On May 3, the Spanish National Securities Commission (the “CNMV”) approved Circular 1/2006 of 3 May 2006 on Free Investment Collective Investment Schemes (the “Circular”) implementing the provisions of the Regulations on Collective Investment Schemes (“RIIC”) on Free Investment Collective Schemes (“IICIL”) and Funds of Hedge Funds (IIC of IICIL). The Circular will enter into force on the day after its publication in the Spanish Official Gazette (Boletín Oficial del Estado) (which is likely to occur next week), except for information obligations which will be enforceable as from October 1, 2006.
Following the entry into force of the Circular, authorisations to incorporate or extend the activities of management companies that intend to manage hedge funds and to manage this type of collective investment institutions (CIIs) may be filed with the CNMV. Thus, the much awaited Spanish “hedge funds” market will finally be created.
The Circular implements the applicable regime for Spanish management companies which intend to manage IICIL and IIC of IICIL, as well as the regime of such IICIL, and IIC of IICIL which is initially contained in Articles 43 and 44 of the RIIC and in the Ministerial Order 1199/2006, of 25 of April 2006 (the ”Order”). We have summarised the main contents of the Circular in two sections:
§ The applicable rules for Spanish management companies which intend to manage IICIL and IIC of IICIL; and
§ The applicable rules for IICIL and IIC of IICIL.
As foreseen in the Order, Spanish management companies which intend to manage IICIL and IIC of IICIL are not required to have an exclusive purpose. Management companies may therefore manage IICIL and IIC of IICIL by amending their business activity plan and complying with certain additional requirements:
· Access to the activity
Management companies will be obliged to have a business activity plan which expressly includes managing IICIL and IIC of IICIL as well as a description of internal control measures which shall include their organizational structure, the specific technical and human resources and a general description of the controls and procedures applicable to the management of this type of CIIs. In addition, the controls over the activity of entities which have been entrusted with certain delegated functions and the activity of entities with which the management companies have executed financial collateral arrangements will have to be described.
· Own resources
Finally, in order to better cover eventual operational risks, additional own resources of 4% of the gross income from management fees (calculated as the average of the three latest years) of IICIL and IIC of IICIL are required.
· Material and human resources
- Board of Directors and Executive Officers: management companies must have directors and executive officers or similar posts with a minimum experience on IICIL and IIC of IICIL or other similar alternative management functions of at least 2 years.
- Training programs: management companies must establish training and continuous testing programs in order to ensure that their personnel have the appropriate professional experience.
- Calculation and risk control systems: management companies must have appropriate calculation and risk control systems for the concrete investment strategies that are going to be implemented in order to calculate the current and potential risk exposure, in particular when they are going to carry out transactions which imply leverage or transactions on non-listed securities, illiquid financial instruments or financial derivatives with complex valuations, or short sales. Management companies are also obliged to perform stress tests and tests simulating specific crisis scenarios periodically.
- Internal communication systems: management companies must establish internal communications systems to ensure that relevant information from third party service providers or companies with delegated functions is rapidly disclosed to the management company’s personnel.
- Assets provided as collateral: management companies must have procedures to ensure control over the assets provided as collateral and the assets which have been executed by the beneficiary of the collateral.
- Liquidity control: management companies must have mechanisms to control the liquidity of the underlying investments in order to duly comply with the redemptions on time.
- Control over use of managed CIIs underlying structured transactions: management companies must have internal measures to know the units or shares of the managed CIIs used by third parties as underlying assets of structured transactions. This requirement will not be easily complied with.
- Separation of duties: duties must be separated, especially with regard to management, administration and control duties, whether they are carried out by the same management company or delegated to third party service providers. In principle, individuals carrying out management duties, whether delegated or not, must not participate in the calculation of the net asset value of the IIC that are being managed.
- Valuation and analysis of investments in IICIL: management companies must include, as part of their internal control proceedings, the quality, quantitative and operational criteria used for the valuation and analysis of the investments made in IICIL for the IIC of IICIL which they manage. Such criteria must have been agreed with the depositary and must have been authorised by the Board of Directors of the management company. Finally, the participation of the depositary shall be limited to the duties that pertain to it as depositary.
· Delegation of duties
Management companies may delegate the management of IICIL and IIC of IICIL to third parties subject to the requirements set forth in Article 68 of the RIIC. In the event of delegation, the management company shall keep the necessary means to control the delegated activities. In any event, the delegation of duties must not make the management company an instrumental entity without any duties.
In addition, management companies may receive investment advice on their investment policy from third party entities and must provide information of any such entities in the Prospectus.
Management companies may delegate the administration duties provided that:
a) The entity to which the administrative duties are delegated has human resources with sufficient experience in the valuation of the investments that the Management Company intends to make, as well as the necessary material resources to carry out these duties.
b) The delegation of administration duties does not cause the controls required by the regulations to be reduced. In particular, the entity to which the delegation is made must not be the depositary, or exercise sub-custodial duties, or exercise Control Unit duties.
c) A system is established to control the activities of the entity to which the delegation has been made. There must be, among other controls, regular reconciliation procedures among the entity to which the administration has been delegated, the management company and the depositary and the entities with which a financial collateral arrangement has been entered into, if any, of the cash and securities positions.
d) If the task of determining the net asset value is delegated, the corresponding delegation agreement must contain provisions that ensure appropriate consistency between the valuation practices of the entity to which the task is delegated and the asset-valuation criteria imposed by the standards and collected in the fund prospectus. In addition, the agreement should contain clauses to allow the depositary to comply with its supervisory functions. In any event, specific procedures for the resolution of discrepancies that may arise between the calculations of the net asset value made by the entity to which the task was delegated must be reconciled and the estimated net asset value calculated by the management company should be established.
The above mentioned requirements will also be applicable to Free Investment Companies (SICAVs) and SICAVs of IICIL which may have not appointed a management company for the management of their assets.
In addition to the rules contained in the RIIC and in the Order regarding the applicable regime for IICIL and IIC of IICIL, the Circular sets forth and specifies the following rules:
· Investment policy of IICIL
The Circular has not included additional investment restrictions for IICIL. For the purposes of calculating their indebtedness limit (five times the CII’s assets), the calculation shall only be made taking into account all the amounts received in cash by the institution, excluding temporary assignments of assets, financing received through simultaneous transactions and financing from the sale of borrowed securities. Diversification and leverage limits and further restrictions shall be specified in the Prospectus.
· Investment limits of IIC of IICIL
With regard to IIC of IICIL, both the Circular and the Order refer to the assets that are suitable for the compulsory investment coefficient of 60% of IIC of IICIL, as follows:
a) Spanish IICILs.
b) Other CIIs domiciled in OECD countries, or with a management company or entity with similar functions to the management company and similar responsibility, subject to supervision with domicile in a country of the OECD and with similar investment rules to those established for Spanish IICILs.
As foreseen in the Order, the Circular has deleted the reference to CIIs which investment advisor is based in the OECD but not its management company. There is only a reference to CIIs from the OECD or other CIIs with a management company or entity with similar functions to the management company and similar responsibility, subject to supervision in the OECD and with similar investment rules. In any event, we shall wait and see how the CNMV interprets this rule when applying it in practice to the new vehicles and whether or not it will allow investments in CIIs with an investment advisor based in the OECD.
c) Management companies, portfolio companies and vehicles or similar structures, which prospectus or incorporation documents provide investment rules similar to those established for the Spanish IICILs, the purpose of which is to imitate an IIC with the same characteristics (managed accounts). The said companies must be domiciled in countries of the OECD, or the company in charge of the management must be subject to supervision and be domiciled in a country of the OECD.
The mentioned coefficient may be reached through investing in derivative financial instruments, which underlying assets are referred to in letters a), b) and c) above, or financial indices composed of such assets which meet certain requirements.
The final wording of the Circular allows IICs of IICILs to invest more than 10% of their assets in other IICILs or similar entities, which in turn may also invest more than 10% of their assets in other CIIs.
· Information duties
Specific information obligations regarding IICIL and IIC of IICIL are set forth in the Circular. Among others, the Prospectus and simplified Prospectus must include information regarding subscriptions and redemptions, the general policy on the collaterals granted by the institution, information about advisory agreements, the CII`s investment and management strategy and its risk exposure, the policy on investments in liquid assets and on liquidity management to make redemptions, the indebtedness limit, as well as the additional leverage, the criteria on valuation of the assets of the portfolio and the maximum management and depository accumulated fees that they may bear.
Furthermore, every investor must subscribe a consent document declaring that he/she is aware of the risks inherent in investments in IICIL and IIC of IICIL and also assumes the risk of loosing part or the whole of his/her investment, and of the liquidity restrictions. In addition, the investor declares in this document that he/she has been duly informed about all the characteristics of the IIC in which he/she is investing, releasing the management company or the IIC from the burden of proof concerning the information to be provided. The alternative of excluding qualified investors from the obligation of subscribing this document has been removed.
The annual, semi-annual, and quarterly reports of IICIL and IIC of IICIL shall comply with the general provisions applicable to ordinary CIIs, with certain special characteristics.
IICIL and IIC of IICIL managers must submit to the CNMV on a monthly basis two documents containing information on statistical, operational and investment portfolio issues with respect to the last day of the referred period, according to the standard version provided by the CNMV.
We shall wait and see the rules applicable in practice on this matter. Notwithstanding this, this type of management is mainly based on the competence, talent and know-how of the manager. The excess of public information available on these CIIs could cause the risk of an imbalance between the necessary information to be delivered to investors on the risks assumed by the CII and the maintenance of certain privacy on its positions which safeguards the know-how and management style of the manager before its competitors. As it is not strictly necessary to inform investors, an excess of transparency could deter the most innovative foreign managers.
· Rules for estimated liquidation values and subscriptions and redemptions
IICIL and IIC of IICIL can choose not to provide investors with redemption rights on every NAV calculation date, provided that it is specified in their Prospectuses. In addition, IICIL may pay redemptions in kind if this is foreseen in the Prospectus.
Unit holders and shareholders of IICIL and IIC of IICIL may receive from management companies, as regularly as they deem appropriate and in accordance with the Prospectus, preliminary or indicative estimates of the NAV, calculated by the management company.
The final version does not include the possibility of having a lock-up period of at least 2 years, or of providing notice for redemptions of up to 3 months for IICIL or 1 month for IIC of IICIL, or of having a maximum limit for redemptions on a given date. These possibilities are common in international hedge funds and are caused by the illiquid nature of the underlying assets. The application of these sections of the RIIC remains to be seen but if the omissions referred to above cause an IICIL or IIC of IICIL to be subject to general rules, it will make the management of these entities’ liquidity extremely difficult.
· Pledged assets
The Circular provides an obligation to inform the Depositary when a financial collateral arrangement is entered into with a third entity, by virtue of which the ownership of the asset is transferred or pledged, with the pledgee having disposal rights. This is a positive advance since in previous drafts, it was compulsory to sign a sub-custodian agreement with the Depository.
The agreement executed must set forth that the Depositary will receive the necessary information to comply with its duty of oversight and supervision, the execution of the mentioned arrangements is limited to financial entities subject to the supervision of an OECD country.
Furthermore, agreements containing financial collateral arrangements must include clauses that facilitate and allow for the CNMV’s supervisory duties, specially regarding the financing transactions and loans on securities. Likewise, these agreements shall clearly foresee the liability of both the IIC and the beneficiary of the pledge in the event of non-fulfilment of their respective obligations or the right to termination in case of insolvency by making a sole net payment by the party whose debt is higher than the other.
The CII prospectus must contain the CII general policy regarding collaterals and identify the entities with which financial collateral arrangements have been made, as well as providing information concerning its financial solvency.
Furthermore, the Prospectus must provide information about the guaranteed obligations in favour of third parties on financial collateral arrangements and about the maximum percentage market value of the assets assigned to guarantees that its beneficiaries can dispose of.
The Circular completes the regime for IICIL and IIC of IICIL and implies the effective creation of a hedge funds market in Spain. On a more general basis, the Circular is a positive advance as the starting point of a Spanish hedge funds market, although in some issues, it could be seen to be a step back from previous drafts and to move away from the standards of the international hedge funds market. In any event, we must wait and see how the CNMV interprets the Circular in order to further assess the possibilities of establishing a domestic hedge funds market.
May 9, 2006
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For further information, please contact Salvador Ruiz Bachs (firstname.lastname@example.org) or Marta Oñoro Carrascal (email@example.com) (phone number 915860696) in our Madrid office, or Juan Carlos Machuca (firstname.lastname@example.org, phone number +44.20 7.645.02.80 ) in our London office.