UCITS — improving the efficiency of the EU investment fund market

Jun 22 2007 David Doyle

In its November 2006 white paper on undertakings for collective investment in transferable securities, the European Commission examined the challenges facing cross-border EU investment fund investments. It also proposed ways of simplifying and clarifying the UCITS III Directive. The commission addressed many of the well-documented obstacles faced by fund providers in selling their offerings across borders and suggested that a radical overhaul of existing legislation was probably not the best approach. Instead, it set out its plan to initiate "targeted amendments to the UCITS directives". High on the commission's agenda were measures that would:

Simplify the notification period.
Create a framework for cross-border merger of funds.
Create a framework for asset pooling.
Enable fund managers to manage funds domiciled in other EU member states.
Improve the quality and relevance of key disclosure documents destined for the end client.
Strengthen supervisory cooperation to monitor and reduce risk of cross-border investor abuse.

A foundation principle of previous UCITS directives, and especially the latest directive, was based on the need to provide fund managers with a "passport" to trade across borders. The premise behind this was that funds, once registered in one EU country, would have unrestricted access to other EU member states.

In theory, a French investment fund company in possession of a passport approved by French regulator Autorité des Marchés Financiers, only had to ensure that the AMF notified the host country’s regulator of the company’s intention to offer the same product in its jurisdiction. The company could then start selling the same fund there within two months. Serious delays in complying with the two-month notification period soon emerged, however, as a result of the formalities, length and complexity of national rules. Many of these delays could not be blamed on different administrative practices; divergent interpretations of the directive also created problems.

Varied information

Once approved by the host country, home state fund-providers faced wide variations in the information that they were required to provide to the client, with restrictions on certain marketing, advertising and selling practices. On March 19 2007, the commission took aim at two specific areas of inefficiency associated with the EU investment fund market: the adoption of legally binding guidance on whether new financial instruments can be included in such investment funds; and guidance on how host country regulators should exercise limited scrutiny powers when UCITS are notified for sale in their jurisdiction. In the first case, the EC used an implementing directive and in the second an interpretative communication.

The implementing directive sought to clarify the definition of eligible assets for UCITS with regard to certain classes of assets. Instruments that can now be included in such investment funds include: asset backed securities, listed closed-end funds, Euro commercial paper, index-based derivatives and credit derivatives, transferable securities, money market instruments embedding derivatives, and financial indices. Two additional precisions were also noted: while liquid instruments with a value that can be accurately determined at any time were allowed, derivatives based on a single commodity remained outside the scope of this directive.

For closed-end funds to become transferable securities, such investments could be included in UCITS, but were subject to certain corporate governance mechanisms. This was defined as ensuring that the asset management activities were carried out by an entity that is duly authorised and supervised for the purposes of investor protection. EU member states now have one year after the implementing directive comes into force to adopt and publish the regulations and implementing rules. States have four months beyond March 23 2008 to align their national legislation with the new directive.

The other important piece of commission work on UCITS was the interpretative communication on the respective powers retained by the home member state and the host member state in the marketing of UCITS (Section VIII of the UCITS Directive). In a very comprehensive communication on this frequently sensitive and problematic issue, the commission clarified the exact responsibilities of each party. Referring to Article 44(1) of the UCITS directive, the commission states that the basic rule on the sale of investment funds that seemed to elicit different views as to the residual responsibility of the host member state was the following provision: "A UCITS which markets its units in another member state must comply with the laws, regulations and administrative provisions in force in that state which do not fall within the field governed by this directive."

Responsibility

The commission sets out the field of responsibility attributed to each party in three crystal clear points:

The home member state areas of responsibility are:

Fund authorisation.
Fund structure, i.e., obligations regarding management companies and investment companies, etc.
Management, i.e., operating conditions, mandatory conditions related to investment policies and eligible assets, limitations on borrowing, etc.
Compulsory information to be provided to the unit holders.
Under this "reserved field", and based on "common basic rules", the host member state is prohibited from imposing additional rules, requirements or information requests.

The host member state areas of responsibility cover all aspects associated with the marketing and distribution of UCITS that fall outside the reserved field:

Distribution infrastructure, which it is assumed should be in place prior to marketing the UCITS units; in certain member states, this may imply the use of an authorised and/or supervised intermediary.
Marketing techniques and channels used; this covers rules on canvassing, cold calling, direct selling, internet selling.
Advertising — much detail is provided on this aspect to ensure that a clear distinction is made between advertising and compulsory information (see below).
The availability of facilities for making payments to unit-holders, repurchase or redemption of units and to allow for available information on the UCITS to the unit-holders, also come under the remit of the host authorities.

The interpretative communication is also intended to reinforce existing harmonised EU legislation that falls outside the field reserved under the directive, including legislation pertaining to marketing channels and techniques: E-Commerce Directive, Distance Marketing Directive and consumer protection rules, Unfair Commercial Practices Directive and, of course, the Markets in Financial Instruments Directive.

The commission has also accounted for the prospect of the UCITS provider using a third party to market the units in the host member state. There is an explicit requirement that the host member authority could:

Ask that the UCITS provider comply with certain standards in respect of the choice of its local partner, such as the necessity that the latter is an authorised and supervised intermediary in the host market.
Insist that the UCITS management company, in the case of advertising campaigns implemented by the local partner in that state, provide fair, clear and non-misleading information on the products to the local entity.

A significant safeguard in preventing host member states from going overboard and imposing disproportionate restrictions on UCITS’ providers in that state is provided: "When imposing restrictions on the freedom of establishment or on the freedom to provide services on the basis of investor protection, the relevant host member state has to demonstrate that the restrictions is objectively necessary to attain investor protection and that the latter could not be achieved by less stringent rules."

Policing the prospectus

The respective roles of the host and home authorities in policing information being proposed in a simplified prospectus is examined in the interpretative communication, with clearer distinctions made with respect to advertising and compulsory information.

In the case of a simplified prospectus, both pre-contractual information and marketing information provided by the UCITS provider falls under the responsibility of the home member state.

A host member state may, on the basis of local advertising rule, impose additional information requirements to UCITS offered in its jurisdiction, e.g., the host state authority could decide that the proposed investments entail new or high-level investment risks and it could ask for more information or issue a risk warning.

Disclosure of costs and fees associated with the individual UCITS falls under the exclusive competence of the home member state, whereas the disclosure of such information relating to the provision of services by third parties, i.e., intermediaries, local agents, distributors, etc, falls under the provisions of Article 34 of the 2006 MiFID Directive.

A host member state reserves the right to check the translation of the full and simplified prospectuses as well as the annual and interim reports.

A distinction between, advertising and compulsory information — that the UCITS is required to provide to unit-holders under the directive — should not be confused with information incorporated in a marketing campaign, which could be considered as advertising. The home member state vets compulsory information while the host member state is responsible for advertising.

The EU economic ministers meeting at Ecofin on May 8 2006 endorsed the targeted approach to bringing amendments to the existing UCITS legislation. The council seized the opportunity to stress the need for the EC and member states to ensure the enforcement of conduct of business rules provided for under MiFID and the coherence of application between the MiFID and UCITS directives.

The council invited the EC to "review the consistency of EU legislation in respect of different types of retail products, such as unit-linked life insurance, investment funds, certain structures notes and certificates etc, with a view to ensuring a coherent approach to investor protection and avoiding mis-selling possibilities". Over the next year, the commission has committed itself to undertaking an assessment of the case of EU action in the area of private placement to be ready by autumn 2007. It is also expected to examine the cross-border distribution potential for non-harmonised funds, i.e., funds of hedge funds, open-ended real estate funds, etc, by mid-2008.

The views and the opinions expressed in 'hot topics' are that of the individual authors and not necessarily those of the Securities & Investment Institute.