UCITS V and UCITS VI - Where are we.pdf85kB - Farrer & Co

Page 21. Depositaries1.1 FunctionsThe UCITS rules on the role of depositaries have remained unchanged since the first UCITS Directive was adopted in1985. The EC now plans to better define 'safe-keeping' and make a clear distinction between different legalstructures. The new proposals affirm the principle of a single depositary function (so that one fund cannot haveseveral depositaries) and that the appointment must be evidenced in writing. They also define the circumstances inwhich a depositary's safe-keeping duties can be delegated to a sub-custodian (bringing the rules in this regard in linewith those applicable under the Alternative Investment Fund Managers Directive ('AIFM Directive').1.2 EligibilityThe proposal is to use consistent eligibility criteria for depositaries across the EU. Article 23(2) of the UCITS VDirective provides that only two categories of entity will be capable of acting as a UCITS depositary; (i) EU-authorisedcredit institutions; and (ii) MiFID-authorised investment firms providing safe-keeping and administration services.The proposal is that there will be a two-year grandfathering period, during which UCITS will be permitted to use adepositary that is non-compliant. These provisions are not final and the funds industry is pressing for additionalcategories of eligible depositaries to be included in line with the AIFMD (which is more widely drawn and refers to'institutions which are subject to prudential regulation and ongoing supervision').1.3 DutiesUCITS V (like the AIFMD) aims to set down a list of uniform rules harmonising the core safe-keeping and oversightfunctions of depositaries across the EU. These duties include: (i) verifying compliance with applicable rules whenUCITS shares are issued, re-purchased, redeemed, cancelled or valued; (ii) verifying that any consideration isremitted to it within the usual time limits; (iii) verifying that the investment company's income is applied in accordancewith the law and instruments of incorporation; and (iv) carrying out the instructions of the management or investmentcompany.Like the AIFMD, UCITS V sets out the duties of a depositary which include: (i) cash monitoring; (ii) the segregation ofassets of the fund from the depositary's own assets; and (iii) a requirement that no cash account associated with thefunds' transactions can be opened without the depositary's knowledge. Depositaries must avoid conflicts of interest.1.4 Delegation of custodyThe intention is to align the conditions in which the depositary's safe-keeping duties can be delegated to a subcustodianwith those that are applicable under the AIFM Directive. In substance this means that delegation will needto be objectively justified and will be subject to strict requirements regarding the selection and appointment of the subcustodian.The depositary must monitor the sub-custodian on an ongoing basis.The present proposal is that where any safe-keeping function is to be delegated to a depositary, details (identifying thedelegate and any conflicts of interest) are included in the UCITS prospectus.1.5 Liability for lossUCITS V aims to clarify what the UCITS's depositary's liability will be in the event of the loss of a financial instrumentthat is held in custody and in doing so to harmonise the liability standard across the EU. In common with the AIFMD,UCITS V imposes strict liability in the event that instruments held in custody are lost. The depositary will be obliged topromptly return to the UCITS a financial instrument of an identical type or of the corresponding amount. The onlyexception is where the depositary can prove that the loss was due to an 'external event beyond its reasonable controland with consequences that were unavoidable despite all reasonable efforts to the contrary'. In contrast to theposition under the AIFMD (which envisages that the depositary could be discharged where assets are transferred to asub-custodian), this strict liability will apply under UCITS V, even where the loss occurred with the sub-custodian.Investors will be able to invoke claims relating to the liability of depositaries either directly or indirectly (through themanagement company).Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk

Page 31.6 InsolvencyAll EU member states will be obliged to enact legislation to ensure that in the event of the insolvency of the depositary,the assets held on behalf of the UCITS will not form part of the body of assets available to the depositary's creditors.2. Remuneration policies2.1 New RequirementAcross the financial services industry, the EU is driving regulatory changes designed to ensure that remunerationpolicies promote sound and effective risk management and discourage risk taking.Against this background, UCITS V introduces an express obligation on UCITS management companies to establishfor those categories of staff whose professional activities have a material impact on the risk profiles of the UCITS theymanage and maintain, remuneration policies and practices that are consistent with sound and effective riskmanagement. These categories of staff must include senior management, risk takers, individuals performingcontrolled functions and any employees receiving total