating authority. The responsibilityfor supervisory decisions remains with thedelegating authority1.

Under the mutual recognition regime, thedecisions of the home supervisor extend toall EEA markets where the supervisedentity operates (e.g. supervision of branches)or the transaction is executed (e.g. publicoffering of securities). Normally the supervisors of the host jurisdictions concerned have no right to intervene("European Passport"), or have limitedrights in certain supervisory areas (e.g.supervision of branches under MIFID; orthe UCITS IV Management CompanyPassport). Home state decisions are bindingin other jurisdictions, and are only open toreview in accordance with home state procedures. Liability is governed by thehome state. Supervisory sanctioning issubject to home state rules, while the hoststate is not entitled to impose measures for misconduct within its jurisdiction,except in cases in which the home staterepeatedly refuses to take action (e.g."precautionary measures" under the securities' law Directives).

The main difference between mutualrecognition and delegation of responsibilitieslies in the character (mandatory versus voluntary) and the basis (law, contractualrelationship) of the two "approaches".Mutual recognition is a mandatory processregulated by the EU law whereby competencies and responsibilities are

transferred to one authority (generally thehome supervisor) directly under EU law.The delegation of responsibilities, asdescribed here, is a voluntary processwhereby the transfer of responsibilitiesbetween two competent authorities takesplace by virtue of existing legislation suchas the Prospectus Directive2 implementedby a voluntary agreement drawn up inaccordance with rules laid down in EUlaw. Therefore, while in the case of mutualrecognition all aspects of the transfer ofresponsibility (including the particularresponsibility, the applicable law ie the lawof the home Member State) are regulateddirectly by EU law, in the case of the delegation of responsibilities the mostimportant issues would be regulateddirectly by EU law and other, less importantissues, would be agreed between competentauthorities.

The main advantage of delegation ofresponsibilities is the improved andenhanced use of the technical expertiseand know-how of a supervisor. For example,delegation of the scrutiny and approval ofa prospectus for a public offer might takeplace where one supervisor may be lessexperienced in dealing with more "complex"investment techniques which would bemore appropriately delegated to a supervisorthat has the relevant expertise. In caseswhere mutual recognition would lead toan unacceptable result, delegation mightallow flexibility to the relevant supervisorto find solutions that meet the specificneeds of the case to be dealt with.

An EU wide kind of mutual recognitionand delegation has already been provedsuccessful in certain areas of cross-borderfinancial activities, e.g. within the scope ofthe MIFID, Market Abuse Directive andthe UCITS Directive3. Co-operationarrangements should be aimed at enhancingthe efficiency of the relevant supervisoryactivity and reducing the burdens for thesupervised entities. However some major



obstacles in terms of marketing and taxationstill remain. Therefore, I think that priorityshould be given to the improvement ofmutual recognition and delegation at aEuropean level prior to reassess existingEU rules.

As a first step the 3L3 Committees4 agreedon the creation of a task force on delegationwhich would examine and analyse thelegal/technical aspects of cross-border delegation of tasks and of the delegation ofresponsibilities5.

As a consequence on June 2, 2009 CESRpublished key principles for the delegationof tasks between competent authoritiesand the 3L3 report on the delegation ofresponsibilities. The key principal paper isrestricted to delegation of tasks. Futurework of the task force would be focused onthe delegation of responsibilities.

I KEY PRINCIPLES

1. Responsibility of the delegatingauthority:

2. Sufficient legal basis:3. Compliance with national law4. Efficiency and proportionality5. Delegation to the best placed authority6. Cooperation agreement between the

competent authorities7. Voluntary character of the delegation 8. Temporary character of the delegation 9. Liability

10. Good communication/Reporting11. Access to information of the delegate12. Confidentiality13. Transparency14. Fees15. Accountability

I LEGAL AND LIABILITY ISSUES

In any discussion on mutual recognitionand delegation, liability issues are central.A distinction should be drawn betweenthe liability of supervisors of the delegationagreement, and the liability towards third parties (creditors, other market participants, etc.) of any of the supervisedentities which are parties to the relevantagreement. The responsibility of the parties to a delegation agreement to third

parties is critical as only the responsibilitiesof one party to another can be dealt within the agreement. Therefore it would beimportant that the supervised entities beinformed in advance of the delegationagreement to allow consideration ofappropriate levels of responsibility to thirdparties. A change in the allocation ofresponsibility could involve a differentdegree of protection for depositors,investors and clients, for example, if thelaw applicable to the delegate provides forlimitations in the level of liability or a different burden of proof. Moreover, itwould be more difficult for the supervisedpersons to protect their rights when violated by the delegate as they will have toenforce their rights in a different jurisdictionunder a foreign law and before foreigncourts.

The same solution has been applied in thecase of mutual recognition, where anItalian Tribunal has referred to Belgian liability rules for establishing liability forallegedly misleading information in aprospectus that had been approved by theBelgian supervisor, and used in Italy underthe mutual recognition regime6.

I CONCLUSION

I think that a mapping exercise within theEU should be initiated to map the respectivesupervisory and sanctioning powers of EU supervisors in order to harmonize theEU regulatory landscape of UCITS andnon-harmonized collective investmentschemes. Within the EU a mismatchbetween the level of European integrationof EU financial markets and the nationalorganization of supervisory responsibilitiesis still one of the major obstacles to mutualrecognition within the EU.

Delegation rules and mutual recognitionwithin the EU and with third countries willonly be effective if the parties concerned arebound to the same extent as to applicablepowers and obligations. Thus it is only in asufficiently harmonised environment thatdelegation can effectively operate7.

As the integration of European financialmarkets progresses, the advantage of thedelegation of responsibilities as comparedto mutual recognition is that such delegation

would allow, without imposing strict andless flexible mutual recognition rules,supervisory competence to rest with thesupervisor best placed to deal with thesubject matter.The benefit of delegation ofresponsibilities is recognised. However acertain number of important legal andpractical issues must be properly addressedto enable efficient and appropriate delegation considering that the mostimportant issues would be regulateddirectly by EU law and other, less importantissues, would be agreed between competentauthorities.Luxembourg, as a global centrefor cross-border distribution of UCITS,should take a primary role in the integrationof European financial markets as a centreof competence in cross-border distributionissues through the delegation of responsi-bilities, just as in the past it made optimaluse of the mutual recognition regimeunder UCITS I and UCITS III.

Rafael Aguilera

Senior Manager ERS-

Regulatory Consulting

Deloitte S.A.

1 EC letter of the 5th of June 2008 (DG Market/BPC/IP(2008)6108

2 Art 13§5 of the Prospectus Directive 2003/71/EC

3 Art 17 and 48 of the MIFID Directive 2004/39/ECArt 13 of the Market Abuse Directive 2003/6/EC Preambre 8 and 68 and Art 101 of the UCITS IVDirective 2009/65/EC

4 The three "Level 3" committees of European financial supervisors, i.e. CEBS, CEIOPS and CESRCEBS: Committee of European Banking SupervisorsCEIOPS: Committee of European Insurance andOccupational Pensions SupervisorsCESR: Committee of European Securities Regulators

5 CESR/09-190 3L3 Delegation Task Force

6 Trib. Ord. Rome (Civ), 30 January 2007, Colomboe.o.v. CBFA and Consob, RG 26939-2003.

7 CESR has already conducted mapping exerciseson the supervisory and sanctioning powers of itsmembers arising out of the Market Abuse Directive,the Prospectus Directive, the MIFID and theTransparency Directive.



IN VALUATION, WE TRUSTCESR UPDATE ON OTC DERIVATIVE VALUATION PRACTICES 1

CESR consulted the asset management industry onthe level 2 measures related to the UCITS managementpassport in July 2009. Section IV of this consultationaddressed the issues related to risk managementincluding inter alia, procedures for the valuation ofOTC derivatives.

Valuation of OTC derivatives is not a new topic.Valuation issues nevertheless arise in conjunctionwith financial instability each time a crisisappears. The CESR consultation paper updates, atEU level, the minimum valuation practices withwhich UCITS will have to comply.

'PRICE IS WHAT YOU PAY. VALUE ISWHAT YOU GET.' (WARREN BUFFETT)

I CESR REAFFIRMS THE FAIRPRICING PRINCIPLE

Management companies (or in the case ofinvestment companies that have not designated a management company theself-managed UCITS itself) should verifythat fair values of OTC derivatives do notrely only on market quotations by thecounterparties of the OTC transactions.

The valuation should be based on a reliablemarket value of the OTC instrument.It should reflect, where appropriate andmeaningful, the up-to-date market valuesof such instrument, if possible by reference to the prices of comparabletrades. If such value is not available ormeaningful, a pricing model using an adequate methodology must be used. Inthat case, the management company shallduly assess that the underlying assumptionsand the theoretical basis implemented bysuch models appropriately capture all thefeatures of the OTC instruments and aresufficiently well calibrated. Additionally,models should be maintained and revisedover time. We would add that modelsshould be also (independently) validated.

In any case, valuations obtained via modelsshould correspond to the probable trading

values of the OTC derivatives. Prices fromcounterparties to the OTC derivatives, orfrom external contributors, can be compared with valuations derived frommodels. Significant differences must beappropriately documented, explained andpromptly disclosed to the managementcompany.

Such valuations can be open to discussion,particularly with the auditors of theUCITS. In that respect, it is important tohave clear guidelines on the methodologyused and on a consistent usage of thesources and the model. Discussions canarise from the fact that a quote from acounterparty as to the value of an illiquidinstrument may differ substantially fromthe fair market value derived from amodel. In order to avoid volatility in thevaluation, some would like to favor theprice calculated by the model, arguing thatthe quote observed in the market shouldbe considered as a 'forced' price, i.e. aprice that a seller would receive in theevent of a forced sale of the instruments.Fair value often refers to the price at whichan asset could be bought or sold in a transaction between willing parties, ortransferred to an equivalent party, otherthan in a liquidation sale. The Board ofDirectors of the UCITS or the managementcompany will define the necessary criteriaof a fair price, and the criteria for excluding a valuation that would be considered as 'forced'.

There is also currently a debate in theindustry as to whether the fair valuemethodology should take into account theilliquidity of OTC instruments. Besides apremium for the counterparty/credit risk,some would propose including a discount,reflecting the absence of liquidity in a specific instrument. The reason behind isthat if the UCITS was forced to sell thederivative, due to the specific nature of anOTC transaction, the price received wouldbe significantly different than the fairprice estimated via a model. If the

valuation principles specify that theUCITS will be valued on a bid basis, sucha discount should be provided for. Thereare currently various academic papers onhow to integrate liquidity risk in valuationmethodologies. Liquidity spreads areclosely related to credit spreads andhence, it is often difficult in practical termsto isolate them. In short, the principle of aliquidity premium/discount is recognizedalthough no practical methodology to compute this premium/discount is sufficiently robust.

I NEED TO USE ADEQUATE DATA

Market data used to calibrate model-basedvaluations should be adequate to reflectthe market realities at all times. Data shouldtherefore be updated at adequate intervals.Market data being the preferred source,valuations derived from a model should beregularly back-tested and challenged bythe risk management function.

Particular attention will be put on the independence of the process. This can bethe case if some important parameters to beused in the models are built and providedby the investment manager (such as certainimplicit correlations or certain creditspreads). Different sets of data can also beused for valuation and risk managementpurposes, leading to differences in the interpretation or limits. We believe that theresulting discussion will enable the riskmanagement function to better understandthe modeling choices and their impact onthe valuation.

