• Welcome
• UCITS IV: Focus Shifts to Implementing Measures
• The EU Regulatory Regime for Alternative Investments Takes Shape

Welcome

Jervis Smith
Managing Director, Global Head of Client Executive
Global Transaction Services, Citi

Our March 2010 Spotlight considers two important regulatory developments in the funds industry - Undertakings for Collective Investments in Transferable Securities (UCITS) IV and the Alternative Investment Fund Managers Directive (AIFMD). They result from different industry drivers, but both will have a significant impact on Europe’s competitive position in the global funds industry.

Below Stefano Pierantozzi, EMEA Head of Fiduciary Oversight and Research, discusses the impact of UCITS IV on Europe’s investment management industry and why this constitutes a major step forward. Of course, caveats remain. There are legacy issues as well as new challenges. Jurisdictions must be aware of the work needed to become a location of choice for master funds and fund management companies - skills, scale, taxation and clear regulation will all be key factors.

Meanwhile, the industry continues to debate AIFMD and its potential impact on the industry. The Spanish Presidency continues to publish compromise texts and hold follow-up discussions in order to resolve as many issues as possible before the 16 March meeting of the Council of Economic and Financial Affairs (EcoFin). Below, Robert Hennessy, EMEA Head of Fiduciary Services, notes the need for clear-cut, well defined rules if we are to avoid the grey areas that caused some challenges in the past. Nevertheless, he is optimistic that the right political decisions will be made when the time comes.

UCITS IV: Focus Shifts to Implementing Measures

Stefano Pierantozzi
EMEA Head of Fiduciary Oversight & Research
Global Transaction Services, Citi

The last of three technical advices from the Committee of European Securities Regulators (CESR) was finally published late last year and as such draft level 2 legislation, to put UCITS IV into effect, will require formal adoption by June this year. With the shape of UCITS IV becoming increasingly clear, the focus is now on implementation.

For the less acquainted, CESR was mandated by the European Commission (EC) to advise on three areas of UCITS IV and conducted a parallel process covering all three issues:

• Management company passport (MCP)
• Key investor information
• Fund mergers, master-feeder structures and notification procedures

Its MCP advice covered five areas:

• Organisational requirements and conflicts of interest
• Rules of conduct
• Measures to be taken by a depositary of a UCITS managed by a management company situated in another member state
• Risk management
• Supervisory cooperation

The technical advice defining key investor information was published towards the end of October 2009 and the committee’s final advice came in December 2009. This focused largely on master-feeder structures and outlined:

• The contents of contractual agreements between the UCITS and service providers such as management companies, depositaries and auditors;
• Measures to avoid market timing;
• Reporting obligations, in particular as they apply to the master UCITS and its service providers;
• Corporate events such as mergers, liquidations, changes to investment objectives and transfers of assets in kind.

Continuing Legacy Issues

The final advice on the harmonisation issue is shortly due from CESR, which is carried over from UCITS III, and involves risk measurement.

CESR has published a consultation paper on risk measurement (June 2009) for the purpose of calculating UCITS’ global exposure - UCITS funds are required to establish an extensive system of risk limitation to ensure the risks involved in using derivatives are properly identified, measured, managed and monitored. The definition of consistent risk measurement methods is of fundamental importance in ensuring common levels of investor protection throughout the European Union (EU).

CESR is expected to provide clarification within a harmonised approach. While no significant move is anticipated, CESR’s consultation paper proposed doing away with the classification of UCITS as either 'non-sophisticated' or 'sophisticated'. If carried through to the final advice, this would leave managers free to adopt a method of measuring risk consistent with their strategy and risk management plan. At present, when a fund is deemed to be 'sophisticated', it is substantially obliged to use the Value at Risk (VaR) methodology. The final level 3 guidelines will be published, as stated by CESR in its MCP technical advice, along with level 2 UCITS IV implementing measures, in June 2010.

Another clarification exercise recently undertaken by CESR deals with the introduction of an EU-wide definition of money market funds. While not strictly part of the UCITS IV package, the introduction of a common approach to money market funds is seen as necessary for both investor protection and financial stability. In CESR’s view, only those funds operating with the sole objective of preserving capital, and offering daily liquidity, should be labelled as money market funds. The consultation process closed at the end of 2009 but no final guidance has been published yet.

New Challenges

The UCITS world has also suffered backwash from last year’s publication of the draft AIFMD as the existing rules and business practices relating to safekeeping and custody have been challenged. In July 2009, the EC launched a consultation process on the UCITS depositary function in order to clarify the:

• Safekeeping duties
• Responsibility regime - by introducing controversial rules relating to the liability for any loss of assets and reversing the burden of proof
• Eligibility rules for the provision of depositary services

Responses, including that from Citi, have now been made public. Many service providers believe any move to reverse the burden of proof in the event of loss would be enough to drive all but the biggest custodians out of the UCITS market and increase costs. CESR’s feedback, published on its website, is similarly negative. 'The AIFMD provisions as currently drafted, and which are in any case subject to change, do not represent a sound basis for the requirements that should apply to UCITS depositaries,' it says.

Within this consultation process, the Commission also considered introducing the concept of an 'independent valuator' for UCITS - in line with the first draft of the AIFMD. The definition of 'independent' remains uncertain, and the subsequent Presidency compromise proposals, as well as the European Parliament (EP) rapporteur’s report seem to allow internal valuations, provided they are conducted behind Chinese walls. Introducing independent valuations in the UCITS regime would require new legislation not only to ensure that the responsibilities of the management company / investment company are reviewed accordingly, but also to clarify the regulatory characteristics (permissions, capital, infrastructure and organisation) of the valuator.

The feedback statement recently published on the Commission’s website summarises all the responses received to the UCITS depositary consultation but does not provide any clear indication of how the regulatory landscape may evolve - although the most sensible approach would be to build on the existing framework rather than introducing radical changes.

While the issues surrounding risk measurement, valuations and custodial responsibilities are still to be resolved, UCITS IV itself constitutes a major step forward for Europe’s investment management industry. The next step will be to develop a strategy for capitalising on the changes it brings. For alternative managers facing challenges raised by the AIFMD, the progress on UCITS IV is only likely to increase its attraction as a route to market for future funds.

The EU Regulatory Regime for Alternative Investments Takes Shape

Robert Hennessy
EMEA Head of Fiduciary Services and Market Advocacy
Global Transaction Services, Citi

AIFMD, the EC's proposal for tightening up the regulation and sale of non-UCITS funds, is having a difficult birth.

Although the EP is due to vote on the proposed directive in the ECON commission in April and the plenary in July, multiple versions have been published which contain conflicting clauses.¹

There are multiple outstanding issues that worry industry insiders. Despite its name, the directive does not focus on alternative investment fund managers only bearing significant provisions on areas such as leverage, marketing, third country (non-EU) rules, fund administrators and depositaries. This causes concern for virtually every industry participant.

Clarifying Third Country Rules

The biggest threat to the current business models of many asset management firms’ is contained in the so-called 'third country regime'. It focuses on two areas: whether or not EU domiciled funds can be managed by non-EU domiciled service providers, and how non-EU non-UCITS fund products can be sold to EU institutional investors.

The question over whether or not EU-domiciled funds can delegate asset management or any other function to a service provider domiciled outside the EU has serious implications for US-based managers, many of whom manage EU-domiciled funds. While the UCITS III/IV legislation would permit them to manage the portfolios of UCITS funds from outside the EU, the AIFMD could prevent them from doing the same for European non-UCTS funds.

The other element of the third country regime focusing on the way in which non-EU based non-UCITS fund products (whether managed by a European or a non-European manager) can be sold to institutional investors in the EU also has serious implications.

There have been a variety of proposals on both elements. Although the Gauzès draft was deemed unsatisfactory by many, the feedback following extensive discussions with the Parliament’s rapporteur and other MEPs is encouraging. The third country rules are expected to be substantially reviewed to allow non-EU managers to continue to provide portfolio management services to EU-domiciled funds and establish a grandfathering period for non-EU domiciled funds sold in the EU, during which third countries may decide whether or not to introduce regulatory regimes equivalent to the EU.

Safekeeping Rules Introduce Unwanted Systemic Risks

Another debated issue involves the role of depositaries. Although the directive requires every non-UCITS fund to appoint a depositary, it could ultimately reduce the number of providers and increase costs throughout the industry by imposing much higher liability standards on depositaries than they bear under the UCITS rules (as outlined in current drafts).

The danger lies in some depositaries leaving the industry thereby reducing competition. Whilst larger global custodians, such as Citi, may be in a position to limit its exposure to sub-custodians by making use of its proprietary custody network, some custodians will question whether there balance between risk and reward is and can be fairly distributed. In fact, the industry is consistent in stating that clients will not be willing to pay for this exposure, which is widely viewed as not insurable.

Still, the effort made by the investment fund industry seems to have produced some results. The Gauzès draft was substantially closer to the realities of the depositary and custody businesses, although it still contained contentious provisions – including, but not limited to, a provision that made the depositary co-responsible with the manager for the production of a fund’s net asset value. However, most global custodians’ concern is focused on the AIFMD’s enhanced liability regime for depositaries and restitution obligations and the impact of such a regime on the future of the non-UCITS business and the existing UCITS regime.

MEP’s proposed amendments to the AIMFD seem to be heading in the right direction by establishing a generic asset restitution obligation with contractual or technical carve-outs for all cases where assets cannot be safe-kept by the depositary or have not been entrusted to it. However any amendment still needs to be discussed and negotiated. Only time will tell what the final regulatory regime will look like.

Industry Trends

Although not implemented yet, some effects of the AIFMD are already evident. Non-EU asset managers may be inclined to establish their alternative fund platform (or move their existing one) to Switzerland, whose regulatory regime will most likely be considered equivalent by the EU. This trend may seriously undermine the strength of the UK portfolio management business, and the asset servicing business in Ireland or Luxembourg.

Likewise, there is a risk that ill-designed third country and grandfathering rules may lead to a proliferation of non-EU domiciled funds being sold in Europe in the short term.

What Next?

At a recent Brussels meeting the EC only spoke on one area - third country issues. It expressed dissatisfaction with the provisions in the Spanish text and 'laid down a marker' indicating that it would take a very tough line and would not agree to a regime creating an un-level playing field for European funds. They want an equivalence regime after a 3-5 year transition period, but without too much discretion in the hands of national member states.

While the scope of the directive and the custody/depositary chapter are two other issues that need to be resolved, the third-country issue is the area which has received both political attention and heat.

At this time, the only clarity is the likelihood of many more questions as the Directive goes before the EP. While some issues will be technical, there will no doubt be political wrangling as well.

Footnotes:
1 - Versions from the former EU Swedish presidency, the current EU Spanish presidency and French Member of the European Parliament (MEP) Jean-Pierre Gauzès who as the Parliament’s rapporteur has the task of managing the directive’s development).