remuneration that takes them into the same remunerationbracket as senior management and risk takers. These rules will also apply to UCITS investment companies that donot designate a management company.2.2 What they must look likeThe proposal provides that sound remuneration policies must be in line with business strategy, objectives, values andinterests of the management company and the UCITS it manages. These principles include that:(i) implementation of the remuneration policy must be reviewed at least annually and the remuneration of seniorofficers in the risk management and compliance functions directly overseen by a remuneration committee;(ii) where remuneration is based on performance, it should be on a multi-year cycle and the total amount ofremuneration based on a combination of the assessment of the performance of the individual and of the business unitor UCITS concerned and of the overall results of the management company;(iii) fixed and variable components of total remuneration are appropriately balanced and at least 40% of the variablecomponent is deferred over a period which is appropriate to the life cycle and redemption policy of the UCITS. Thevariable remuneration, including the deferred portion, is paid or vests only if it is sustainable according to the financialsituation of the management company as a whole and justified according to the performance of the business unit, theUCITS and the individual concerned;(iv) subject to the legal structure of a UCITS and its rules, a substantial portion (at least 50%) of any variableremuneration must consist of units of the UCITS concerned or equivalent ownership interests or share-linkedinstruments or non-cash instruments, unless the management of the UCITS accounts for less than 50% of the totalportfolio managed by the management company, in which case the 50% will not apply.The proposal is that (Article 14b)'When establishing and applying the remuneration policies…… management companies shall comply with theprinciples in a way that is appropriate to their size, internal organisation and the nature, scope and complexity of theiractivities'Key to this policy is what 'appropriate' means in practice. Further detail is needed from the EU in this regard.3. Breaches of the UCITS Directive3.1 Telephone and data recordsThe proposed Directive will amend UCITS IV to ensure that a regulator is entitled to see existing telephone andexisting data traffic records held by a telecommunications operator, a UCITS, a management company, an investmentcompany or a depositary where a 'reasonable suspicion' exists that those records relate to the subject matter of theinspection and may be relevant to prove a breach of the UCITS V Directive.Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk

Page 43.2 SanctionsIn a move designed to level the playing field across the EU, UCITS V will require: (i) a minimum scale of administrativesanctions and fines across EU member states; (ii) a minimum list of sanctioning criteria; and (iii) an obligation uponregulators and management companies to establish whistle-blowing mechanisms.B. What next? – UCITS VThe draft of UCITS V will go before the European Parliament and European Council for consideration. Once the finaltext is agreed, member states are likely to have a period of two years to transpose the Directive into national law.During this two-year period, the EU will provide greater detail as to the implementing requirements. Implementation inthe UK is likely to be at the end of 2014 or the first half of 2015. The European Parliament is due to consider theproposal in a plenary session on 12 March 2013. We shall all have a better guide to timing thereafter.C. The likely impact on your business and how to prepareUCITS V has implications for UCITS funds and their managers of all sizes. The enhanced risk management practiceswill occupy greater management time and result in an additional compliance cost. Depositaries are set to assumegreater responsibility and liability. This will have an impact on the services offered and, inevitably, fee structures. It islikely to put pressure on the profitability of asset managers and part of that cost may need to be passed on tocustomers.Preparing for UCITS V necessitates:1. a review of existing policies across the business;2. an assessment as to the impact of the rules and how they affect your business;3. board agreement as to a programme of operational changes necessary to ensure compliance with the new rulesin good time.Global custodians have indicated that they are likely to consider reducing the risk associated with taking on third partyliabilities by investing in local custody networks in those markets where they do not already have a presence. Again,as with the plethora of reforms that the industry has to deal with, much management time and a careful assessment ofthe implications of UCITS V to your business model and practice will steer a course through the latest regulatoryoverhaul.D. UCITS VIJust as the ink had dried on the proposals for UCITS V and the industry began to brace itself for the changes itheralds, on 26 July 2012 the European Commission released a paper outlining further ideas as to how the UCITSDirective can be improved and so we have the proposed UCITS VI. Since