I APPROPRIATE VERIFICATIONOF THE VALUATION

Management companies should establish,implement and maintain processes whichensure appropriate, transparent and fair



valuation of OTC derivative instruments.Management companies should ensurethat the principle of independent assessmentconcerning the valuation of OTC derivativesis fully complied with.

Verification of valuation is carried out byone of the following:

a) a third party which is independentfrom the counterparty of the OTCderivative, at an adequate frequencyand in such a way that the managementcompany is able to check the verificationprocess. The management company,however, remains responsible for thecorrect valuation of the OTC derivativesand will have to verify that the independent third party can adequatelyvalue the types of OTC derivative.

b) a unit within the management companywhich is independent from the department in charge of managing theassets and which is adequately equippedfor such purpose.

I ADEQUATE, ACCURATE ANDINDEPENDENT ASSESSMENT

Article 51(1) of the UCITS Directive statesthat management companies shouldensure that the fair value of OTC derivatives is subject to adequate, accurateand independent assessment.

Regarding the accuracy requirement,management companies should adoptappropriate arrangements to ensure thatthe valuation of OTC derivatives is carriedout according to fair pricing principles.

While it is recognized that managementcompanies can in general use proprietaryvaluation systems, the independencerequirement precludes relying on valuationmodels that have not been subject to independent review within the companyor by independent third parties. This principle also precludes the use of data(such as volatility or correlations) produced by a process which has not beenreviewed by the management company.A due diligence exercise would thereforeneed to be performed on the process.

It is expected that management companiesestablish clear escalation process in caseof differences between the valuation produced and the verification controls of

these valuation. Ultimately, the Board ofDirectors of the UCITS or the managementcompany remains responsible for determining the reasonableness andappropriateness of the verification procedure.The procedure should describeinter alia, the primary source to be used forthe NAV.Appropriate thresholds or tolerancelevels should be defined. Ideally, thesethresholds should vary depending on thetype of instruments or the volatility of the markets.

Accurate assessment of the valuation ofOTC derivatives should imply the performance of ongoing checks. The frequency of these controls should be adequate and proportionate to the complexity of the OTC instruments, theNAV computation and redemption periodicity of the UCITS, and the organi-zational features of the valuation process.

I INCREASING ROLE OF THE RISK MANAGEMENTFUNCTION

The risk management function shouldhave specific responsibilities in relation tothe valuation purpose. In any case, the riskmanagement function should review and,if necessary, provide appropriate supportconcerning the processes adopted for thevaluation of OTC derivatives. CESRbelieves that there should be sufficientinteraction between the risk managementand the valuation functions so as to allowmutual support. Indeed, models used forpricing assets that require complex valuation, such as illiquid, structuredfinancial instruments or OTC derivatives,must be closely aligned with the measurement framework used for riskmanagement. As a consequence, CESRbelieves that, in most cases, the risk management function may be particularlywell placed to carry out an assessment ofthe valuation process for OTC derivativesadopted by the management company.Therisk management function should, in thisrespect, be sufficiently equipped with theappropriate resources and systems to tacklecomplex issues related to the valuation ofOTC derivatives. Furthermore, the riskmanagement function should be affordedthe required level of independence withinthe organization of the company.

I CONSISTENT APPLICATION OFFAIR PRICING PRINCIPLES

Management companies should ensurethat the principles adopted are appliedconsistently to the valuation of other typesof financial instrument subject to the samedifficulties and issues as OTC derivatives.In this respect, management companiesshould adopt similar procedures for thevaluation of illiquid or complex transferable securities and money marketinstruments, such as those that typicallyembed OTC derivatives, which require theuse of model-based valuation methods.

The valuation procedures and arrangementsdescribed should be adequately documentedand formalized.

I CONCLUSION

The valuation processes for OTC derivatives is constantly evolving, not onlywith the type and complexity of financialinstruments, but also when the market situation calls into question the prices andthe models used. The methodology therefore requires skilled judgment andexperience.As various outcomes are possible,management companies should implementconsistent, robust and transparent valuationguidelines to ensure a fair pricing approach.CESR reaffirms the need to have stronginteraction between the risk managementfunction and the valuation process. It isimportant to understand and agree on theunderlying assumptions, parameters anddata used in order to come to a fair valuation.Indeed, fairness can be interpreted in different ways…

Laurent DenayerPartner

Financial Services Risk ManagementErnst & Young, Luxembourg

1 This article was written on the basis of the consultation paper CESR/09-624, 8 July 2009.Parts of this article are quoted from the CESR consultation paper.The final advice was expected bythe end of October 2009.


TAX UPDATE

ABERDEEN: A CASE OF DISCRIMINATION

In Case C-303/07 Aberdeen Property Fininvest

Alpha Oy, the European Court of Justice ("ECJ")

addresses and declares incompatible with the

freedom of establishment and the free movement of

capital set out in the Treaty establishing the European

Community, the discriminatory tax treatment of

investment funds in the European Union based on

residency. The decision opens up the possibility for

European based investment funds to challenge

discriminatory treatment when investing cross-

border within the European Union.

This preliminary ruling of the ECJ applies throughout

the European Union, it is of particular importance to

the Luxembourg fund industry, which is the most

important fund centre in the European Union by

number of investment funds and assets under

administration and is cross-border by essence.

Considering the economic impact of source taxation

in cross-border investment situations, Luxembourg-

based investment funds may thus clearly benefit

from a further strengthening of the single market by

confirming the level playing field between domestic

and cross-border investment funds.

I FACTS

Aberdeen Property Nordic Fund I SICAV,

a Luxembourg property fund in the form

of an investment company with variable

capital ("SICAV" or "Fund") owns the

entire share capital of Aberdeen Property

Fininvest Alpha Oy ("Alpha"), a Finnish

special purpose company set up to invest

into and hold Finnish real estate either

directly or indirectly.

In order to clarify the profit repatriation

between Alpha and the Fund and hence

the viability of the ownership structure,

Alpha applied to the Finnish tax

authorities seeking clarification as to

whether it would have to levy withholding

tax when making dividend distributions to

its parent, i.e., the Fund.Alpha argued that

if these dividends were to be paid to a

Finnish investment fund, Alpha would

benefit from a full dividend withholding

tax exemption.

The Finnish tax authorities rejected theapplication and confirmed that Alpha wasto charge tax at source. The Finnish taxauthorities argued that SICAVs do not fallwithin the scope of application of CouncilDirective 90/435/EEC on the common system of taxation in the case of parent companies and subsidiaries of differentMember States and can thus not benefitfrom a conditional withholding tax exemption applicable to dividends paid bysubsidiaries to their parent companies.

The Finnish tax authorities further contended that the Fund could not be compared to any qualifying Finnish recipient due to the fact that (a) its capitalwas variable, a concept unknown underFinnish law and (b) it was exempt from corporate income tax in its home MemberState (i.e., Luxembourg). Alpha then challenged this outcome and thus theFinnish tax levy before the Finnish courtsas being contrary to EC legislation.

Since the resolution of the disputerequired an interpretation of Communitylaw, the Supreme Administrative Court ofFinland stayed the Finnish proceedingsand filed a request for a preliminary rulingwith the ECJ on the following questions:

"Are articles 43 EC and 48 EC and Articles

56 EC and 58 EC to be interpreted as meaning

that, in order to safeguard the fundamental

freedoms set out therein, a share company or

an investment fund governed by Finnish law

and a SICAV governed by Luxembourg law

are to be regarded as comparable despite the

fact that a form of company corresponding

exactly to a SICAV is not recognised in

Finnish legislation, having regard, first, to the

fact that the SICAV, which is a company

governed by Luxembourg law, is not mentioned

in the list of companies referred to in article 2 (a)

of Council Directive 90/435/EEC, with which

the Finnish withholding tax legislation

applicable in the present case is consistent,

and, second, to the fact that a SICAV is

exempt from income tax under domestic

Luxembourg legislation?

Is it therefore contrary to the above articles of

the EC Treaty for a SICAV resident in

Luxembourg which is the recipient of a

dividend not to be exempt from withholding

tax charged in Finland on dividends ?"

I OUTCOME

In its judgment of June 18, 2009, the ECJ

ruled illegal the withholding tax levied by

the Finnish revenue on dividends paid to

a foreign parent. The ECJ found that

according to Finnish tax legislation, the

Finnish revenue could not have levied

such tax if the dividend payment had been

made to a Finnish parent company instead.

Alpha argued that objectively comparable

situations should be treated the same way.

The profit repatriation from Alpha to the

Fund should thus be treated in the same

neutral manner as if the distribution had

been made to a Finnish fund.

The ECJ confirmed Alpha's interpretation

and ruled against the discrimination based

on residency.

I ANALYSIS

The Aberdeen case confronted the ECJwith the difficult task of determiningwhether any of the two fundamental freedoms at stake was violated in a situation which involves parties from

1 0 I L U X E M B O U R G F U N D R E V I E W I N ° 8

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different Member States and subject todifferent laws. In order to assess a possibleviolation, the ECJ had to determine at firstwhether the situations under considerationcould be compared. While everything inthis case appeared to be different at first,the ECJ undertook the difficult task ofcomparing the situations against the background of a single market.

The ECJ firstly examined the Finnish legislation providing for an exemptionfrom withholding tax on dividends distributed by a Finnish resident company(i.e., Alpha) to its parent recipient (i.e., theFund). If the Fund were a resident ofFinland, the distribution would not havebeen subject to tax in the hands of Alpha.

1) Since the recipient was a non-resident,the ECJ examined the dividend distribution under the Finnish implementation of Council Directive90/435/EEC. The Directive, as implemented into Finnish law, requiresthat the Fund would hold a participation of at least 20% in Alphaand would qualify as an entity listed in the Annex to the Directive. While the quantitative condition was met (i.e., Alpha is a wholly-owned subsidiary), SICAVs are not listed inthe Annex to the Directive. Thus theFund was not a qualifying recipient andthe parent-subsidiary exemption provided for under Finnish tax law wasnot applicable to the distribution fromAlpha to the Fund in accordance withFinnish provisions.

2) While the Finnish legislation at stakeand the alleged discrimination potentially touches upon questionsrelating to the freedom of establishmentand the free movement of capital, theECJ resolved that "where a company hasa shareholding in another company whichgives it definite influence over that company's decisions and allows it to determine that company's activities, it is theprovisions of the Treaty on the freedom ofestablishment that are to be applied".The ECJ thus declined to further examinea potential violation to the free movementof capital, if any and concentrated itsanalysis on Article 43 EC.

I COMPARABILITY WITH THEFREEDOM OF ESTABLISHMENT

3) The Court then referred to settled caselaw showing that the freedom of establishment entails the right to exercise an activity in a Member Statethrough a subsidiary. The Fund shouldtherefore be free to exercise its activities in Finland via the establishmentof a subsidiary. The Court stated that inthe case of companies, their registeredoffice for the purposes of Article 48 ECserves, in the same way as nationality inthe case of individuals, as the connectingfactor with the legal system of aMember State.

The Court therefore stressed thatArticle 43 EC precludes a MemberState from applying differing treatmentdepending on whether the registeredoffice is located in another MemberState or not.The Court concluded that:"Freedom of establishment thus aims toguarantee the benefit of national treatmentin the host Member State, by prohibitingany discrimination based on the place inwhich companies have their seat".

4) The ECJ stressed that if a MemberState chooses to relieve a domestic parent company from taxation at sourceif the distribution is made by its domestic subsidiary, it must also extendthat relief to non-resident companiesprovided they are in a comparable situation.

The Finnish Government however contended that a Finnish companycould not be compared to aLuxembourg SICAV due to the differences in the applicable legal (i.e., Finnish company law does notknow the variable capital concept) andtax (i.e., a SICAV is not subject to corporate income tax unlike a Finnishcompany) regimes. The FinnishGovernment further argued that aFinnish investment fund would not beallowed to invest in real estate and thatany distributions by such a fund wouldin principle be subject to tax (unlike thecase for a SICAV, as Luxembourg

tax law does not tax distributions to a SICAV's shareholders at source),in the absence of relief under a doubletax treaty.

5) The ECJ rejected the Finnish argumentson the grounds that:

- the fact that Finnish law does notenvisage a legal regime similar to theSICAV cannot in itself justify a difference in treatment, as companylaws of Member States have notbeen fully harmonised at Communitylevel;

- the non-taxation of dividends atSICAV level in Luxembourg doesnot justify its taxation by the FinnishState, since Finland has chosen notto exercise its tax jurisdiction oversuch income where it is received bya company or fund resident inFinland;

- furthermore the Finnish Governmenthad not demonstrated how the different tax treatment of the relevant recipients (Finnish andLuxembourg) and different types ofincome was justified in determiningeligibility for exemption from withholding tax on dividends received.

The ECJ therefore concluded thatthese differences were not sufficient tocreate an objective distinction withrespect to eligibility for exemption fromwithholding tax on dividends receivedand thus resolved that the differenttreatment constituted a restriction ofthe freedom of establishment prohibitedby Articles 43 and 48 EC.

I JUSTIFICATION OF THERESTRICTION OF FREEDOMOF ESTABLISHMENT

6) Notwithstanding the foregoing andwhile a restriction on the freedom ofestablishment is in principle prohibited,it may nevertheless be permissible if itis justified by overriding reasons in thepublic interest, provided however thatsuch permissible restrictions may notgo beyond what is necessary to protectsuch public interest.


TAX UPDATE

The Finnish Government submitted onthis point that its national rules wereprimarily intended to prevent tax avoidance. The Government stressedthat since the non taxation of the dividend income in the hands of theSICAV and the subsequent non taxation at source on a distribution tothe SICAV's shareholders would ultimately result in the complete avoidance of tax. It furthermore arguedthat its tax system was intended to prevent conduct which could compromise Finland's right to exerciseits tax jurisdiction in relation to activities carried out in its territory.

The ECJ acknowledged that certainrestrictions to a fundamental freedomcould be allowed if they were intendedto protect the coherence of the Finnishtax system. However for any suchrestriction to be valid, it would requirea direct link between a particular taxadvantage (i.e., the exemption fromwithholding tax) and the off-setting ofthat advantage by a special tax levy.

The ECJ however considered thatFinland failed to establish such a linksince a Finnish fund recipient could

also have received the relevant dividend income without it being subject to corporate income tax andwould furthermore not have beenunder any obligation to distribute therelevant proceeds to the ultimate shareholders thereby triggering the taxation of the relevant income in thehands of the shareholders.

I CONCLUSION

With a restriction on Articles 43 EC and 48 EC thus established and in the absenceof a valid justification for such a restriction,the ECJ concluded that: "The answer to thereferring court's question is that Articles 43 ECand 48 EC must be interpreted as precludinglegislation of a Member State which exemptsfrom withholding tax dividends distributed bya subsidiary resident in another Member Stateto a share company resident in that State, butcharges withholding tax on similar dividendspaid to a parent company in the form of aSICAV resident in another Member Statewhich has a legal form unknown in the law ofthe former State, does not appear on the list ofcompanies referred to in Article 2 (a) ofDirective 90/435, and is exempt from incometax under the law of the other Member State".

While this decision recognises the importance of the logic of domestic taxsystems, it is clearly recasting this logicwithin the European single market context. This is good news for investorsthroughout the European Union as theywill not have to select investment funds byreference to the tax treatment in the various source countries. This is also goodnews for the investment fund model.While the ECJ sets aside the tax exemption at fund level as an insufficientreason for differentiation, it indirectlystrengthens one of the core features of aninvestment fund, i.e., its tax neutrality.

While further discrimination continues toexist within the single market, this decision will now help to assess andremove these situations.

Gilles Dusemon Partner

Loyens & Loeff, Luxembourg



RELOCATION OF OFFSHORE FUNDS TO LUXEMBOURGWHY AND HOW

The investment fund market witnessed a recentintensification of interest in the migration of offshore funds to Luxembourg. The recent financialcrisis, as well as the perspective of the EuropeanUnion's proposed Directive on AlternativeInvestment Fund Managers (AIFM Directive) areoften mentioned as the motives to migrate to anonshore jurisdiction. In this perspectiveLuxembourg, being Europe's largest fund domicileand second largest global leader behind the UnitedStates, offers great advantages in terms of solidbut flexible regulation, global distribution, recognized brand mark, extensive and well-established infrastructure for servicing funds, andoutstanding reputation throughout the internationalfinancial world. This also certainly explains thegrowing interest in the migration of funds from offshore jurisdictions such as Cayman and the BVI to Luxembourg (I). In addition, the Luxembourg legislation offers tools which facilitate the migration process (II).

I I. WHY TO MIGRATE?

One of the tangible results of the economiccrisis was a weakened faith in the financialmarkets and their products. Consequently,this lack of trust resulted in an accrueddemand for a stronger and more efficientprotection of investors. In order torespond to this trend and continue toattract capital, promoters were naturallyencouraged to establish their entities inthe markets with solid regulation and continuous prudential supervision overthe investment activities. Luxembourgresponds to these preoccupations with itsflexible but robust European legal framework and pragmatic but vigilant regulator - the Commission de Surveillancedu Secteur Financier (CSSF).

In addition, the European Union nowpushes alternative fund managers towardsa much higher level of regulation. Investorprotection is indeed a focus of internationaldiscussion. G20 members have decided

that financial products should be subjectto appropriate regulation, and theEuropean Commission has issued a draftdirective to this effect. Without enteringinto the detailed provisions of the draftAIFM Directive, and notwithstanding thecriticism it has crystallised, it represents a manifestation of the global trend towards regulation, and increases the pressure on alternative fund managers toaccept a more regulated environment,thus accelerating the re-domiciliation of offshore funds to Luxembourg.

In this respect, Luxembourg is a well-established European Union domicile with a regulated product regime.It already offers a great balance betweenmature fund legislation, wide range ofavailable vehicles and flexibility in termsof eligible assets.

Luxembourg has developed a very well-known UCITS industry, and was thefirst Member State of the European Unionto implement the European legislation onUCITS, offering inter alia the advantage ofthe "European passport" for cross-borderdistribution and broadening the scope ofeligible investments. Luxembourg thusbecame a leading jurisdiction for collectiveinvestment products, including UCITS.Recent years have shown rapid growth inthe number of sophisticated UCITS allowing offshore managers to use derivatives to replicate alternative strategiesin a regulated environment, and makingalternative products available to a muchbroader market throughout the EuropeanUnion. Hedge funds executives are thusincreasingly talking about the "onshoring"of the industry, new funds being domiciledin Luxembourg rather than the Cayman,their traditional home. For strategies suchas long-short equity, UCITS funds areconsidered as offering enough flexibilitywhilst giving investors access to funds theysee as being more transparent1.

In addition, the law of 13 February 2007(the "SIF Law") created the specialisedinvestment fund which appeared as a particularly attractive vehicle for alternativefund managers in terms of eligible assets,including inter alia, hedge funds, realestate funds, funds of funds, private equityfunds, funds investing in money marketinstruments, transferable securities,financial derivative instruments, and soon. The 2007 Law created a genuinelyattractive regime for sophisticatedinvestors, since it offers a tailor-made legalframework for various and specific products. Whilst directly inspired by thelaw of 20 December 2002 on undertakingsfor collective investments (the "2002 Law"or "UCITS Law") and the law of 15 June 2004on the investment company in risk capital,as amended (the "SICAR Law"), the SIFLaw adapts to the needs of sophisticatedinvestors, eases the setting-up of theirstructures, allows more flexibility as to theoperating rules of these funds and lightensthe legal regime applicable to them, all thewhile offering the advantages of a regulatedvehicle subject to rigorous prudentialsupervision. The SIF thus seems to fit perfectly well as a vehicle that meets the requirements of those insisting oncloser supervision while offering flexibilityin terms of structure and investments, aswell as a domicile in the world's leadingcentre for cross-border distribution.It is worth noting that according to therecent figures published by the CSSF, atotal of 906 SIFs accounting for aggregateassets of EUR 143.bn2 were in existence atthe end of July 2009.

Last but not least, Luxembourg market'sintrinsic characteristics such as maturefund administration, custody and transferagency services, as well as strongly developedcompliance and risk management structures appear also very attractive foroffshore entities. Luxembourg perfectly



accommodates their practical expectationsin terms of infrastructure, serviceproviders and skilled and multinationalworkforce guaranteeing at the same timehigh standards of investors' protection.

The legal, regulatory and administrativeframework in place in Luxembourg in thelight of the growing pressure on alternative fund managers coming frominstitutional investors and European regulators to accept a more regulated environment directly strengthens thecompetitiveness of Luxembourg as a historical and highly competitive financialsector, which will attract more and moreoffshore funds. The question then is:how such offshore funds concretelymigrate to Luxembourg?

I II. HOW TO MIGRATE? MORETHAN ONLY ONE OPTION

The Luxembourg legal regime in place,whether the Law of 10 August 1915 oncommercial companies, as amended (the"Law of 1915"), or the various laws governing the different types of investmentstructures, i.a. the UCITS Law, the SICARLaw or the SIF Law, offers different routesto achieve the relocation of an offshorefund to Luxembourg.

The principal options are (1) the transferof the registered office of the foreign fundto Luxembourg, (2) the merger of the foreign fund into a Luxembourg fund,(3) the contribution by the foreign fund ofits assets to a Luxembourg fund.Ultimately, although this would not reallyqualify per se as relocation, (4) the assets ofthe foreign fund may be purchased by theLuxembourg fund. Without prejudice tothe potential tax issues which might berelevant in this context, the choice amongthe different options will depend on the legal form of the offshore fund concerned (incorporated fund or contractualpartnership arrangement), and on thepotential legal restrictions existing in thehome jurisdiction.

Disregarding the option retained, andbeyond the corporate and tax implicationsof the relocation to Luxembourg, a particular attention shall also be broughtto the verifications and diligences which

shall need to be performed by the different Luxembourg service providers ofthe migrating fund.

I 1. PACK YOUR CASE: TRANSFEROF DOMICILE OF A FOREIGNFUND TO LUXEMBOURG

An efficient and not too burdensome wayto relocate a foreign fund to Luxembourgis to transfer its domicile to Luxembourg,without such foreign fund ceasing to be alegal entity.

Although no express provisions dealingwith the transfer of corporate domicile offoreign companies exist in the Law of19153, a now long-standing practice hasdeveloped over the last forty years andcompanies from many offshore jurisdictionshave moved to Luxembourg. This practiceis based on a flexible interpretation of theprovisions of the Law of 1915, which provide that any company having its central administration in the Grand-Duchyof Luxembourg shall be governed byLuxembourg law, even if the deed of incorporation has been executed abroad.

