The Undertakings for Collective Investment in Transferable (UCITS) regime has seen various evolutions since its inception. The UCITS V Directive, the latest incarnation, is currently at proposal stage with the European Commission.1 It promises to be a long drawn out affair, in keeping with its predecessor directives. The proposed changes over depositaries and remuneration policies, in their current format, would have significant and far-reaching consequences for all UCITS participants.
The UCITS Directive2 came into force in 1985, as part of the EU's effort towards establishing a single market for financial services across Europe. The key cornerstones of the directive were to:
Over the years, the UCITS regulatory model has become the benchmark for fund regulation and it is the basis of a fully integrated European fund market. However, it says a lot about Europe’s collective ability to negotiate that, 26 years and four directives later, Europe is still not in full agreement on some of those key cornerstones. The UCITS regime has, somewhat unsteadily, evolved since 1985 in various iterations. Most recently, on July 1, 2011, UCITS IV was implemented.3 UCITS IV seeks to harmonise management company requirements across Europe, while streamlining cross-border distribution and facilitating cross-border pooling of assets. One key aspect of this is the production of a standard investor information document, the Key Investor Information Document, that will allow "the man on the street" to compare (and understand) fund ranges across a range of standard criteria. As UCITS IV beds down, the Commission began its UCITS V consultation process in 2009, looking at the role played by a UCITS depositary and introducing new provisions on the remuneration of UCITS managers. Investor protection is the overriding aim of UCITS V; however, the Directive also seeks to align UCITS funds with some of the pending requirements for alternative investment funds that will be contained within the Alternative Investment Fund Managers Directive (AIFM Directive).4
In a post-Madoff and Lehman world, there has been a focus on where, how and by whom assets are held. UCITS depositaries' core role is the safe-keeping of assets while ensuring that "transactions" (such as the subscription and redemption of units) carried out by UCITS funds accord with the fund’s constitutional provisions. The current UCITS Directive ensures that all assets of a UCITS must be entrusted to a depositary for safekeeping. This requirement has been implemented in different ways across Europe. UCITS V will define what activities and responsibilities are related to the term "safe-keeping" of assets. They will also distinguish safekeeping duties between 1) those relating to custody of financial instruments kept in the name of the fund on the depositary’s book and 2) the monitoring of other assets that cannot be kept in custody by the depositary. The oversight function of a depositary can differ depending on the legal form that the UCITS takes. UCITS V will align the oversight functions performed by an investment company with those performed by a unit trust. Implementing these new measures will also further the scope of each depositary’s supervisory duties. A key measure being introduced will be clarification on the depositary liability regime. A mapping exercise performed by the European Securities and Markets Authority (formerly the Committee of European Securities Regulators (CESR)) revealed that Member States' interpretation of an "unjustifiable" failure to perform depositary duties varied across Europe.5 UCITS V proposes replacing the existing depositary liability standard in UCITS IV with a more robust interpretation: making a depositary liable for unjustifiably failing to perform its obligations or for improper performance of its obligations. While this does not amount to a strict liability regime, it is quite a step from where the industry is currently. UCITS V will address a depositary’s liability in the case of UCITS suffering losses as a result of a depositary's negligence or intentional failure to perform its duties. Furthermore, in the case of loss of assets at the UCITS, the depositary will be obliged to return the financial instrument of the identical type or of the corresponding amount to the UCITS. Depositaries would remain liable for the loss of assets, even where part or all of its safekeeping tasks have been delegated to a third party or sub-custodian. Furthermore, the the burden of proof will fall on the shoulders of the depositary (i.e., that it is the depositary that must prove that its duties have been properly performed). Currently Member States can prescribe the types of entities that can be UCITS depositaries at a national level. This has led to Member States imposing different levels of capital requirements on each depositary. Given that UCITS funds are sold on a cross-border basis, this situation may create uneven levels of investor protection in different jurisdictions where claims against the depositary are made. To combat these issues, UCITS V will introduce a list of entities that it considers eligible to act as a UCITS depositary. Current UCITS depositaries that are not included on the new list will still be able to act as depositaries by means of a grandfathering clause, but all future depositaries would have to be included on the list. Two final provisions will firstly require all investment companies to appoint a depositary where previously they could avail of an exemption; and secondly, the requirement for an annual certification of the assets held in custody by the depositary. UCITS V is likely to have a significant effect on the depositary industry. Increased potential liability can only lead to an increased cost of doing business with these entities; a cost that will likely be borne by UCITS and their investors. Industry commentators also point to a potential systemic risk, as given the role, scope and cost of performing depositary duties, smaller players may exit the market, leaving the entire UCITS industry in the hands of a few global depositaries.
UCITS V is also focusing on UCITS managers’ remuneration policies. It is suggested that remuneration and incentive schemes within financial institutions were one of the key factors leading to the recent financial crisis. Through various directives, the Commission has tackled these issues. It adopted a proposal to revise the Capital Requirements Directive6 tackling, among other things, the remuneration policies of credit institutions which, by virtue of Directive 2006/49/EC, would apply to investment firms within the meaning of Directive 2004/39/EC on markets in financial instruments (MIFID). The various initiatives are aimed at addressing the shortcoming of remuneration policies which failed to align employee incentives with the long-term objectives of a company, while addressing the issue of insufficient oversight by regulatory authorities of the risks posed by inappropriate remuneration policies. Under UCITS V, the Commission is looking to align UCITS remuneration criteria with those of the AIFM Directive. Remuneration structures would be required to include, amongst other matters, criteria for calculating compensation for different categories of staff where remuneration is performance related, as well as rules around fixed and variable parts of pay structures, in addition to rules on pension benefits and pay on employment termination. The rules would apply to staff whose professional activities may have a material impact on the risk profile of the UCITS, specifically senior management, including the board of directors, those performing supervisory functions or the permanent risk management function. UCITS funds were not seen as one of the causes of the financial crisis; nonetheless the Commission sees strong arguments in favour of applying sound remuneration principles to UCITS managers. UCITS' use of more complex and sophisticated strategies, coupled with an increase in the usage of performance fee structures which put in place individual remuneration polices linked to fund performance, suggests that UCTS might not be immune from remuneration structures that may incentivise managers to take undue levels of risk. UCITS V will include requirements for sound remuneration principles for UCITS managers. It is suggested that this policy will promote sound and effective risk management, and discourage any risk-taking which is inconsistent with the risk profiles of UCITS. It would seem appropriate therefore that UCITS managers should be given a level of flexibility, so that they could apply the principles of sound remuneration policy in a manner proportionate to their size, internal organisation as well as the nature, scale and complexity of the activities carried out by the UCITS manager.
While the ultimate aim of UCITS V to increase investor protection is laudable and many of the proposed changes are indeed intuitive in that regard, in as much as they align UCITS with other Europe-wide regulatory initiatives, the practical reality for the industry is that compliance and regulatory costs will increase. It is vital for all players in UCITS funds (not just the depositary and manager) that they put in place a governance structure and an independent supervisory framework at board/senior management level that allows investors to take comfort from a high level of transparency and organisation and indeed regulatory efficiency. It is only through this strategic process approach to implementing UCITS V, that investors, while accepting the increased costs, will reap the real benefits of greater protection.
Killian Buckley is a member of Kinetic Partners LLP and is responsible for regulation and compliance consulting services in Dublin. He is a UCITS expert and is an authorised Designated Individual for UCITS funds, as well as acting as MLRO. Killian has worked previously in corporate finance and stock broking for leading Irish and European institutions and is a regular contributor to both trade publications and newspapers. He is also co-chair of the Irish Funds Industry Association Marketing Committee and sits on its AIMFD Steering Committee. Telephone: +353 1 4750534; E-mail: firstname.lastname@example.org.
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