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18 October 2005
On June 16 2005 the Swiss Federal Banking Commission published for public comment its Position Paper on the Applicability of the Investment Fund Law to Structured Products and Other Finance Vehicles, dated April 27 2005. The commission asserts in the position paper that structured finance products have evolved during the past 30 years to the point that they have become publicly offered substitutes for regulated investment funds; therefore, under the principle of 'same business, same risk, same rules', they should be regulated as investment funds.
The position paper raises issues about the applicability of the Swiss Federal Law on Investment Funds of March 181994 to securities not previously considered to be interests in investment funds, such as securities linked to indexes, baskets of securities or derivatives. As a result, the position paper may have implications for structured finance transactions in Switzerland and the offer of securities in Switzerland based on structured finance transactions consummated outside Switzerland.
Statutory Definition of 'Investment Fund'
The Investment Fund Law employs layers of definitions to define an 'investment fund' that falls within its scope. The general definition in Article 2, paragraph 1 states that an 'investment fund' is:
This general definition of an 'investment fund' is narrowed by Article 3: assets
which are managed pursuant to a collective investment agreement - a term that
is not further defined - constitute an investment fund under the Investment
Fund Law (Article 3, paragraph 1); assets which are managed in any other manner,
in particular through a form of business organization (eg, corporation, limited
liability company) do not (Article 3, paragraph 2).
Article 3, paragraph 3 eliminates this distinction with respect to "foreign investment funds, the securities of which are distributed in Switzerland". Such foreign investment funds, "regardless of their legal form, are subject to the relevant provisions" of the law. Article 44, paragraph 1 specifically includes two type of foreign investment funds within the scope of the law: (i) assets which were raised pursuant to a collective investment agreement or a contract with similar effect and which are administered by fund management which has its domicile and primary administrative activities outside of Switzerland; and (ii) business organizations:
Finally, Article 44, paragraph 2, which operates as a lowest common denominator
clause, states that if the business organization or the assets are regulated
as a fund in the originating country, then the distribution of interests in
that entity or assets in Switzerland is subject to regulation under the law.
The Swiss Federal Council is authorized by Article 3, paragraph 4 to include or exclude so-called 'segregated assets' which are similar to investment funds "so long as the protective purpose of the law is not thereby impaired". The position paper relies on the definition of 'segregated assets' given in a decision of the Swiss Supreme Court to explain the meaning of this term. Segregated assets are:
"a composite of assets which are managed as fiduciary property by the fund management for the account of the investors, which is to be separated from the assets of the fund management and therefore constitutes an entity labelled as a segregated asset."(2)
Other than the lack of a public solicitation requirement, the definition of
'segregated assets' does not differ in content from the definition of an 'investment
fund' given in Article 2, paragraph 1.
It emerges from all of these definitions that the essential element of an investment fund or segregated assets subject to the law is the management of the assets by a fund management. Measured against these definitions, assets raised from investors and invested for their account without management by a fund management do not constitute an investment fund or segregated assets subject to regulation under the law.
'Management' is not defined in the law, but the Swiss Federal Council has specified in the Investment Funds Regulation of October 19 1994 that the "fund management manages an investment fund when it can choose investments independently".
Interpretation of Statutory Definition
The position paper reduces the five explicit statutory elements to three core characteristics deemed to indicate the existence of an investment fund:
Under the position paper's interpretation of the Investment Fund Law, if all
three characteristics are present in respect of a financial instrument or product,
then it is an investment fund subject to the law; if any one of these elements
is absent, it is not.
Elimination of the public solicitation requirement
The position paper's definition of an 'investment fund' eliminates the public solicitation requirement from Article 2, paragraph 1 of the statute by claiming that the only purpose of the public solicitation requirement is to distinguish between publicly offered investment funds and so-called 'bank-internal segregated funds'.(3) This argument lacks force because Article 4, paragraph 3 prohibits banks from publicly soliciting investments in bank-internal segregated funds, so the public solicitation requirement in Article 2, paragraph 1 is not needed merely to make this distinction.(4)
Redefinition of the term 'assets'
The position paper also redefines the term 'assets' in its reduced definition of an investment fund to mean 'segregated assets': "With the term 'assets', the creation of segregated assets is meant".(5) Unfortunately, stripping the word 'asset' of its ordinary meaning and replacing it with this technical definition results in a repetitive and circular definition of an 'investment fund' - an investment consists of:
Non-statutory basis for excluding structured products from scope of law
After redefining the term 'investment fund', the position paper then constructs a specific, non-statutory basis for excluding structured products, as defined in the position paper, from the scope of the Investment Fund Law.