Luxembourg takes however the view thatthe legal personality of a transferred company continues in Luxembourg,provided that the law of the company'shome country allows it to transfer itsdomicile without discontinuation of itslegal personality. Opting for a transfer ofdomicile may thus only be considered forinvestment companies of the corporatetype.

Assuming that the change of domicile ispermissible under, and the decision relating thereto has been taken in compliance with, the laws of the homejurisdiction, upon the transfer of its central administration to Luxembourg theforeign company shall become aLuxembourg company and will abide tothe Luxembourg applicable law. Thismeans that i.a. the articles of association ofthe foreign company must be amendedsubstantially so as to comply with the Lawof 1915 and, as the case may be, the lawapplicable to the type of fund (UCITS, SIFor SICAR) which the foreign companycontemplates to adopt, as well as the relevant regulatory prescriptions.

The restated articles need to be adoptedby an extraordinary general meeting ofshareholders to be held before aLuxembourg notary. The deed shall nevertheless comply with both therequirements of the law of the country oforigin and of Luxembourg law with regardto conditions for amendments to the articles of association (convening forms,content of the agenda, quorum and majorityrules …).

Opinions from legal counsels in bothjurisdictions confirming the conditionsand modalities for a valid transfer in continuation might also be required by theLuxembourg notary.

Finally and as a prerequisite to the relocation, the draft deed of transfertogether with the whole revised documen-tation of the offshore fund shall gothrough the whole approval process of theCSSF so as to be recorded on the officiallist of Luxembourg investment funds asfrom the date of the relocation.

I 2. CROSS-BORDER MERGER

The option of a cross-border merger onlyexists for investment companies as norules currently permit and govern themerger of a foreign fund into aLuxembourg Fonds Commun de Placement("FCP"). It should however be noted thatthis will change for UCITS, as theprospective UCITS IV Directive4 will entitle all UCITS funds to merge, regardlessof their structure (corporate, unit trust orcontractual type of funds).

The cross-border merger is the operationwhereby an offshore investment fund isabsorbed into, or amalgamates with, aLuxembourg regulated investment company, whether a UCITS, a SIF or aSICAR, all its assets and liabilities beingtransferred to the absorbing Luxembourgcompany against the issuance of newshares in the Luxembourg entity and theirallocation to the shareholders of the foreign fund which is dissolved.

A cross-border merger may however onlybe contemplated to the extent that it isalso permissible under the relevant foreign law5. The whole merging process



must then comply with the applicable provisions of both jurisdictions.

The process can be summarised as follows:

The boards of directors of both theabsorbing and the absorbed companiesshall formally adopt a common mergerproject providing for all the details of theirmerger, such as, among others, details onthe merging companies, the relevantaccounting reference dates for the respectivevaluation of the merging companies, andthe consideration to be received by theinvestors of the absorbed company.

The absorbing company being aLuxembourg regulated investment vehicle,the CSSF must grant its approval on thedraft merging project.

Once adopted, the merger project shall befiled with the relevant company's registrars and published in the officialgazettes of both Luxembourg and thecountry of the absorbed company, so as togrant equivalent information and protection to the investors and creditors ofboth entities.

The merger project is, in most cases6,submitted to the approval of the extraordinary general meeting of theshareholders and other securities holdersof both merging entities7 together with (i) ajoint report drafted by their respectiveboard of directors describing, and justifying, under a legal and economicpoint of view, the merger project and, inparticular, the exchange ratio of the shares,as well as (ii) a report established by one ormore independent auditors for each of themerging companies addressing in particular the relevance of the valuationmethods used to determine the shareexchange ratio.

The merger project, the directors' reportand the auditors' report must be madeavailable at least one month prior to thegeneral meetings convened to approve themerger, together with the companies'three latest annual accounts and a morerecent interim financial statement. Bothreports may be waived with the approval ofall the shareholders and other securitiesholders of the two merging companies.

The resolution adopted by the generalmeeting of the Luxembourg absorbing

company to approve the merger must meetthe form, quorum and majority conditionsto amend the articles. In addition, thenotaries in each jurisdiction shall addressto their colleague in the other jurisdictiona certificate confirming that the legalmerging formalities have been duly andvalidly complied with in their respectivejurisdiction.

Among the shareholders of the two merging companies, the merger shall becomplete and effective as from theapproval by the extraordinary generalmeetings of both merging companies.

Once complete, the merger has the effectthat (i) all assets and liabilities of theabsorbed company are, by the effect of thelaw, universally and automatically8

transferred without discontinuity to theLuxembourg absorbing company, (ii) theforeign absorbed company is dissolvedand (iii) the shareholders of the absorbedcompany become shareholders of theLuxembourg absorbing company.

I 3. THE CONTRIBUTION OFASSETS BY A FOREIGN ENTITYTO A LUXEMBOURG REGULATEDINVESTMENT FUND

The third legal mechanism whereby aninvestment fund organized under a foreignlaw could convert itself into a Luxembourgregulated investment fund consists in theoffshore fund contributing all its assets,and to the extend feasible, its liabilities, toeither an already existing Luxembourginvestment company or to an existing FCP,or as initial funding capital to a new company or FCP.

The offshore fund then results in becoming the shareholder or unit holderof the Luxembourg vehicle, and is thereafter generally wound up, its assets,consisting in the shares or units of theLuxembourg vehicle being distributed inkind as liquidation proceeds to its ownshareholders or unitholders.

Provided that the articles, the managementregulations9 or the offering documents ofthe Luxembourg receiving entity authorise, or at least do not exclude such

subscription by contribution in kind, andprovided that the contributed assets complywith its investment policy, no priorapproval by the CSSF shall be required.

The process shall be slightly differentwhether the receiving entity has a fixed ora variable share capital, it being noted thatFCPs are generally set up with a variableasset base.

In a UCITS, SIF or SICAR with a variableshare capital, a contribution of assets maybe decided or accepted by the managementbody without having to convene a generalmeeting of its shareholders, nor having thearticles amended to reflect the increase ofthe share capital.

In an investment company with a fixedshare capital, the decision to accept such acontribution and to proceed to the necessarycapital increase is submitted to an extraordinary general meeting of shareholders complying with the quorumand majority requirements of the Law of1915 for amendments of the articles,unless the capital increase may be decidedby the management body in the context ofthe authorised capital.

In all contemplated cases, a valuationreport from an external independent auditor is required, confirming that thevalue of the contributed net assets is atleast equivalent to the value of the sharesor units issued in consideration thereof.

One of the major differences between themerger procedure described under section (2) above and the present contribution of assets resides in the factthat a merger leads to the universal transfer of all assets and liabilities of theabsorbed company to the absorbing company. There is a continuity of the existence of the absorbed companythrough the absorbing company. As a consequence, all agreements entered intoby the absorbed company are automaticallytransferred to the absorbing companywithout a requirement to notify each creditor/debtor individually of the transfer.

On the contrary, a contribution in kindgoverned by Luxembourg law does notoperate such automatic transfer of assetsand liabilities. Therefore, the assignmentof all outstanding assets and liabilities of



the contributing entity will need to berealised in strict compliance with eitherthe law under which the contributing offshore fund is organised, or the law governing the respective assets or liabilities which are assigned, and, as thecase may be, with Luxembourg law, so thatthese assignments are validly notified toeach creditor/debtor and accepted individually by each of them.

I 4. THE PURCHASE OF A FOREIGN ENTITY'S ASSETS BYA LUXEMBOURG REGULATEDINVESTMENT FUND

The fourth option whereby investors maysubstitute their holdings in a foreign fundby holdings in a Luxembourg regulatedinvestment fund10 would consist in havingan already existing, or newly organised,Luxembourg investment company orFCP11 purchasing the net assets of the offshore vehicle against a debt instrument.In a way rather similar to the third optiondescribed here above, the offshore fundwould then result in becoming the creditor or note holder of the Luxembourgvehicle, and would thereafter be woundup, its assets, consisting essentially in thedebt instruments issued by theLuxembourg vehicle, being distributed inkind as liquidation proceeds to its own

shareholders or unitholders, who, in a laststep, shall contribute these debt instruments in kind to the Luxembourgfund, and thereby become the directshareholder or unitholder of the latter.

Provided that the articles, the managementregulations12 or the offering documents ofboth the foreign funds and the Luxembourgpurchasing entity authorise, or at least donot exclude, such mechanism, this acquisition would no be subject, inLuxembourg, to the requirements ofeither external auditor's valuation reportsnor to a prior approval by the CSSF.

Luxembourg has a well-established reputation for hosting foreign investmentfunds pursuing a very large spectrum ofinvestment policies. It is certainly also avery welcoming jurisdiction for offshorefunds wishing to benefit from theLuxembourg professional expertise infund administration, compliance and riskmanagement, as well as from the pragmaticbut vigilant supervision by the CSSF,guaranteeing an appropriate level ofinvestors' protection.

Benoît DuvieusartSenior Associate, Corporate Law, M&A

Myriam Moulla Senior Associate, Regulated Investment Funds

Arendt & Medernach, Luxembourg

1 Reuters Blogs, Hedge Hub, "Onshoring the hedgefund industry", 2 October 2009.2 CSSF Newsletter No. 104, September 2009.3 On the contrary, article 67-1 (1) expressly considersthat a Luxembourg Company, by resolution adoptedat unanimity by its shareholders, may change itsnationality, implicitly recognizing that such achange does not interrupt the legal personality ofthe company.4 Directive of the European Parliament and of theCouncil on the coordination of laws, regulationsand administrative provisions relating to undertakingsfor collective investment in transferable securities(UCITS) (recast) of 22 June 2009.5 Article 257, § 3 of the Law of 1915.6 Art 264 of the Law of 1915 provides for exceptionsto this rule.7 In Luxembourg, this extraordinary general meetingof shareholders needs to comply with the conditionsof quorum and majority required for amendmentsto the articles of association (art. 263 (1) of the Lawof 1915).8 Except for intellectual and industrial propertyrights, and certain rights on movable and immovableassets.9 In the case of an FCP.10 Excluding coordinated UCITS.11 Through its management company.12 In the case of an FCP.



FUNDS INVESTING IN INSURANCE POLICIES:UNDERSTANDING THE CHALLENGES AND OPPORTUNITIES OF THE US LIFESETTLEMENT MARKET

Life insurance is one of the largest businesses in

the world, and in some countries, secondary

markets have emerged and moved from being small,

discreet markets to well-established markets.

Among these secondary markets, the US "life

settlement" market attracts worldwide institutional

investors such as investment banks, insurance

companies, pension funds, private equity funds and

hedge funds because of its non-correlation with

traditional investments. The ongoing development

of this market in the coming years creates unique

opportunities but also challenges for its entire

range of participants including policyholders,

insurance companies, regulators and investors.

I INTRODUCTION TO LIFEINSURANCE SETTLEMENTSAND REASONS FOR EMERGENCE OF A SECONDARYMARKET

A life insurance settlement is a financialtransaction whereby an investor buys anexisting life insurance policy from the initial policyholder who no longer needsit. After the sale, the original policy owneris relieved of premium payment obligations and the investor takes overthese payments until policy maturity, andreceives the policy benefit.

The concept of a secondary market for lifeinsurance is not new. A secondary marketfor life insurance has existed in the UK forover 150 years. It developed because theprimary insurance market was inefficientand insurance companies, as sole repurchaser, dictated the prices. A competitive area has now emerged, whereinvestors offer to purchase policies.

However, a secondary market for life insurance will not emerge in every countryas it requires a robust primary market with

a sufficient number of policies, conducivelegal factors enabling the transfer of property from the initial policyholder,adequate financial safeguards as regardsinsurer solvency and, last but not least,demand from third-party investors.

These three conditions are currently metin three of the world's largest life insurance markets, which according toSwiss Re are: the United States, with apremium share of 23%, representing thelargest global market life insurance; theUnited Kingdom, which ranks third with14%; and Germany which takes fifth position worldwide with a 4% share. Totallife insurance premiums worldwide represent$2,490 billion(1). The second and fourthplace in the life premium volume are heldby Japan and France respectively, neitherof which have the conditions in place for asecondary market to emerge.

I AVAILABLE PRODUCTS IN THESECONDARY LIFE INSURANCEMARKETS

The insurance products in the three leadingsecondary markets differ substantially.In the United Kingdom and Germany,insurance contracts negotiated are calledtraded endowment policies or "TEPs", andthey combine a term life insurance product with an investment fund. In theUS, the majority of the secondary marketconsists of permanent, lifelong policiesand operations taking place are called lifesettlements.

These two types of operation are exposedto different risks. US life settlements provide a fixed payout (no correlation tomarket conditions), but the term isunknown. As a consequence, they involvelongevity risk meaning that if the insuredperson outlives the life expectancy

forecast, then the returns on the policydecrease as premium payments must continue until the insured person's deathotherwise the life insurance policy willlapse or be cancelled.

British and German TEPs have no suchlongevity risk, as policies have a fixedmaturity date. On the other hand, theyhave a variable payout which is dependenton the bonus rates declared by the lifeoffices. The bonuses vary according to theinsurer's performance and the way theychoose to allocate profits. Once declared,they can not be reduced.

I ATTRACTIVENESS OF US LIFESETTLEMENT MARKET

At present, the US life settlement marketattracts most attention from investors as itoffers the largest and fastest growing number of target policies while theGerman and UK markets are perceived asmature and stagnant.

There is no official source of informationon the size of the US life settlement market.However, data estimates can be obtainedeither from industry representatives (suchas LISA - Life Insurance SettlementAssociation) or from consulting firms.Regarding the latter, Conning Research &Consulting, a renowned consulting firmfor US insurance companies, estimatedthat the market has grown from $2 billionin 2002 to $12.2 billion in 2007 in terms ofpolicy face values. The 49% annual growthin 2007 marks the biggest increase since2005. According to the same source,market growth will continue for severalyears as both the policies supply anddemand increase and the annual volumeof settled policies will reach $21 billion inaverage in face value per year over the2009-2017 time horizon.



Indeed, the supply side is expected to growsignificantly as the huge US baby boomergeneration is gradually reaching retirementage and moreover, has been left with feweroptions for a successful retirement after theeconomic turmoil following the sub-primecrisis.The target group for life settlements isseniors over 65 years of age, and currentlyrepresents 39 million persons but a hugedemographic shift is underway. The proportion of seniors will continue to expand,reaching 89 million people by 2050(2).Additional reasons for sustainable growth inthe supply of policies include increased consumer knowledge about the secondarymarket, as only 20% of people in the US arecurrently aware of the existence of a second-ary market for their life insurance policies(3).

However, the life settlement market wasalso affected by last year's global negativeeconomic downturn and slowed considerablyin late 2008. It turned from a sellers' market with numerous institutional participants to a buyer's market with manypolicies chasing for fewer buyers mainlydue to liquidity issues faced by majorinvestors. According to some key marketparticipants, capital has however comeback since this summer as the world economy shows signs of a rebound butthis growth is expected to take place at amuch lower rate than in the past years.

I THE ORIGINS OF US SECONDARY LIFE INSURANCE MARKET AND ITS DEVELOPMENT

The origins of the US secondary marketcan be traced back to 1911, where the USSupreme Court (Grisby v. Russell) ruledthat a life insurance policy, once issued,becomes the personal private property ofthe owner and may be transferred to anyperson at the owner's discretion. That ruling created the foundation for today'ssecondary market.

However, a secondary market for life insurance in the US developed in the 1980sin conjunction with the AIDS epidemic,which saw "viatical settlements" of policiesowned by terminally ill policyholders witha life expectancy of below two years.

A nascent secondary market emerged andthese policies found their way into thehands of investors seeking alternative marketproducts offering high rates of return.

In the mid 1990s, after the discovery ofnew anti-retroviral drugs, the viatical market dried up, being too risky forinvestors from a financial perspectivebecause life expectancy forecasts becameunpredictable. To fill this gap, a new market emerged, which focused on policyholders over 65, who were not facingcatastrophic medical problems but nevertheless had a theoretical lifeexpectancy of 3 to 15 years.

Today, the sale of an unwanted life insurance policy is divided into two types:"viaticals," which involve a transaction withan insured person who has a terminal or life-threatening illness and "life settlements,"which involve the sale of life insurance policies covering the life of someone over theage of 65 who may not necessarily be suffering from a terminal illness.

Life settlements currently represent thegreater part of the secondary life insurance market and are considered anestablished asset class. The fact that thelife settlement industry has grown out ofthe viatical market initially made manyinvestors reluctant to invest in this assetclass. However, the last 7 years have seenfirstly, German private equity funds andthen well regarded investors, such asWarren Buffet's Berkshire Hathaway gradually entering the market. By now,most of the well-known investment bankssuch as Goldman Sachs, Morgan Stanley,Credit Suisse and JP Morgan are active inthis market. Even some insurers such as AIG have made no secret of their involvement. Institutional investorsincluding banks, insurance companies andhedge funds continue to drive the life settlement industry.

I THE US LIFE SETTLEMENTMARKET FROM A POLICY-HOLDER'S POINT OF VIEW

Today, someone who no longer wants orneeds a life insurance policy has a broaderrange of financial choices for managing his

life insurance assets more effectively, asthere is an alternative to policy lapse oracceptance of a low surrender price fromthe insurance company. In fact, life settlements can be considered as a "win-win" transaction for both the policy ownerand the institutional investor.

Indeed, the policy owner receives morevalue than can be obtained by surrenderingthe policy to the life insurance carrier asthe surrender price does not reflect the"true" value of the policy. As an illustration,US insurers do not take into account theinsured person's state of health, whereason the secondary market, policyholdersreceive on average, three to four times thecash surrender value for the sale of theirpolicy.

Policyholders are attracted by such transactions because their individual lifecircumstances may have changed and thepolicy coverage is no longer required.There are variety of reasons includingdivorce, death of the intended beneficiary,inability to continue premium payments,need for liquidity, desire to distributeassets during lifetime, etc.

I THE US LIFE SETTLEMENTMARKET FROM ANINVESTOR'S POINT OF VIEW

Investors have been attracted by US lifesettlements because they can achievedesirable returns estimated at 8 to 12 percenton average without the disadvantages ofmore volatile investments. Insurance isperceived as asset class with no correlationto traditional markets: insurance policiesare independent from movements on theequity and bond markets, interest ratefluctuations, political changes, etc.

Investors identify and assess the value of alife insurance policy in cooperation withspecialised life settlement intermediariescalled underwriters or life expectancyproviders. These intermediaries have amedical expertise complemented by actuarial insight and provide investorswith a report whereby they estimate thelife expectancy of an individual. This isperformed using data extracted from population mortality tables (the current



standard is the 2008 VBT) together withmedical condition. Most underwriters havedeveloped proprietary tables and actuarialvaluation models according to their ownexperience but the majority of these models is inspired by the Milliman model,a leading provider of actuarial consultancyservices to the life insurance industry.

If a policy suits their investment riskspreading strategy as well as their targetrate of return, investors will either purchaseit directly from an individual or from a lifesettlement provider. Without the servicesof a provider, investors have no entry pointto the secondary market as a life settlement transaction requires connectionsand licences. Actuarial valuation knowledgeis key, but specific market relationshipsand expertise in regulations governing lifesettlements are also required. Indeed, eachstate has its own Insurance Commissionthat regulates the insurance sector withinits borders, and in this context, the life settlement market is inconsistently butincreasingly regulated.

States that regulate settlement transactionsoften implement measures for consumerprotection. Most will require that life settlement providers obtain a state licenceprior to conducting business, submit marketing materials and settlement contracts, disclose confidentiality rules onpersonal information during the settlementprocess, use an escrow agreement duringthe change of ownership process with theinsurance company and offer a cooling-offperiod enabling policyholders to rescindthe settlement agreement 15 days after itsconclusion, among many other regulations.

Only well-established and licensed lifesettlement providers have sufficientknowledge of each State's laws and domost of the work in a typical life settlement transaction. They are in chargeof carrying out the necessary due diligenceon the policy including verification of thecoverage with the insurance company andinsured person such as the review of medical records, calculation of lifeexpectancy and establishment of a policypurchase price in cooperation with under-writers. They also support and assistinvestors during the policy acquisitionprocess.

It should be noted that the use of all theseintermediaries and services providers canresult in significant charges. This has ledsome investors to acquire a provider andan underwriter or to develop these specialistcapabilities through the creation of affiliatedcompanies in order to streamline the policy acquisition process, but principallyto reduce commissions and fees.

Up until a few years ago, it was not easy toinvest directly in life settlements as someinvestors simply lacked the resources tobuild a life settlement portfolio and givenall the market specifics, they chose toinvest into life settlement investmentfunds or securitisation vehicles. As moreplayers enter the secondary market, newfinancial products have been offered toprovide exposure to longevity risk butwithout the significant issues encounteredfor a direct investment. Synthetic productssuch as swaps, longevity linked notes and longevity indices have now becomeavailable.

I RISKS ASSOCIATED WITH LIFESETTLEMENTS

Life Settlements are uncorrelated to themoves of traditional asset classes but, noncorrelation should not be understood asriskless because life settlements have theirown specific risks which are mainlylongevity risk, underwriter risk, liquidityrisk, counterparty risk and potential litigation/reputational risks.

The principal risk in a life settlementtransaction is the longevity risk when theinsured person lives longer than initiallyanticipated.The life expectancy estimate iskey when assessing the value of a policy asthe settlement amount of a policy in thesecondary market is determined after calculating the present value of futuredeath benefits, less the present value offuture premiums to be paid. If the estimateis inaccurate, then this can result in alonger stream of premium payment and alower return generated at the policy maturity.

To mitigate this risk, investors usuallyemploy robust cross-checking proceduresduring the policy acquisition process suchas obtaining at least two life expectancy

estimates for each policy, using estimatesprovided by "conservative" underwritersand reject the purchase of a policy wherethere is too much disparity in the lifeexpectancy opinions. In addition, investorsusually strive to source a significant number of policies in order to build adiversified life settlement portfolio interms of face amount, age, expected maturity dates, disease types and insurancepolicy carriers. This should reduce thelongevity exposure and enable a moreaccurate forecast of the portfolio expectedreturns.

If longevity risk can be reduced, under-writer risk however cannot be elimated asthe market relies heavily on the accuracyof these life expectancy estimates. InOctober 2008, catastrophy struck the lifesettlement market, which was rockedwhen the major medical underwriterschanged their underwriting methodologies,one after another following the publicationof the latest VBT reference table concerningthe longevity of American citizens. Thisresulted in an increase of the lifeexpectancy estimates (for the less conservative underwriter, the impact isestimated at between 20 to 30%) andcaused the devaluation of many life settlement holdings. Investors are nowdemanding the set-up of best practicesand standards during the underwritingprocess and an industry working grouphas been created aiming at achieving thesegoals and re-establishing confidence inthe life settlement market.

