Case Review: The UCITS Directive and the Single European Funds Market

David Rouch, Partner, and Katherine Smith, Associate, of Freshfields Bruckhaus Deringer, examine the new UCITS regime.


Open heart surgery or a course of less drastic measures to improve the patient's health; that is the difficult choice facing the European funds industry.


The botched drafting and chaotic implementation of the revised UCITS Directive1 has left the chief executives of some of Europe's foremost investment houses reaching for the Valium. It has crystallised the belief among industry participants that something needs to change and focused attention on the wider European regime for asset management.


The resulting debate is of central importance to the industry and to Europe more generally, since the industry plays an increasingly important role in managing the assets on which its economic and social health rests.


Some EUR 4,058 billion2 of these assets are managed through UCITS funds. Therefore an effective UCITS regime is central to a properly functioning European asset management industry. However, European funds continue to operate largely along national lines and this fragmentation restricts investor choice and increases costs.


It is estimated that the industry and investors could save up to EUR 5 billion a year were European funds to consolidate and reach the same average size as those in the United States3. So, there is a consensus that something needs to change, but not as to what.


Some favour drastic action: should the UCITS Directive be wiped out and replaced with a European asset management directive? There may be good arguments for vigorous legislative action in some areas, but knee-jerk responses rarely make good law. Furthermore, laws have to be negotiated between the Member States, then drafted and implemented, and anyone who considers this an easy option should reflect on the recent history of the UCITS Directive.


It is also important to be realistic: the European funds market is unlikely to function like a domestic market in the foreseeable future. Cultural and linguistic differences will not go away. But the removal of regulatory, fiscal and operational barriers to cross-border business is a real possibility, as are common standards in the establishment and distribution of UCITS funds.


Therefore a careful case review is needed before doing anything drastic. It should involve not just the denizens of Brussels, national regulators and the industry associations, but also industry participants themselves, particularly those with a pan-European presence.


The forthcoming publication of the European Commission's report on the functioning of the UCITS Directive will provide an important oppor- tunity for this. 4Publication is expected in July 2005 and a period of consultation will follow. The strategy that emerges, and is already emerging, is likely to involve a mixture of approaches, which will doubtless include further legislation. However, there is already plenty of scope under the existing regime to create a single funds market.


Given the shortcomings of legislation, it is essential to make maximum use of what we have already by addressing anti-competitive behaviour, fostering enhanced regulatory co-operation and review, and seeking higher levels of industry communication to nurture consistency of practice and operations. The process of change needs to be legislatively enabled, but market driven.


Against this background, this article surveys the revised UCITS regime known as UCITS III, identifying shortcomings and considering proposals for change and how best to realise it. The article focuses on UCITS investment powers, the role of management companies, UCITS distribution, the role of depositaries, UCITS mergers and the operational infrastructure for UCITS.


It takes a medium to long-term view and so does not dwell in detail on the guidelines recently published by the Committee of European Securities Regulators (''CESR'') on the transitional arrangements for moving to UCITS III, albeit that these are of great short-term importance to the health of the market. 5The accounting and tax treatment of UCITS and the impact of disparate tax regimes lie outside the scope of this article, although these are touched on.


The UCITS Directive


The UCITS Directive is one of Europe's more venerable pieces of financial services legislation. It first appeared in 1985 and was intended to create an investment vehicle that could be sold throughout the European Union without the need for authorisation in every Member State. Its impact has been substantial, but the single market has largely failed to materialise and the original Directive (as amended in 1988 and 19956) has not been able to keep up with the rapid development of sophisticated financial instruments.


UCITS III was a response to this. UCITS III refers to the original UCITS Directive as revised by two amend- ing directives, the ''Product Directive''7 and ''Manage- ment Directive'', 8which took effect in the European Union on February 13, 2004. The Product Directive widened the categories of financial instruments in which a UCITS fund may invest and made it easier to operate tracker funds. The Management Directive introduced a simplified prospectus for use in selling UCITS and was also intended to improve the regime for UCITS management companies. As indicated, implementation of these changes has highlighted the shortcomings of the UCITS regime and galvanised the industry and its regulators in trying to deal with them.


UCITS and the Lamfalussy regime


The prospects for doing this improved considerably in autumn 2004 when the UCITS Directive was included in the Lamfalussy regime under the ''Lamfalussy Extension Directive''.9


The Lamfalussy regime was originally established to streamline and accelerate the European legislative process for securities so as to complete the Financial Services Action Plan by 2005. Although that objective has proved elusive, the Lamfalussy regime has shown its worth. Its adoption saw the establishment of a committee system involving the European Securities Committee (''ESC'') and CESR. Their role has been to assist the European Commission in formulating new legislation, in particular what is effectively directly applicable delegated legislation (referred to as ''Level 2'' legislation or ''implementing measures'') under frame- work legislation such as the Markets in Financial Instruments Directive (''MIFID'').10


Level 2 legislation is only subject to limited challenge by the European Parliament where it considers that the Commission has exceeded the powers delegated to it. CESR also operates at what is known as ''Level 3'' to try to ensure consistent implementation of directives across Member States.