The position paper argues that structured products are similar to bonds (ie, they are similar to a loan which has been divided into participations that have identical terms in respect of issue price, issue date, term and interest rate, which, according to the position paper, includes the redemption amount), and therefore structured products which exhibit these characteristics are not investment funds. This line of reasoning is extended by observing that: (i) structured products are usually issued as debt obligations and therefore appear as a liability in the issuer's financial statements; and (ii) in contrast to an investor in an investment fund, the holder of the debt obligation does not have a claim on a pool of assets, but simply has a general claim against the issuer, "which in turn means that segregated assets have not been created and therefore an element of the definition of an investment fund is missing".(6)
There are at least two significant flaws in this approach to distinguishing between investment funds and structured products. First, the analysis is not based on the text of the Investment Fund Law and the analogy to bonds is nowhere to be found in the Investment Fund Law. It is not necessary to invent a distinction between investment funds and structured products when the statute provides a perfectly useful one - the management of assets. Structured products which lack the element of asset management - such as securities based on fixed baskets of securities, securities indexes or derivatives - should be considered outside the scope of the Investment Fund Law without regard for presence or absence of similarities with debt instruments.
Second, the claim that structured products are debt obligations is not factually correct because some structured products are specifically designed not to be debt obligations - for example, to avoid making the product subject to withholding taxes on income paid in respect of debt instruments or products based on debt instruments under the EU Savings Tax Directive (2003/48/EC).
Despite these analytical weaknesses, the position paper appears to allow the designers of structured products to employ variable terms for income distributions and redemption payment:
"A debt instrument can be defined as a large loan which has been divided into smaller amounts with uniform terms with respect to interest rate, issue price, term, subscription period and issue date... These terms do not have to be fixed, but can be variable. In the case of indexed debt obligations (specifically inflation-protected debt obligations), for example, principal and/or interest are linked to an index... The terms in this respect are to be defined in advance."(7)
Early redemption at net asset value
The position paper's general exclusion of structured products that resemble bonds from the ambit of the Investment Fund Law is subject to a significant exception. If the investor has a right to require early redemption at net asset value, even if the product otherwise lacks the element of active management of the underlying assets, the position paper classifies it as an investment fund:
"With increasing frequency, certificates are issued that are based on an active management strategy, which means the terms of repayment are not fixed as of the issue date. As a consequence, investors are no longer able to assess the value of the certificate on the basis of the terms disclosed at issue. In order to make this circumstance nevertheless attractive for investors, issuers have shifted to products structured in accordance with the 'open-end principle' (specifically certificates). There are in the meantime products in the market which grant the investor a daily early redemption right at net asset value. From here, there is only a small step to the daily issue and redemption of actively managed certificates, as is customary with investment funds."
Whatever the size of this step, a difference remains between an instrument which represents an interest in an actively managed portfolio and an instrument which derives its risk/return characteristics from a derivative, an index or a static basket of securities. An instrument based on unmanaged assets which grants its holder a put option with a settlement price based on the market value of the related derivative, index or basket of securities does not thereby become an actively managed investment vehicle. This is a distinction that the asset management requirement in Article 2, paragraph 1 of the Investment Fund Law recognizes, but the position paper chooses to ignore.(8) Indeed, the position paper acknowledges the lack of statutory support for its conclusion that redemption at any time at net asset value is proof of a structured product subject to regulation as an investment fund:
"The open-end principle is then equally an indicator of an investment fund, and even an element of the definition [of an investment fund] in [the EU Directive on Undertakings for Collective Investment in Transferable Securities (85/611/EEC)].(9) It is, however, not an element of the legal definition [of an investment fund] in the Investment Fund Law, because in Switzerland all investment funds are created under contract law. The collective investment agreement is, in turn, based on the investment mandate, which implicitly includes the open-end principle (redemption at any time)."(10)
This concession notwithstanding, the position paper concludes that the Investment
Fund Law can be circumvented with products that have an open-end structure
(ie, which permit redemption of the relevant instrument on intermediate dates
at net asset value).(11) The position
paper therefore assumes that products which permit redemption at net asset value
before the maturity date are circumventions of the Investment Fund Law and "for
reasons of investor protection" should be governed by the Investment Fund
Law, "without regard for whether active management takes place or not".(12)
The curious result of using the existence of early redemption rights as a substitute for the Investment Fund Law's active management requirement is this: a structured product without redemption rights, and therefore less scope for the investor to control its risk exposure, is not subject to the Investment Fund Law, but the product with a greater inherent investor protection is.
The position paper also failed to recognize that an open-end investment fund possesses other attributes that distinguish it from a non-managed structured product. An open-end investment fund issues its securities on an ongoing basis and in a theoretically unlimited amount; the structured product is normally issued on a specific issue date and limits on the issue size may apply. More importantly, the proceeds of the securities of an open-end investment fund are invested in an ever-changing portfolio of assets without the fund's management consulting with fund security holders or obtaining their approval. This latter characteristic is precisely what Article 2, paragraph 1 of the Investment Fund Law and Article 1 of the Investment Fund Regulation require, and it provides a basis in law for a legitimate distinction between an investment fund under the Investment Fund Law and a structured investment product outside the scope of the Investment Fund Law.
As a consequence of defining investment products with open-end structures as investment funds subject to the Investment Fund Law, it is necessary for the position paper to address the treatment of investment products that lack open-end structures - so-called 'closed-end' structures.(13) The position paper notes that Article 2, paragraph 3 of the Investment Fund Regulation provides:
"foreign segregated assets which are similar to investment funds are subject to the Investment Fund Law, regardless of their legal structure, if the legal relationship between the investors and the segregated assets is overwhelmingly of a contractual nature and the investors are unable to protect their interests in the assets."
However, the position paper fails to note that the quoted provision of the Investment Fund Regulation applies only to foreign segregated assets that are "similar to investment funds" - that is, foreign segregated assets that are managed. Instead, the position paper focuses exclusively on the necessity to:
"determine how the participation rights have been structured, which means, whether the investor has voting rights which are equivalent to those under Swiss corporate law and therefore permit him to exercise influence over the officers and directors of company and the fundamental decisions concerning the collective investment of the assets."(14)
The position paper uses the example of a limited partnership to define the circumstances in which the Federal Banking Commission believes the required voting rights and level of influence over fundamental investment decisions would exist. A limited partnership does not fall under the Investment Fund Law if each of the following conditions is satisfied:
Although it is not discussed in the position paper, a foreign structured product based on a derivative, an index or basket of securities (other than securities representing an interests in investment funds)(16) in many, if not most, instances will have already addressed the issues raised by these conditions. Consider the following:
Thus, in respect of a structured product of this type, all actions to be taken
by investors in order to protect their investment interests will have been taken
and reflected in the transaction documents establishing a structured product.
These protections also are significantly more effective than the required investor
protections listed in the position paper. Indeed, an investor could purchase
a product not subject to regulation under the Investment Fund Law in accordance
with the conditions listed in the position paper and still be left with nothing
more than a black-box investment strategy offering the hope of gains. The structured
product, on the other hand, lacks active management and therefore must disclose
to investors the exact nature of the investment during the entire term of the
instrument. It therefore provides a more comprehensive and transparent basis
for judging the merits of the investment.
The position paper is based on the belief that an investment product which can be substituted for a regulated investment fund should be regulated as a regulated investment fund, without regard for the definitions of 'investment funds' in the Investment Fund Law. As a result of this assumption, the position paper makes at least two mistakes: (i) it neglects the asset management requirement both in the definition of 'investment fund' in the Investment Fund Law and in the Swiss Supreme Court's definition of 'segregated assets'; and (ii) it fails to notice that the unmanaged structured product is not the same business as an investment fund. The lack of asset management means the structured product does not present the investor with the same risk (ie, investment manager risk) as an investment fund and therefore it should not be subject to the same rules.
For further information on this topic please contact Enrico Friz or Evan Spangler at Walder Wyss & Partners by telephone (+ 41 1 265 7511) or by fax (+41 1 265 7550) or by email (email@example.com or firstname.lastname@example.org).
(1) Public solicitation of investments (also referred to as public offerings) comprises "every type of solicitation which is not merely directed to a narrowly defined group of persons"). A group comprising a firm's existing customers is not presumptively a 'narrowly defined group of persons'. Investment Fund Law, Article 2, paragraph 2.
(3) Article 4, paragraph 1 of the Investment
Fund Law authorizes Swiss banks to pool assets from bank customers for collective
investment purposes in the form of a segregated fund. In the event of the bankruptcy
of the bank, these segregated funds are not included in the bankruptcy estate
and are held for the benefit of the relevant investors (Article 4, paragraph
4). Article 16 provides that investment fund assets are treated in the same
manner and are not included in the bankruptcy estate of the fund's management.
(4) The position paper acknowledges that the distribution of interests in a foreign investment fund in Switzerland through a public solicitation requires a licence from the Federal Banking Commission, but the private placement of such interests does not. This is a different issue from determining the elements of the definition of an 'investment fund' under Article 2 of the Investment Fund Law.
(6) According to the position paper, the fact that asset-backed securities (ABS) are structured like bonds is the reason the special purpose vehicles (SPV) issuing ABS securities are not subject to the Investment Fund Law. It is apparently of no consequence that there are explicit statutory reasons why the SPV is not an investment fund: (i) an SPV in an ABS transaction usually purchases a homogenous pool of income-producing assets (or even a single asset) and thus provides little or no risk diversification; and (ii) it manages its assets as operating assets and not as investments (the SPV's business is collecting the income from the assets it has purchased) and therefore investment management is not involved.
(9) Undertakings for collective investment in transferable securities (UCITS) are undertakings "the units of which are, at the request of holders, repurchased or redeemed, directly or indirectly, out of those undertakings' assets. Action taken by a UCITS to ensure that the stock exchange value of its units does not significantly vary from their net asset value shall be regarded as equivalent to such repurchase or redemption." Article 1, paragraph 2 of the EU UCITS Directive.
(10) Position paper, Section 3.2.2, page 10. Some background information may be needed to understand this observation. An agreement for the provision of services, such as investment management services, is immediately terminable at any time under Swiss law, even if the parties have agreed to limitations on their rights to termination in the agreement. Thus the right to terminate the agreement at any time implicitly provides a right to redemption at net asset value (the sale or return of the invested assets) at any time. It is interesting that the implicit open-end character relied upon in the position paper to justify the use of redemption at net asset value as proof of the existence of an investment fund is based on the existence of active investment management pursuant to an investment management agreement.
(11) According to Section 18.104.22.168 of
the position paper, an investment product which permits redemption upon the
investor giving five years' notice in advance of the redemption date is also
structured as an open-end fund.
(13) Neither the Investment Fund Law nor the Investment Fund Regulation refers to investment products with open-end or closed-end structures. The position paper claims that open-end structures are made subject to the Investment Fund Law by Article 44, paragraph 1(b) (ie, business organizations which have their domicile and primary administrative activities outside of Switzerland, which have collective investment as their purpose, and from which the investor has a right to receive payment of its 'share'), and that closed-end structures are made subject to the law by Article 44, paragraph 2 (the relevant business organization or the assets are regulated as a fund the originating country). It is difficult to understand how these provisions could be considered to refer to open-end and closed-end investment products.
(16) Section 3.4.2 of the position paper notes the Federal Banking Commission's longstanding position that a structured product based on investments in fewer than five investment funds is a product subject to regulation as an investment fund, as well as a product based on five or more such investments if the investments are not equally distributed among the funds.
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