the consultation period has just closed, itis too early to prompt a re-cast of your business plans or fund management practices. Nevertheless, additionalchanges to the regulation of UCITS funds are inevitable.The focus of UCITS VI is new. The proposals concern areas other than those addressed by UCITS V, which is ofsome comfort at least. In summary, the eight topics raised for discussion are:1. eligible assets and the use of derivatives – in particular, whether it is necessary to limit the scope of eligiblederivatives and the use of derivatives generally to those traded on multilateral platforms and cleared by a centralcounterparty;2. efficient portfolio management techniques – whether the current criteria (on eligibility, liquidity and diversificationfor example) requires amendment;3. over-the-counter derivatives ('OTC') – how OTC derivative transactions should be dealt with when assessingUCITS limits on counterparty risk;Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk

Page 54. extraordinary liquidity management rules – whether there is a need for a common framework for dealing withliquidity bottlenecks in exceptional cases or otherwise;5. depositary passport – whether a depositary passport should be introduced and how this would work in practice;6. money market funds1 – whether they present a source of systemic risk and/or do they need harmonisedregulation at EU level;7. long-term investments – (a) how access can be afforded to retail investors and how this could be implementedand regulated; (b) what proportion of a fund's portfolio should be dedicated to such assets; and (c) whetherdiversification rules are necessary to secure adequate liquidity;8. improvements to the UCITS IV framework – for example Article 64(1) of the UCITS Directive requires UCITS toprovide information to investors in the following two cases: (i) where an ordinary UCITS converts into a feederUCITS; and (ii) where a master UCITS changes. As it stands, this does not cover a third possible scenario,namely where a feeder UCITS converts into an ordinary UCITS. Such conversions may lead to a significantchange in the investment strategy.E. Feeder FundsIn relation to feeder funds, the Commission is considering: (i) whether Article 64 should be applied to cover the thirdscenario (referred to above); (ii) should the UCITS Directive be further harmonised with AIFMD; and (iii) are revisionsto the timelines for notifications required by the Directive desirable.In its reply to the EC consultation document on UCITS VI, the European Fund and Asset Management Association('EFAMA') expressed a concern shared by many of our clients that the master/feeder structure permitted by UCITS IVis not working well in practice. Article 50(1)(e)(iv) of UCITS IV provides that 'investing UCITS' are able to invest inanother UCITS or other collective investment undertaking only if the target UCITS/collective investment undertakinghas terms that prohibit more than 10% of its value consisting of units of other collective investment schemes ('the 10%rule'). In practice the 10% rule works to prevent UCITS, such as funds of funds, from investing in feeder funds whichnecessarily invest more than 10% in another scheme (as a result of the rule that a feeder must invest at least 85% inthe master).EFAMA has asked the EC to amend Article 50(1)(e) so that the 10% rule applies only to investments into funds otherthan feeder UCITS and to add to Article 50 feeder UCITS as another category of permissible investment. We shall bemonitoring with interest the EC's response to this proposal not least as the FSA is likely to follow the approach takenon UCITS in relation to NURS funds.F. What can firms do to prepare for UCITS VI?The answer at this stage is 'very little'. The paper published by the EU initiated a consultation with the industry thathas now (for the time being at least) closed. The detail and the timing of further reform is not yet sufficiently clear toprovide a basis for additional substantive change to the management of UCITS funds. Nevertheless, sincegovernments across the world have identified the management of liquidity and derivatives in particular as sources ofsystemic risk and have collectively resolved to tighten their regulation, a form of UCITS VI is inevitable. The industrymust continue to register the challenges and seek to identify opportunities that further change will bring.If you require further information on anything covered in this briefing please contact Grania Baird(grania.baird@farrer.co.uk), or Louise Steinberg (louise.steinberg@farrer.co.uk), or your usual contact at thefirm on 020 3375 7000.This publication is a general summary of the law. It should not replace legal advice tailored to your specificcircumstances.© Farrer & Co LLP, November 20121 The European Central Bank defines an MMF as a collective investment undertaking whose units are close substitutes for deposits and that primarily invest in moneymarket instruments, shares or units in money market funds, and/or other transferable debt instruments with a residual maturity of up to and including one year; and/orbank deposit, cf. Council Regulation (EC) 2423/2001 of 20/11/2001, Annex 1, Part 1, Section 1, paragraphs 6 and 7.Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk