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.