Another important risk is the liquidity ofthe life settlement market which hasseverely diminished over past months.Even if there has been an increasing number of investors enabling the creationof a "tertiary" market(4) where resale ofpolicies is possible from one investor toanother, life settlements remain "buy andhold" investments. First of all, the timingneeded to settle a transaction is longer dueto the specifics of this asset class but, moreimportantly, the market simply froze asmany investors stopped or postponedinvestments because of liquidity problemsgenerated by the changes in life expectancycalculation methodologies.



Counterparty risk, as in the risk that aninsurance company would default on itsobligation to pay the policy maturity amount,was considered a low risk in the past witheach state operating a compensationscheme for policyholders' indemnification.However, it regained attention followingthe financial crisis because even largeinsurance companies faced liquidity problems and some were obliged to applyfor assistance from the Trouble Asset ReliefProgram (TARP) of the US government.

Life settlement investors usually assessthis risk using insurance companies' ratings and through the selection of highly rated policies. However, this riskmanagement process had negative consequences on the market, as in early2009, downgrades of credit ratings of several insurance companies occurred.Although these insurance companies didnot go bankrupt and were still in a position to meet their commitments, themarket became illiquid for highly ratedpolicies. For the policyholders or investorsholding these policies, the secondary market dried up and they were eitherstuck with the policies or obliged to sellthem at a deep discount.

Finally, litigation/reputational risk is alsosignificant for investors as an increasingnumber of "manufactured" life insurancepolicies (so-called "STOLI" or Stranger-Originated Life Insurance) have appearedon the secondary market as life settlementsbecome more common and demand formore policies grew. STOLI is a challengefor both the life insurance and life settlement industries as it requires a differentiation to be drawn between legitimate and illegitimate life settlements.

In a STOLI scheme, a third party investorencourages individuals through economicincentives (such as an up-front payment)to take out a life insurance policy in orderto resell it in the secondary market afterthe expiration of the policy contestabilityperiod.The contestability period is usuallya two-year period following the policyissuance during which an insurance company is entitled by law to cancel a policy on the basis of fraud or materialmisrepresentation. As the policy was initiated with the intent to sell it at a later

stage, insurance companies have claimedthat these policies should be rescindedbecause they violate state laws and in particular the "insurable interest" prerequisite. "Insurable interest" is a concept dealing with the legal legitimacyof a life insurance policy and aims at providing financial protection to familymembers or relatives should the insuredperson die. It must exist at the time of thepolicy issue or the policy is void as a matter of law.

In addition, STOLI transactions operateusing various mechanisms including premium financing which causes confusion with the specific life settlementsector. Attractive during low interest periods, traditional premium finance is acommon financial option which providesinsured persons with a loan to finance thepremiums. The collateral usually consistsof large but in most cases, illiquid assets(homes, art, etc.). However, the premiumfinance sector has been distorted to facilitate the purchase of new life insurance policies by investors throughthe use of non-recourse premium financing. It provides the insured personswith the same loan facility but the policy isthe only collateral for the loan repayment.Although the policyholder usually has theoption to repay the loan at the end of thecontestability period, some lenders haveorganised their programs to discouragethis option using high exit fees so that, theownership of the policy is directly transferred to the lender or sold to aninvestor.

Since 2007, prevention of STOLI has beena priority issue for the state insurance regulators because of its negative effectson the public and the life insurance industry.STOLI causes a distortion in the industry'spricing models which are based onassumptions of mortality, lapse and surrender rates and thus lead to reducedprofits. In reaction, a growing number ofStates' bills have been enacted based onlaw models provided by the NationalAssociation of Insurance Commissioners(NAIC) and the National Conference ofInsurance Legislators (NCOIL), the twoleading associations of US State governmentofficials in charge of insurance supervision.

One of the key elements of these new regulations is the implementation of awaiting period before a policy can be sold,with certain exceptions. A minority ofstates have adopted the NAIC's five-yearmoratorium which is supported by the lifeinsurance industry. Alternatively, a majorityof states have adopted or planned to followthe NCOIL model proposing a moratoriumin line with the contestability period.Another distinguishing point in theNCOIL model is that it defines STOLIaccurately, adds new measures for insurersto detect STOLI during the applicationprocess and includes important consumerprotection to prevent abuses in premiumfinancing.

Due to the delicate status of STOLI andthe changing regulatory environment,investors usually avoid buying non-recourse premium financed policies andcontestable policies because their insurableinterest may somehow be questionable.

I INTERVIEW

Could you explain your fund administration and custodian experience in terms of life insurance policy funds?

Everything started in 2007, following arequest from one of our clients who wasconsidering appointing a custodian inLuxembourg for a vehicle investing in USlife settlement policies.

Life settlement funds demand custom-designed operational processes and servicesas their underlying investments are unlikeother types of instrument. Therefore, wedeveloped specialised workflows to handletheir day-to-day operational needs. Havingidentified the potential of this asset class,and having taken into account the numberof policies involved, we decided to build afully-automated operating model.

For US life settlement funds, we haveappointed Wells Fargo Bank N.A. as sub-custodian due to their expertise withsuch products. In addition, Wells FargoBank N.A. plays the role of security intermediary vis-à-vis the insurance companies which facilitates the operationsrelated to policies during the acquisition,premium payment and maturity pay-out



processes. These two contractual relation-ships ensure that CACEIS is in a positionto keep control of the assets entrusted butalso enabling a smooth day-to-day operatingprocess related to the policies.

For traded endowment funds, CACEISsafekeeps all the policies in its vault. Thefunds appoint an agent with responsibilityfor premium payments and the investmentmanager is in charge of communicationwith the insurance companies.

As fund administrator and custodian,CACEIS manages the relationship and theoperations with the fund manager. We calculate the fund's net asset values andmonitor the assets deposited either withWells Fargo Bank or in our vault.

Having built robust servicing models forfunds investing in life insurance policies,we have the experience and reputation foreffectiveness among potential clients on themarket. In addition, the legal environment of the Grand Duchy of Luxembourg isattractive to clients seeking to launch lifesettlement portfolios through structuressuch the SIF, SICAR or securitisationvehicles set up under the LuxembourgLaw of 22nd March 2004.

What have been the biggest challenges since youstarted administering such specialist funds?

Funds investing in life insurance remain aniche market in the alternative investmentarea. Understanding the products' specifics,designing the appropriate workflows andservicing model and last but not least,keeping abreast of the hot topics of the secondary insurance market, such as new taxregulations on life settlements, STOLI,premium financing, investment in contestablepolicies. These are some of the biggest challenges met so far. Such work requires aspecialised project team which circulates andshares this knowledge across our sales, legal,tax and fund administration departments.

Capitalising on our experience with USlife settlements, we are working to supportanother client seeking to launch a TEPfund. This is a sizeable project, as currentworkflows will need to be overhauled tosuit traded endowment specifics: premiumsin the UK are paid using direct debit facilities and we have taken the decision tosafekeep the policies in our vault.

We have also been active in helping ourclients understand the challenges imposedby the taxation of life settlements. Most

vehicles under administration are organisedas fiscally transparent entities in order toenable their underlying investors to benefit from tax treaties between theircountry of residence and the UnitedStates. However, the IRS's acknowledgementof a flow through entity in the scope of lifesettlement investments requires the use ofwell-established tax advisors with in-depthknowledge of both international tax challenges and the life settlement industry,in order to organise and secure the vehiclein a tax efficient manner.

Christine GilletSenior Business Development Analyst

CACEIS Bank Luxembourg

(1) Source : Swiss Re, Sigma No 3/2009.(2) Source : US Census Bureau.(3) A major consumer protection measure was adoptedin April 2009 by Washington State, making it the firststate in the US to require life insurance companies toadvise seniors that life settlement is an alternative toletting a policy lapse or surrendering it.(4) In competition with the secondary market when alife insurance policy first enters the marketplace.



CONSOLIDATION IN PRIVATE EQUITY STRUCTURES

Luxembourg private equity structures1, unless set upas a SICAR or a SIF, are potentially subject to mandatory consolidation of their controlled portfoliocompanies as required by the provisions of the Lawof 10 August 1915 (the "Law") applicable to commercial companies in Luxembourg. Typically, the so-called SOPARFI are subject to these consolidation requirements. Do consolidated financial statements for private equity structuresgenerate valuable information and transparency for investors and third parties or do they simply constitute a burden for private equity players? The consolidation of financial information may beregarded as of questionable benefit in the privateequity industry as investors and the public haveother needs and expectations in terms of reporting.

In our opinion and as evidenced in the analysisbelow, the private equity community operating in Luxembourg calls for an adaptation of the current regime to take their concerns into accountand align the operating model of the Luxembourgstructures used in private equity with their needsand expectations and the principles applied in otherjurisdictions such as the US.

I CURRENT REGULATIONSAPPLICABLE IN LUXEMBOURG

Under the provisions of the Law, any

company controlling another entity either

through direct or indirect control or

through the ability to appoint or remove

its management is required to prepare

consolidated financial statements. In

practice upon consolidation of an investment

structure, all intercompany transactions

are eliminated and the controlled entities

are fully integrated into the controlling

company. The outcome, a consolidated

balance sheet, a consolidated profit and

loss account and consolidated notes to the

financial statements are prepared to give a

picture of a single entity encompassing all

the consolidated companies.

The basic consolidation requirements inLuxembourg are detailed in the Law2.However, a number of specific exemptionsare provided for in the Law among which:

i) the so-called small group exemptionwhich applies where the combinedentities do not exceed 2 of 3 metrics(total balance sheet, total turnover andtotal workforce) during two consecutiveyears and other formalistic conditionsare met,

ii) the exemption granted where the groupcontrolled by the Luxembourg entity isalready consolidated in a larger groupof entities under specific conditionsapplicable to the consolidated financialstatements of the larger group,

iii) the exemption available to financialholding companies.

In addition, the Law also permits theexclusion of an entity from consolidationif this entity is to be sold "later". From thecurrent practice and the common understanding of the wording "later", theusual holding period of a portfolio company for a private equity structure (3 to 8 years) is too long to benefit fromthis exclusion.

As a result, since the exemptions andexclusions envisaged by the Law do notaddress the specific needs of the privateequity industry, unregulated vehicles usedfor private equity transaction are requiredto produce consolidated financial statements.

Under IFRS3, consolidation requirementswhich refer to the power to control do notprovide a framework for exemption of private equity from the requirement toprepare consolidated financial statements.The exposure draft 10 on consolidationwill certainly revisit some of the rules relative to consolidation, but no formal

exemptions for private equity structuresare provided for at the moment.

I ISSUES RAISED BY CONSOLIDATION IN APRIVATE EQUITY CONTEXT

We consider that consolidation in a private equity structure raises several concerns among which we highlight:

i) the relevance of consolidated financialstatements for private equity in general,and for investors,

ii) the practical difficulties of the consoli-dation process implementation and theassociated cost and

iii) the risk associated with non compliancewith these consolidation requirementsin Luxembourg.

Relevance of the consolidated financial statements

The relevance of consolidated financialstatements for a private equity structure ishighly questionable. This directly derivesfrom the core business model of a privateequity fund which consists of acquiringvarious companies for a limited period oftime (in general between 3 and 8 years),developing these companies and sellingthem as quickly as possible to achieve thehighest return. This private equity businessmodel does not fit into a consolidationscheme as the later supposes:

i) that all the portfolio companies areacquired and managed according to anindustrial strategy with synergiesbetween such companies, operating insimilar industries and not managed ona fair value basis.

ii) that the group of companies consolidatedwill be quite stable from one year to theother.



iii) that the focus is on financial position,operations and cash flow of the portfolio companies rather than financial position, operations and cashflow of the private equity structure.

iv) that the controlled (more then 50% ofvoting rights) portfolio companies willbe subject to full integration and theremaining companies subject to a different consolidation method (equitymethod or proportional integration).

