Luxembourg's extensive legal, fiscal and regulatory provisions have clearly helped it become the jurisdiction of choice for the European investment fund market. The Grand Duchy's success is most easily demonstrated by the fact that its funds form nearly one-quarter of the net assets of the regulated European investment fund industry.

Indeed, Luxembourg's fund industry employs at least 11% of the workforce and accounts for more than 30% of its gross domestic product. Furthermore, the industry directly contributes 32% of Luxembourg's tax revenues. The healthy fiscal revenues generated have secured an ongoing commitment to public expenditure. As a result, Luxembourg has an excellent public services infrastructure which contributes to residents enjoying a consistently high quality of life.

This article, however, concentrates on Luxembourg's public policy approach to a comprehensive, yet flexible, regulatory system, which is crucial to its success as an investment funds centre.

Regulation theory

The form and level of financial services regulation, which varies significantly between jurisdictions, is normally based on a combination of practical experience and economic theory.

One approach to state regulation of the economy is the public policy theory promoted by Richard Musgrave, which advocates state intervention as a necessary and complementary market tool. It incorporates four principles of general public interest:

. allocation or reallocation of primary resources, products and services;

. redistribution of wealth more evenly throughout the population by taxation and the provision of social security;

. stabilisation of the economy using fiscal and monetary measures; and

. regulation of economic activities in the form of a legal, administrative and judicial system.

Regulation of financial markets in this manner encompasses the promotion of a stable business environment that inspires market confidence, protects the consumer and reduces financial crime. It also considers objectives such as full employment, public services and quality of life.

Regulatory environment

Since 1945, Luxembourg has been governed by the centre-left Christian Social Party (CSP) for all but one term. The state-approved publication, Langage et Principes de l'Economie, confirms that Luxembourg's economic and social policy under the CSP is based on Musgrave's public policy theory. Accordingly, Luxembourg's public bodies not only intervene to correct significant market imperfections but also when it is in the public interest as part of a social policy.

This broad regulatory approach is evident in Luxembourg's legal and regulatory framework for investment funds.

. Article 3 of the law of 23 December, 1998, provides that the mission of the financial services regulator, the Commission de Surveillance du Secteur Financier (CSSF), extends to the promotion of a prudent business sector, the protection of financial stability of regulated entities and the finance sector, the quality control of organisations and the improvement of risk management.

. Article 97(2) of the 20 December, 2002 law, as amended, Luxembourg's primary funds law, requires the CSSF to act exclusively in the public interest in monitoring the application and adherence to the finance sector's laws and rules.

. The CSSF's public interest responsibility also features prominently in its mission statement.

The regulatory system is continually evolving to mitigate risk and reflect market trends. It now caters for a diverse range of investment funds, investors and asset classes. As such, Luxembourg law offers regulatory regimes under which investment funds may operate. These are detailed in the table.

Part I of the 2002 law implements the Undertakings for Collective Investments in Transferable Securities (UCITS) Directive 85/611/EEC, and subsequent related EC Directives, into Luxembourg law. It applies to the marketability of funds to the general public. Funds operating as UCITS must comply with strict investment, borrowing and risk mitigation requirements.

Like all regulators in the European Union, the CSSF has little room for flexibility in these areas. However, the supervisory and regulatory aspects of the law have been delegated to the CSSF with some degree of freedom. This discretion is exercised with a commercial attitude to the approval and supervision of qualifying funds, presumably for the public interest.

Part II of the 2002 law also provides investors with a comprehensive level of regulation. However, it is specific to Luxembourg and normally relates to funds created to invest in assets other than transferable securities and liquid financial assets, referred to as undertakings for collective investment (UCIs). The investor base for UCIs principally comprises institutional and high net worth investors with an appetite for a more diverse range of assets.

Consequently, the law gives the CSSF a licence to be proactive and flexible to market trends and the mitigation of risk. Articles 67, 72 and 75 of Part II of the 2002 law allow the CSSF to determine investment parameters, borrowing limits and other strategies on a case-by-case basis for funds. The CSSF uses this discretion if it deems that an individual scheme is of a sufficient quality to benefit the finance industry and the national economy.

The CSSF issues circulars that update the industry on its attitude to issues within its discretion. Circulars provide guidelines in response to developments in the industry and offer a degree of certainty to the regulatory process. For example, Circular 02/80 sets out provisions relating to alternative strategy funds. Its issue has coincided with a marked increase in the establishment of Luxembourg-domiciled hedge funds.

The CSSF also exercises its discretion to derogate from circulars in certain circumstances. In recent years, it has allowed certain real estate funds to borrow in excess of Circular 91/75′ s spec-ified limit of 50% of net asset value. The adaptability of its armoury has meant that Luxembourg has been able to welcome investment managers with the requisite quality and track record to operate fully regulated Luxembourg funds falling out-side otherwise rigid parameters.

Evidence of the public interest approach is reflected in the significant Luxembourg presence that is required by funds operating under its regimes. Funds operating under the 2002 law must appoint Luxembourg-based and CSSF-approved custodians and central administrators. This enables the CSSF to closely monitor a scheme's activities and ensures that Luxembourg-regulated funds benefit the local economy.

Luxembourg's other regulatory regimes confer similar discretionary powers on the CSSF. Moreover, the other regimes demonstrate the public policy approach by requiring genuine Luxembourg presence for fund operations.

In developing its regulatory environment for investment funds, Luxembourg has recognised the benefit of attracting quality investment managers and reputable investors with tiered regimes providing an appropriate level of protection to investors. It also ensures that regulated schemes generate identifiable economic benefit to Luxembourg. Ultimately, this policy has had a tangible positive effect on the overall quality of life.

The Luxembourg funds industry is not without its skeletons. For example, Luxembourg funds were implicated in Eliot Spitzer's exposure of market-timing practices, even though the principal focus was on US-based fund managers. However, considering its size, instances of fraud or failure in Luxembourg's fund industry are few.

Lessons for the UK?

The value of UK-domiciled funds is less than half that of Luxembourg, accounting for 9.8% of the European investment fund industry. Admittedly, this is more due to Luxembourg's unique characteristics and UK tax inefficiency, than the UK regulatory regime. Nevertheless, the Financial Services Authority (FSA) might be well-served to incorporate certain principles and practices from Luxembourg.

A policy based on common sense which encompasses wider objectives might result in the development of a regulatory regime providing a more attractive place from which to operate and facilitating a broader range of UK-domiciled investment funds. Such a shift in emphasis would not necessarily require legislative amendments. Section 2 of the Financial Services and Markets Act 2000 arguably already empowers the FSA to regulate more expansively, using social and democratic values as well as market driven principles.

Although it is unlikely that a successful regulatory regime in the UK fund industry will noticeably improve the quality of life, it might improve the UK's disproportionately low share of the European investment fund market.

Keith McShea is a chartered secretary who has held senior positions in firms administering collective investment schemes in Jersey and Luxembourg. He now provides consultancy services to fund managers in London.