Matthew Feargrieve: Evolving Asset Management Regulation in Switzerland Part II

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In the previous article (Part 1), Matthew Feargrieve examined the composition of the Swiss alternative asset management market, focusing on single managers and managers of funds of hedge funds (FoHFs).  In the first post, we revealed super important data, which taught us about the backdrop of economic austerity and regulatory zeal in Europe. In “PART 2”, we’ll keep learning on  future alternative asset management.

The topics we’ll develop in “Part 2” of “Evolving Asset Management Regulation in Switzerland ”:

(PART 1 contains: the introduction, the composition of the Swiss alternative asset management market, focusing on single managers and managers of funds of hedge funds (FoHFs); as points 1 and 2)

3-The regulatory environment in Switzerland for each type of manager
4- Switzerland  alternative asset management.

The Regulatory Landscape: Switzerland. The Swiss government and financial regulatory authorities have historically had a benign approach to the oversight of hedge fund managers. Only those managers selling fund products to the retail public in Switzerland are required to be licensed by FINMA, the Swiss Financial Market Supervisory Authority. The majority of single and FoHF managers take advantage of a provision in the Swiss Collective Investment Schemes Act (CISA) that effectively exempts managers selling to “qualified investors,” broadly supervised financial institutions and their clients.

Investment funds domiciled outside Switzerland are not subject to any supervision by FINMA.
Advisers to hedge funds are not subject to regulatory oversight or licensing requirements in
Switzerland as long as they do not participate in the running of the fund and do not engage in
brokerage activities. The Swiss Federal Banking Commission (SFBC) is considered to have
MATTHEW FEARGRIEVEsufficient oversight of the hedge fund industry through its supervision of the banks in Switzerland, which usually hold the assets and act as prime brokers, albeit primarily through their London and New York operations. To date, the SFBC’s view has been that this kind of indirect regulation of the Swiss asset management industry is an adequate means of ensuring an appropriate level of macro prudential oversight.

European Union: AIFM Directive. Contrast the position in the EU. European and U.S. managers of non-EU funds are familiar with the spectre of exclusion from EU markets threatened since early 2009 by the AIFM Directive. The AIFM Directive is designed to ensure high level regulatory oversight of managers selling EU and non-EU funds to EU investors (institutional and non-institutional) by requiring managers to comply with rules on capitalization, leverage, mandatory disclosure and so forth. The AIFM Directive seeks to place EU-style regulation on non-EU countries by requiring them to implement cooperation agreements with regulators in EU member countries. In this way, the
Directive shines an EU spotlight on non-EU countries where managers operate (like Switzerland)
and where investment funds are domiciled (like the Cayman Islands).

For a time it was thought that the Directive would effectively prohibit the sale of non-EU funds
into the EU. Thanks to a last-minute intervention by the U.S., the agreed version of the AIFM Directive strikes a short term compromise by preserving existing national private placement
regimes in EU member states as the primary means of access to EU markets until around 2018.
Around 2015 an EU “passport” (for non-EU managers) may be introduced. Thereafter the two
regimes – private placement and passport – will run in tandem until around 2018, at which point
the private placement regimes can, on the recommendation of the newly established European
Securities and Markets Authority (ESMA) be terminated.

So Swiss managers, being outside the EU, have a mixture of options broadly comprising qualifying for the passport in 2015, continuing to place reliance on the private placement regimes of individual EU countries and utilizing UCITS as passportable vehicles for their funds. The ability of Swiss managers to access EU investors will, however, depend largely on the extent to which Switzerland is prepared to come to the EU table to ensure access for its financial services industry.

Switzerland: Three Responses to AIFM Directive. The AIFM Directive, which takes EU-wide effect in 2013, has had three immediate effects on the alternative asset management community in Switzerland.

Amendment of Collective Investment Schemes Act

To obtain the EU passport in 2015, a Swiss-based management company must firstly be
registered with the regulator of an EU member state via an EU “Member State of Reference”
(MSR). Rules are being developed that will govern how to determine which MSR is appropriate,
it generally being the state with which the manager has the closest ties. If the fund is domiciled
outside the EU, then appropriate cooperation arrangements must exist between the MSR
regulator and the supervisory authority of the fund’s domicile. If the fund is domiciled within the EU, then cooperation agreements must exist between the MSR regulator, the fund domicile’s supervisory authority and FINMA. So it is clear that FINMA must have a cooperation agreement with non-EU domiciles like the Cayman Islands as well as the key EU domiciles like Luxembourg (the latter being the FoHF domicile for around 30% of Swiss FoHF managers).

In this regard, the first significant impact the AIFM Directive has had in Switzerland is to be
found in the government’s proposed changes to CISA. The changes, if enacted, will effectively
raise the regulatory bar almost to EU levels with a view to agreeing to cooperation agreements
with EU regulators, thereby ensuring the continuing ability of Swiss managers to access EU
investors. Part of what is proposed is a reduction the application of the “qualified investor” exemption, thereby requiring all Swiss managers selling to qualified investors in Switzerland to
apply for a licence from FINMA. This will entail full compliance by Swiss firms with the CISA
rules pertaining to capital adequacy, corporate governance, reporting and so forth. The changes to CISA are, at the time of writing, being discussed in a dialogue between Swiss government, financial regulator and industry bodies (notably the Swiss Funds Association) with an agreed position expected sometime in 2012.

Take up of UCITS. The second impact of the AIFM Directive on the Swiss asset management community is the attention on the part of FoHF managers (and some single managers) that it has focused on UCITS. UCITS enjoy automatic rights of distribution and sale in the EU. Non-UCITS (whether domiciled in the EU or elsewhere) do not. As an EU regulated investment product, UCITS can be sold throughout the EU to both institutional and retail investors. In addition to being attractive, fully regulated investment products for EU pension funds, UCITS open up to managers a previously forbidden client base: retail investors.

A significant portion of Swiss FoHF managers domicile their funds within the EU, increasingly
in Luxembourg, in order to maintain their leading position in the European FoHF market. Dedicated Swiss FoHFs Harcourt, Man Investments/RMF and GAM have all launched UCITS FoHFs, as have several Swiss-based private banks such as Credit Suisse, Pictet, 3A (Bank Syz), Clariden Leu and EFG.

It should be noted that the UCITS framework does not provide for direct translation of portfolios
of traditionally structured hedge funds into a UCITS compliant format; however hedge fund
index replication techniques remain one option to provide investors with quasi-FoHFs exposure
through a UCITS fund. Given the increasing number of hedge fund strategies being operated
within UCITS-compliant structures, there appears to be an increasing opportunity for growth of a
nascent Fund of UCITS Funds market driven by managers in Switzerland.

On the other hand, the greater pressure to generate higher performance returns experienced by
Swiss single managers (in line with single managers the world over) makes the majority of them
skeptical about UCITS. They point to the significant restrictions the UCITS regime imposes on
use of leverage, shorting and derivatives, and the knock-on impact that has on returns (not to
mention fees). For single managers, this is a serious downside of UCITS. The problem of lower
returns and lower fees is compounded for investors and managers alike by the higher organizational costs involved with UCITS which are sky-high compared to the traditional Cayman private fund model. The slow and burdensome regulatory approval process, conservatively taking two to six months, is also a major turn-off for most single managers.

The majority of Swiss single firms manage non-EU, non-UCITS funds. If they want to sell those
funds into the EU, they have a number of choices: continue to market their funds on a private
placement basis (and comply with the new regulatory requirements imposed by the AIFM
Directive); adopt full compliance with the AIFM Directive and obtain a “passport”; or go the
UCITS route, either in alternative or addition to the traditional offshore products.

The AIFM Directive will not have an immediate impact on a large number of Swiss single hedge
fund managers because they manage assets of less than EUR100 million (the Directive’s
applicability threshold). Whilst all managers in Switzerland (in line with managers in the U.S.)
want to ensure continuing access to EU investors, the cost and burden of obtaining a FINMA
licence would be largely unsupportable for a large proportion of Swiss single managers. The
industry is expectant of a favourable outcome to the amendment of the CISA, and it can be sure
of a favourable response from the offshore fund domiciles, particularly the Cayman Islands and
British Virgin Islands, that are ready and willing to implement cooperation agreements with the
Swiss regulator and EU regulators alike.

Boosting Offshore Substance. The third immediate impact of the AIFM Directive is an ongoing debate about the extent to which FINMA will permit the outsourcing of investment decisions by Swiss investment firms to foreign management companies. This structure, whereby the Swiss firm will provide “advisory and support services” to an offshore management company, which in turn will provide management services to the fund, has for some time been the paradigm means of achieving a tax- efficient repatriation of profits from the fund to the Swiss firm and its principals. Under the changes proposed to CISA, the delegation of decision-making to a foreign management company
will be permitted if the foreign company is deemed to be subject to equivalent supervision and
there is a cooperation agreement between the foreign regulator and FINMA.

This proposed change has coincided with a dissemination of AIMA’s statements on corporate
governance, together with increased scrutiny of foreign investment structures by Swiss tax
authorities. See “Alternative Investment Management Association Publishes Institutional
Investor Guide Covering Hedge Fund Governance, Risk, Liquidity, Performance Reporting,
Investor Relations, Marketing, Operations, Valuation, Due Diligence and Other Topics,” The
Hedge Fund Law Report, Vol. 4, No. 19 (Jun. 8, 2011). The net result is a renewed focus on the
“substance” of offshore management companies. Law firms in Switzerland are helping managers implement offshore substance and good corporate governance of their hedge funds in
the following ways:
  • Reviewing delegation arrangements between the Swiss investment firm, offshore fundand offshore management company;
  • Providing fully insured and independent, non-executive directors to funds andmanagement companies;
  • Hardwiring substance provisions into the constitutional documents and service agreements of fund and management company;
    Reviewing arrangements for location and frequency of board meetings, and provision of advice on how offshore substance can be reflected in board papers; and Conducting a health check on a fund’s board in light of the recent Weavering Macro Fixed Income case in the Cayman Islands, the subject of previous articles in The Hedge Fund Law Report. See, e.g., “Cayman Grand Court Holds Independent Directors of Failed Hedge Fund Weavering Macro Fixed Income Fund Personally Liable for Losses Due to their Willful Failure to Supervise Fund Operations,” The Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).

    In line with their peers in the United Kingdom and, to a similar extent, the U.S., managers in
    Switzerland face a fourfold challenge: (1) increased prudential supervision; (2) amendment of
    local laws designed to ensure access to EU markets under the AIFM Directive; (3) increasing
    scrutiny by regulators and tax authorities of the “substance” of offshore structures; and (4) a
    heightened interest by regulators and investors in the corporate governance of hedge funds. The
    bottom line, though, is that these are industry developments that will be handled with confidence
    by managers in the world’s third largest centre of alternative asset management.

    Well, dear readers, we’ve reached the end of this series of articles. The road was quite long, but I hope you’ve found it as rewarding and you've learned alot.

    Matthew Feargrieve is an investment funds lawyer with more than twenty years' experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom,  Luxembourg, Ireland and the Cayman Islands. He is qualified as a financial services lawyer in the UK, and as a commercial lawyer in the Cayman Islands and the Eastern Caribbean. He is also familiar with the regulation of investment funds and management companies based in Luxembourg and Ireland.More about the Matthew Feargrieve in the news here. You can also follow Matthew Feargrieve on Facebook for more legal news and advice.

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