In some cases, the sectors in which theoperating companies owned by the privateequity structure operate are so differentthat the consolidated figures are meaning-less. Recently we have advised a privateequity player, who had to consolidate atelecom company and an ice-cream producer, to comply with the Law.We noted that the core substance of consolidated financial statements is atstake when the investment strategy of theprivate equity structure is focused on aspecific geographical area rather then on aprecise activity sector.

Furthermore, group accounting assumes acertain degree of stability in both thegroup's activities and scope4 from year toyear in order to achieve comparabilitybetween the consolidated figures. The private equity business model which aimsto acquire and sell the company at theright moment to achieve the best return isdefinitely a factor increasing the instabilityin the scope of consolidation and again decreasing the relevance of the consolidation.

In addition, users of financial statementsfor private equity structures need to focuson the private equity structure and understand the cash flows and changes inthe fair values of the investments. Whilethe portfolio company's individual assetsand operations are ultimately the source ofchange in fair value, consolidated financialstatements would preclude recognition ofthe full changes in fair value since certainitems cannot be measured at fair valueunder LUX GAAP.

If the private equity structure were to holdnon-controlling and controlling interests,non-controlling interests would be reported differently thereby hindering the

ability to compare portfolio companies,despite the fact that the investments areboth managed and evaluated on a fairvalue basis.

If we consider the information requirementsof an investor, we can also question therelevance of the consolidated financialstatements as they will not provide theinvestor with the information he is actuallylooking for. Private equity investors areinterested in knowing the realisable valueof the investments in portfolio, and thereturn which might be achieved from theinvestments. This information is not provided by consolidated financial statements. In this respect one should notethat the EVCA reporting guidelines do not contain any specific consolidationrequirement but focus on the informationon each of the portfolio companies, suchas the fair value, the cost, the expected exitstrategy, the expected rate of return, etc.

One could also argue that consolidation ofall the entities held provides relevantinformation on the leverage level of thegroup as it enables the users to comparethe consolidated equity of the privateequity structure with the consolidatedtotal balance sheet and assess the effectiveleverage level of the group. However, we donot consider this information to be relevant as it would again "mix pears andapples". Optimal leverages to run a business in a profitable and efficient waycan vary significantly from one businesssegment to another. In addition, financingcycles from one portfolio company toanother can be different. Therefore consolidating these figures would againcreate more confusion than clarity for the reader of the consolidated financialstatements.

Practical difficulties implementing the consolidationprocess

In general, the consolidation of differententities requires the implementation of aspecific process aiming at collecting andgathering harmonised financial data fromthe companies included in the scope ofconsolidation.

In the case of consolidation operated by agroup of entities, major efforts aiming to

harmonise the accounting policies of allthe entities have to be undertaken. Theimplementation of reporting systemswhich will generate timely and accuratedata adequate for consolidation purposewill be a significant challenge. The development of a centralised reportingcell which has the ability to review all thereported data, ensure consistency ofaccounting treatment, perform controlwork on the accuracy of the informationsuch as reconciliation, initiate the consolidation process through the elimination of intercompany transactionsand record the consolidation accountingentries will be another critical success factor.

This process which is quite straightforwardfrom a theoretical standpoint leads tomajor issues in practice which are not inthe usual scope of the expertise and competency of a private equity house.Private equity houses do not implementintegrated consolidated reporting processesat the Fund level but obtain the relevantoperational and financial key performanceindicators from their portfolio companiesfor measuring and monitoring the financial performance of the portfoliocompany as a financial investment.

In addition, the direct and indirect costsassociated with such an implementationare significant both at the level of the private equity structure and at the level ofthe operating companies in the portfolio.

Risks associated with non-compliance

Risk associated with non-compliance aremainly for the governing bodies of the private equity holding vehicles. In accordance with the provisions of the Law,members of the governing bodies can bepersonally held responsible for any lossresulting from the failure to file these consolidated financial statements. In practice, since the consolidated financialstatements are supposed to be filed withthe Registre de Commerce, any third party isentitled to sue the members of the governing body for any loss incurred as aresult of the failure to file the consolidatedfinancial statements. In addition to thepenalties which might result from this



failure, it is highly likely that a companywhich did not file its consolidated financial statement will be required toproduce the consolidated financial statement retroactively, and within a shortperiod of time thereby leading to substantialcosts.

I THE SICAR LAW, A FIRST STEPTOWARDS MODERNIZATION

The general exemption from preparingconsolidated financial statements forSICAR is surely a major asset for the vehicle and private equity players clearlyconsider this exemption to be a key factordemonstrating the attractiveness of theSICAR as a private equity structure.However, one could argue that the strictapplication of the Luxembourg accountingprinciples applicable to SICAR decreasesthe transparency of the financial statements where operating companies are held via intermediary vehicles. In thiscase, as a result of the exemption from consolidation, the SICAR discloses theintermediary vehicle on the face of its balance sheet and the information on theunderlying portfolio companies is disclosedin the notes to the annual accounts.In practice, to comply with the provisions

of the SICAR Law and give any informationrelevant for the investors to understandthe activities and results of the SICAR,it is expected a "look-through" approachwill be adopted in the annual accountswith the focus on the underlying portfoliocompanies and not the intermediary vehicle. Typically, information on theacquisition cost of investments, their fairvalue and the valuation technique used to compute such fair values has to be provided.

I NEXT STEP IN LUXEMBOURG

The items described above in relation tothe current consolidation regime applicable to non-regulated private equitystructures strongly suggest that discussionswhich are currently under way by differentbodies such as the private equity players,the audit and accounting professions andthe lawyers for a revision of the exemptions available and an adaptation tothe needs of the industry and third partiesare relevant.

Olivier CoekelbergsSenior Manager

Private Equity-Audit servicesErnst & Young, Luxembourg

1 The wording "structure" covers any type of vehicle incorporated for private equity transaction(fund or acquisition vehicle) which is not either aSIF nor a SICAR.2 Provided that another law does not directlyaddress the consolidation requirements, such as theSIF or the SICAR laws do.3 and more specifically IAS 27.4 Being all the entities to be included in the consolidation.



A SHORT SUMMARY OF CROSS-BORDERDISTRIBUTION OF COLLECTIVE INVESTMENTSCHEMES INTO THE UNITED STATES

This short article seeks to summarize the regulatory

framework for cross border distribution of

collective investment schemes into the United States.

I BACKGROUND

The US regulatory environment is fragmented. Unlike the United Kingdom,for example, there is no legislation comparable to the Financial Services Act2000 and there is no one regulator similarto the Financial Services Authority.Instead, the U.S. regulatory environmenthas accumulated by means of legislationdesigned to address narrowly defined markets, often by establishing regulatorswith limited jurisdiction to supervise specific markets. In particular, marketsupervision of the distribution of collectiveinvestment schemes is fragmented amongstsecurities regulators (primarily theSecurities and Exchange Commission),regulators of employer sponsored retirement plans (the Department ofLabor) and banking regulators (including,for example, the Office of the Comptrollerof the Currency). There is no over- arching logic to U.S. regulation of collective investment schemes or to theirdistribution. Accordingly, distribution ofcollective investment schemes into theU.S. from outside the U.S. has to be considered separately by distributionchannel1. This article addresses distributionof "private funds"; distribution of funds toemployer sponsored retirement plans; anddistribution of funds to the U.S. retailinvesting public.

I PRIVATE FUNDS

There is a species of unregulated collective

investment scheme in the U.S. referred to

as "private funds". The universe of private

funds is typically considered to be made

up of "hedge funds" and "private equity

funds", but also may include non-U.S.

based collective investment schemes, such

as Luxembourg SICAVs. As a regulatory

matter, the critical common feature for so

called private funds is that the fund's

participations are offered in a "private

placement".That is, if there is a prospectus

or offering memorandum, it will not have

been filed with the SEC and the securities

offered will not be "registered" under the

Securities Act of 1933, as amended (the

"1933 Act"). This is perfectly legal in so far

as the US federal law requires registration

of offerings to the "public"2. In contrast,

private offerings are made to sophisticated

and financially significant investors (so

called "accredited investors"3) who do not

seek or need the SEC's protection.

Moreover, because the offerings are

private, and the investors are either limited

in number or highly sophisticated (so called

"qualified institutional buyers"4), the fund

need not submit itself to SEC supervision

under the Investment Company Act of

1940, as amended (the "1940 Act"). In the

main, funds organized outside of the U.S.

that are distributed in the U.S. distribute

their shares in the U.S. in private placements

and do so to either a limited number of

U.S. resident beneficial owners (i.e., 100 in

reliance on Section 3(c)(1) of the 1940 Act)

or to an unlimited number of qualified

institutional buyers (in reliance on Section

3(c)(7) of the 1940 Act).

The principles of private placement of securities

Private placements need to be made

without a "general solicitation". Typically

this means that a proposal to invest in the

collective investment scheme (or private

fund) is made to someone who has a

"pre-existing business relationship" with

the fund's sponsor or a distributor acting

for the fund sponsor. Face-to-face proposals

to existing high net worth clients that are

financially sophisticated would be one way

to conduct a private offering that exemplifies

the conceptual frame work. (There are

permissible alternative ways to conduct a

private placement. For example, the SEC

has authorized private offerings over

password protected websites to clients

prequalified for the type of offering made

accessible over the website.)

The need for a registered broker dealer to pitch

clients in the US

Typically, the distribution of privately

offered interests in funds in the U.S.

requires authorization, or as it is referred

to in the U.S. "registration" as a broker-

dealer. This is because the participations

in the fund are viewed as securities under

U.S. securities laws, and the offering of

those securities typically should be made

by a registered person or firm5.

Avoidance of 1940 Act registration

Private funds seek to qualify for exclusions

from the 1940 Act, (and non-U.S. collective

investment schemes must do so, because

they (with very few exceptions) can not

register with the SEC under the 1940 Act

without reincorporating in the U.S.).

These exclusions are perfected by

conducting only a private offering in the

U.S. and limiting U.S. resident beneficial

owners to 100 accredited investors or, in

the alternative, to qualified institutional

buyers (without numerical limit). The 1940

Act imposes on funds that breach their

duty to register (i.e., a non-U.S. fund that

unlawfully conducts a U.S. public offering)

a highly punitive regime allowing parties

that transact with the fund to void their



contracts (potentially) and subjecting the

fund and its controlling persons to legal

liability, which can include civil fines and

imprisonment (after conviction).Accordingly,

any private fund or non-U.S. collective

investment scheme needs to ensure that it

complies with at least one of the exclusions

from the 1940 Act summarized above.

On tax efficiency for US investors

Distribution in the U.S. is further complicated by tax considerations. TheU.S. market is bifurcated between thoseU.S. resident investors that are subject totax (which may include institutionalinvestors as well as wealthy individuals),and institutions and retirement plans thatdo not pay income taxes as such (but arepotentially subject to tax penalties if theyinvest in funds whose portfolios are notconstructed properly - as will likely be thecase for leveraged funds, for example).Unfortunately, that which tends to be beneficial to non-U.S. investors (such asaccumulating funds) tends to be problematicto taxable U.S. investors who typically aredeemed to receive income for tax purposesfrom any non-U.S. fund, whether they doso or not, and require fairly detailed taxreports from their non-U.S. funds to minimize tax inefficiencies. While thesetax reports are not returns filed with theInternal Revenue Service, they can be burdensome to prepare.

Some practical considerations

Accordingly, before starting on distributionof a non-U.S. collective investment schemein the U.S., it is typically advisable todetermine whether a non-U.S. fund will betax efficient for the target market place inthe U.S. and if that market place is madeup of qualified institutional buyers of sufficient number, or whether limiting theoffering to 100 U.S. residents with sufficient assets to invest in the fundmakes for an economically viable businessopportunity after giving consideration todistribution costs. It also makes sense tosort out how much it will cost to hire a registered broker-dealer to act as theauthorized intermediary in the U.S.6. In

addition, it may be necessary to negotiatean agreement to "dual hat" employees ofthe sponsor of the non-U.S. fund to theU.S. registered broker dealer if the sponsor's employees will participate indistribution of the fund's shares (althoughthese persons will have to sit qualificationexaminations given by the FinancialIndustry Regulatory Association). It willalso be important to determine whether ornot the collective investment schemeinvests in a manner that does not generatetax penalties for investors that comprisethe fund's target marketplace.

I FUNDS FOR EMPLOYERSPONSORED RETIREMENTPLANS

It has become common place for U.S.

employers to offer private pension

schemes to their employees. These are

quite popular in as much as income tax

recognition is deferred until retirement.

So called "401(k) defined contribution"

retirement plans typically offer employees

the opportunity to direct a portion of their

wages into investment options that are

collective investment schemes organized

in either one of two ways. The investment

"options" are often either collective

investment funds sponsored by a U.S.

bank or trust company, or registered

mutual funds (discussed below). Bank

collective investment funds are relatively

difficult for most offshore fund managers

to sponsor and are effectively precluded

from being offered on a cross boarder

basis from outside the U.S., in as much as

any bank collective investment fund must

be maintained by a "bank", although the

U.S. branch of a non-U.S. bank may

qualify as a bank for this purpose. Even if

a non-U.S. fund sponsor is part of a bank

with a U.S. branch which seeks to sponsor

a collective investment fund, care must be

taken to meet the definition of "maintained

by a bank", which may preclude the use of

sister companies of the bank located

outside of the U.S to manage the collective

investment fund. In addition, bank collective

investment schemes must qualify for an

exclusion for the 1940 Act (as policed and

interpreted by the SEC), must operate in

accordance with the requirements of bank

regulators (often relying on guidance from

the Office of the Comptroller of the

Currency) and must meet the disclosure

obligations, fee restrictions, prohibited

transactions restrictions and fiduciary

duties imposed by the Department of

Labor. Suffice it to say that a non-U.S.

collective investment scheme will not be

eligible to be offered to employees as an

investment option in a defined contribution

retirement plan for numerous reasons.

But the sponsor of a non-U.S. collective

investment scheme may distribute to

another segment of the U.S. retirement

plan market. Many employers still provide

their employees with fixed (defined

benefit) pensions upon retirement that are

funded by the employer. Employers must

set aside assets to back their future pension

liabilities under defined benefit plans, and

these assets can be invested in private

funds and/or non-U.S. collective investment

schemes. Accordingly, it is not uncommon

for sponsors of non-U.S. collective

investment schemes (particularly those of

the corporate type) to distribute them to

U.S. corporations investing pension assets

on a private placement basis. Generally,

non-U.S. collective investment schemes

will limit US retirement plan assets to less

than 25% of the scheme, so as to avoid

compliance with U.S. statutory and

regulatory requirements applicable to U.S.

retirement plans.

Distribution of U.S. mutual funds

U.S. distribution of mutual funds is affected

by three principles. First, mutual funds

are sold in public offerings and accordingly

their shares must be registered under the

1933 Act and they must use prospectuses

(including marketing material) and

provide shareholders with financial

statements that comply with SEC disclosure

regulations and the Sarbanes-Oxley Act of

2002 (which imposes requirements relating

to financial statement disclosure and holds

the Chief Executive Officer and Chief

Financial Officer personally liable for



financial statement misstatements or

omissions under certain circumstances).

The second principle affecting U.S. fund

distribution is that the distributors must be

registered with the SEC as broker-dealers

who need to comply with the rules of the

Financial Industry Regulatory Authority

relating to fund distribution (including

review by FINRA of sales materials). Third,

the 1940 Act limits flexibility of pricing

arrangements. Uniquely, U.S. mutual funds

are subject to a retail price maintenance

statutory provision which prohibits the

negotiation of commissions, but permits the

use of sales load breakpoint schedules and

exemptions from sales loads that are

disclosed in the fund's prospectus7.

Additionally, the 1940 Act and SEC

regulations govern the use of fund assets to

pay distribution costs under Rule 12b-1.

Rule 12b-1 is the subject of widespread

criticism and ongoing SEC reconsideration

but remains in force. Typically Rule 12b-1

allows for asset based distribution fees that

are used to compensate distributors based on

a percentage of fund assets. While these

fees are prominently disclosed in fund

prospectuses, they have been criticized as

"hidden fees", in part because of a peculiar

(and widely used) provision of U.S. law that

permits delivery of prospectuses after sale.

The hidden fee controversy has also included

concerns related to shelf space payments and

other inducements paid to brokers by fund

sponsors that seemingly might affect the

objectivity of a broker's recommendation of

those funds and might give rise to conflicts of

interest. Additionally, deferred sales charge

arrangements (so called B Shares) have come

in for criticism in that they have been favored

by brokers because brokers may have been

paid higher commissions to sell B Shares

than they would have received had they

recommended that their clients invest in

lower cost share structures. In response,

some fund sponsors have discontinued their

sale of B Shares and B Shares have receded

from the prominence they once held. In

addition to enforcement actions, the SEC

proposed to remedy the perceived fee and

commission disclosure gap in 2005 by means

of a "point of sale" disclosure document to be

delivered by broker dealers to mutual fund

investors before an initial purchase. The

proposal remains pending. In April 2009,

the Financial Industry Regulatory Authority

proposed that if a mutual fund prospectus

does not disclose compensation paid to the

broker in the fund's "fee table", the broker

would be obliged to make its own disclosure

to its clients, alternatively by means of

website disclosure or written disclosure on a

semi-annual basis. This proposal's comment

period ended in August.8

I REFORM LEGISLATION

Numerous financial services reform

initiatives are currently underway. The

SEC formed an Investor Advisory

Committee which established an "Investor

Purchaser Subcommittee" on September 15,

2009 to (among other things) consider the

needs of investors when they purchase

mutual funds and the fiduciary duties owed

to those investors by persons who

recommend mutual fund investments.

Legislation is pending before Congress

entitled "The Investor Protection Act of

2009" that would make such a committee a

permanent fixture of the SEC's structure and

would authorize the SEC to mandate

delivery of a mutual fund disclosure

document prior to sale. Additionally, the

SEC would be granted broad powers to

adopt rules imposing duties on brokers

and designed to address and eliminate

compensation arrangements and conflicts of

interest that the SEC deems do not serve the

public interest. If adopted, the new

legislation seems likely to lead to significant

changes in the distribution of mutual funds

to the public in the U.S. The SEC's rule

making may also affect private placements.

Distributors of non-U.S. funds considering

engaging in private placements of their funds

in the U.S. will want to monitor closely the

progress of the proposed Private Fund

Investment Advisers Act of 2009 in as much

as the legislation would require foreign

investment advisers with 15 or more clients

in the U.S. and $25 million under

management from U.S. clients to register

with the SEC as investment advisers, and

offshore funds to become subject to

reporting requirements if U.S. persons own

10% of the fund. The SEC would also be

granted the discretion to define "client".

Read together, the provisions of the draft

legislation would grant to the SEC the

discretion to count U.S. investors in a privately

placed non-U.S. collective investment

scheme toward the 15 client limit and the

$25 million registration tests9.

Some practical considerations

Non-U.S. based advisers that are not already

registered with the SEC as investment

advisers will want to watch this proposed

legislation closely and weigh its implications

before conducting a private offering of a

collective investment scheme in the U.S..

A private offering of a collective investment

scheme in the U.S. may give rise to the need

for the adviser to register under the

Investment Advisers Act, implying that U.S.

law will apply to the adviser's U.S. clients,

including disclosure requirements, fee related

regulations, prohibitions on certain trans-

actions, and recordkeeping requirements,

but making it possible that the SEC's could

elect to regulate a non-U.S. based adviser's

activities relating to all of its clients.

Stuart E. Fross10

Partner

Cutler Pickering Hale and Dorr, LLP

1 Justice Oliver Wendell Holmes, Jr. stated in anoften quoted lecture given in November of 1880 that"The life of the law has not been logic; it has beenexperience. …The law embodies the story of anation's development through many centuries, andit cannot be dealt with as if it contained only theaxioms and corollaries of a book of mathematics."2 Literally, 1933 Act Section 4(2) expresses this pointin the double-negative: it provides that transactionsby an issuer that do not involve a public offeringneed not be registered with the SEC (under Section5 of the 1933 Act).3 The term "accredited investor" comes from Rule 501under Regulation D of the Securities Act of 1933.Offering limited to accredited investors that do notinvolve any "general solicitation" of investors are thetypical form of so called "Regulation D" private place-



ments.Private funds and non-US collective investmentschemes typically rely on Regulation D offerings to distribute in the US and yet avoid filing their offeringmaterial and registering fund shares with the SEC.4 The term qualified institutional buyer is defined inSection 2(a)(51) of the 1940 Act. It can be sum-marised as referring to very highly accreditedinvestors, such as banks, retirement plans andinsurance companies, and very wealthy individuals.5 The SEC does allow for an issuer's managementselling securities for the issuer, and that conceptcan allow "management" of a collective investmentscheme to sell that scheme without becoming a broker-dealer, provided, generally, that the sellersare not compensated as such, and have substantialnon-sales responsibilities. See, Securities ExchangeAct of 1934, as amended, Rule 3a-4.6 A U.S. broker can be expected to have an existing

clientele, facilitating the conduct of a valid privateplacement and will reduce the risk that staff associatedwith the non-US fund might engage in unauthorizedbrokerage activities.7 Sales load break point administration has beenthe source of administrative difficulty and enforce-ment, with brokers accused of not properly alertingclients of how to best minimize commissions.FINRA's "Protect Yourself" website provides a goodprimer on U.S. sales loads:http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/p0060088 See, FINRA Regulatory Notice 09- 34:www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p119013.pdf 9 On October 1, 2009 a revised bill was submitted toCongress by Representative Kanjorski.The Kanjorskibill preserves the foreign private adviser and private

fund provisions, but would except advisers "venturecapital funds" (a term to be defined by the SEC) fromthe registration obligation.10 Stuart E. Fross is a partner specializing in investment funds and investment management inthe international law firm of Wilmer CutlerPickering Hale and Dorr, LLP. Please [email protected]. This informationmay be considered to be Attorney Advertising; it isfor informational purposes only and does not constitute legal advice as to any set of facts, nor doesit constitute an undertaking to keep recipientsinformed of all relevant legal developments.(Principal office: 60 State Street, BostonMassachusetts, USA) in the UK, a separate Delawarelimited liability partnership of solicitors and registered foreign lawyers regulated by theSolicitors Regulatory Authority.


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