The Federal Council adopted the amended Collective Investment
Schemes Ordinance (CISO) on 31 January 2024. Not only did the
revised CISO introduce the legal basis for the Limited Qualified
Investor Fund (L-QIF)”, but it also made selective adjustments
to other areas. This includes the regulation governing side pockets
for Swiss collective investment schemes. The new regulation entered
into force on 1 March 2024.
1. Introduction
On 31 January 2024, the Federal Council published amendments to
the CISO for the introduction of the LQIF. It also included the new
art. 110a entitled Segregation of individual investments” in
the CISO.
In view of the numerous liquidity crises that have occurred on
the financial markets in recent years and the inability to create
side pockets in Swiss collective investment schemes, the purpose of
art. 110a CISO is to create a legal basis for side pockets.
However, there is some doubt as to the practicality of the proposed
procedure.
2. What are side pockets?
Side pockets originated in the world of hedge funds and are
particularly common with offshore funds.
The idea behind side pockets is that any investment that is
liquid has the potential to become illiquid. If this occurs, it can
impair the liquidity management of a fund, as redemptions can no
longer be serviced if illiquidity increases. As a result, investors
who redeem early, and for whose redemptions there are still liquid
assets that can be sold, have an advantage over investors who
redeem late, and are stuck” with the illiquid investments.
They either cannot redeem their shares, or the redemptions can only
be fulfilled at a later date.
This is precisely what happened to many hedge funds,
particularly during the 2007 / 2008 financial crisis, and
subsequently also to Swiss funds of hedge funds. Some of them had
to be liquidated due to the impossibility to create side
pockets.
In order to prevent the aforementioned unequal treatment and the
frequently resulting dissolution of the collective investment
scheme, the illiquid investments are to be transferred to a
distinct collective investment scheme, the so-called side
pocket”, at an early stage. All (!) investors of the existing
collective investment scheme will automatically participate in this
newly created, illiquid and thus closed-end collective investment
scheme in proportion to their share in the current fund, so that
all investors are treated equally.
Such a participation in a second, illiquid fund represents a
significant encroachment on the rights of the investor. It is
therefore not feasible without a statutory and contractual basis
and should only be used as a last resort. Art. 110a CISO provides
such a legal basis.
The statutory text of art. 110a CISO can be found at the end of
this publication. Art. 110a CISO entered into force on 1 March
2024.
3. The process for creating side pockets
Art. 110a CISO is formulated in a very rudimentary and open
manner. The Federal Council justified this by stating that there
are currently no international standards that can be used as
guidance. If international standards exist, they should be
transposed into Swiss law.
According to art. 110a CISO, the creation of side pockets
follows the following procedure:
1. The fund contract must explicitly stipulate the basis for
side pockets. This ensures that the investors have agreed in
principle to the creation of side pockets with their subscriptions.
The Asset Management Association of Switzerland (AMAS) provides a
template text for a such provision in the fund contract. It is
recommended to also describe the creation of side pockets in the
risk factors in the prospectus.
2. If a side pocket is to be created, the fund manage- ment
company is required to submit a reasoned application to FINMA. In
particular, it must indicate
- that the creation of side pockets is provided for in the fund
contract (see above); - that this is an exceptional case (description of the
facts); - which investments have become illiquid for an indefinite
period. These need to be accurately identified; ” what
measures have already been taken to manage liquidity and why these
measures have not been successful; ” the advantages of side
pockets over other measures; - that the creation of side pockets is necessary and in the
interest of all investors; - that the rights of investors are protected when side pockets
are created; - that the creation of side pockets is the only solution to
prevent the closure of the entire collective investment scheme
(side pockets as a last resort); - how the creation of the side pockets is technically implemented
(in terms of use, procedure, evaluation, costs and risks),
including the time schedule.
3. FINMA must examine this application and approve it in the
form of a disposal.
4. The decision to create side pockets must be published in the
publication media.
It is likely that such a process, including the preparatory
work, will take at least two weeks. However, as mentioned above,
this raises doubts about the practicality of the process. This is
likely to be far too long a time. Particularly during financial
crises, conditions are usually constantly changing, so that the
measures mentioned in the application are probably already outdated
by the time they are implemented, due to the increasing illiquidity
of investments and the increasing number of redemptions.
It is not intended to comply with the 30-day publication period,
the right of redemption pursuant to art. 27 CISA and the right to
oppose. This would result in all investors redeeming their units,
which is precisely what side pockets are meant to prevent.
4. Combination of side pockets with other measures
As previously mentioned, the procedure for creating side pockets
may be time-consuming, therefore it is advisable to consider
additional liquidity management measures in addition to the
creation of side pockets.
In particular, the deferral of repayment (art. 110 CISO), which
can stabilize the situation for the duration of the procedure for
approving side pockets, or gating measures (art. 109 para. 5 and 6
CISO) should be considered.
5. No side pockets with L-QIF
Side pockets for L-QIFs are not possible. This is regrettable,
as side pockets can prove to be particularly advantageous for these
collective investment schemes.
The rationale behind this is that side pockets must be approved
by FINMA (see above). However, an L-QIF is not subject to FINMA
supervision and does not require approval from FINMA.
Side pockets are therefore equally impossible with an L-QIF as
with all other measures that require FINMA approval.
6. Instructions for action
There is no obligation to prepare for the creation of side
pockets.
However, anyone who is considering taking advantage of the right
to create side pockets should include the provision in question in
the fund contract as soon as possible and refer to it in the
prospectus, preferably also in the risk indications.
Additionally, it is recommended to prepare the application for
FINMA in advance due to the brief time frame following its
submission.
7. Conclusion
It is important to offer market participants a wide range of
options for managing liquidity. This provision is in line with
other provisions that provide for similar measures, in particular
the gating measures (art. 109 para. 5 and 6 CISO).
However, the lessons learned from the financial crisis of
2007/2008 demonstrate that previously liquid investments can
rapidly become illiquid. The same occurred at the beginning of
Russia’s war against Ukraine, when Russian securities
experienced a sudden loss of liquidity.
This sudden occurrence of illiquidity is in contrast to the
lengthy process for creating side pockets, which is characterized
by a formal and detailed application that requires a large amount
of detailed information and must be reviewed, approved and then
published by FINMA.
Accordingly, it would have been helpful if the Federal Council
would have provided a practicable provision in the CISO. The
argument presented in the explanatory report that investor
protection leaves no other options is hardly substantiated.
Investor protection can also be achieved through a comprehensive
provision in the fund contract and prospectus, which the investor
consents to by subscribing.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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