As the UCITS Directive was not drafted with the Lamfalussy procedure in mind, its inclusion in the Lamfalussy process does not give the Commission as much flexibility at Level 2 as it has under directives such as MIFID. However, it does mean that the ESC and CESR now assist the Commission in overseeing implementation of the UCITS Directive rather than the UCITS Contact Committee, which had been fulfilling the function with varying levels of success.
This has already yielded promising results in the way CESR and Member State regulators have developed a pragmatic response to divergent approaches to the transition to UCITS III. It also means that the Commission can make Level 2 rules clarifying definitions contained in the Directive with a view to ensuring its uniform application throughout the Community (but not amend the Directive more widely).


The extension of the Lamfalussy regime to the Directive is broadly good news. Indeed, it is likely that one of the most effective ways of dealing with some of the issues highlighted below would be to revise the Directive so that Level 2 measures can be applied to more of it. However, Lamfalussy is not a panacea. The process of implementing UCITS III has demonstrated the fundamental importance of regulators behaving in an intelligent and co-operative manner in communicating and resolving issues at the earliest opportunity.


What areas of the European funds regime need attention?


UCITS investment powers


UCITS III has extended the investment powers of UCITS, increasing their versatility. Originally, UCITS were restricted to holding transferable securities - principally bonds and shares. Under UCITS III, they can also invest in money market instruments, deposits, units in other funds and derivatives.


However, it was clear from the start that there were ambiguities in the drafting of the new provisions. These have been a source of confusion and their resolution will depend on legislative intervention and regulatory co-operation. In autumn 2004 the European Commission, exercising its new Level 2 powers under Art.53a of the Directive, called upon CESR to help it draft amendments to clarify the investment powers of UCITS. At the time of going to print, CESR is expected to issue a consultation paper soon as the basis for an industry-wide consultation on the proposed changes, with a timetable for final advice to the Commission in autumn 2005. The Commission intends to publish its proposals for clarification in December 2005 with formal adoption in April 2006.


The resulting amendments to the Directive could have significant implications, particularly for some of the more exotic UCITS offerings, and it is therefore important for the industry to engage in the debate. If the process is successful, it will provide an example of how extending Level 2 measures under the Lamfalussy regime to more of the Directive could help achieve its objectives.


There is a need for greater consistency in implementing and applying UCITS investment powers.


True, the current patchwork offers tempting opportunities for regulatory arbitrage for those prepared to go in search of them. Competition to make innovative use of the regime should doubtless be encouraged. But the current state of affairs is ultimately inefficient and potentially corrosive of investor confidence; wide divergences undermine the very concept of a single European fund.


Proper levels of consistency would enable fund houses to concentrate on innovating within the regime rather than spending time and money trying to establish what regulators might let them do in another jurisdiction. Consistent application of the investment rules would also concentrate attention on the core question of which categories of investment are not permitted that should be, a process that needs to be properly informed by a strong understanding of investment risk.


If there is no good reason to maintain the current restrictions (for example, in relation to commodities or real estate exposure), the investment powers of UCITS should be extended. In other cases, as long as all agree the same parameters, firms can focus on giving exposure to alternative asset classes to sophisticated investors through non-UCITS funds. If sophisticated investors need authorised funds that can invest in alternative asset classes, there may be demand for something akin to the new UK ''qualified investor scheme'', an authorised fund with wider investment powers that can only be sold to sophisticated investors. However, the creation of a European private placement exemption for non- UCITS funds is arguably more pressing and could be easier to achieve. 11


What are the UCITS III investment powers and where do the ambiguities arise?


Transferable securities and money market instruments


UCITS III introduced a definition of ''transferable securities'', 12 but left the power to invest in them (generally, only when traded on a qualifying market) largely unchanged. However, holdings in transferable securities must now be aggregated with the new asset class of money market instruments in complying with the applicable investment limits.


Money market instruments are defined as instruments normally dealt in on the money markets that are liquid and have a value that can be accurately deter- mined at any time. This includes instruments such as treasury bills and certificates of deposit. As with transferable securities, money market instruments may generally only be held if they are traded on a qualifying stock exchange or regulated market. How- ever, those traded on markets that are not regulated are also permitted provided that certain criteria relating to the issuer or guarantor of the instruments are met.


There is also a further relaxation that allows up to 10 per cent of the asset value of a UCITS to be held in money market instruments and transferable securities more generally.


The restriction on a UCITS investing more than 5 per cent of its assets in transferable securities of a single body has been retained, but money market instruments must now be aggregated with transferable securities in applying it and the aggregation must take in all such instruments held by the fund that have been issued by members of the same group. As before, the 5 per cent limit can be raised to 10 per cent provided that the aggregate value of instruments held in reliance on this exemption does not exceed 40 per cent of the fund value.


Transferable securities and money market instruments - uncertainty


Concerns as to whether structured instruments could enable UCITS to circumvent the UCITS spread restrictions should be adequately covered by the general requirement for a UCITS to operate on the principle of risk spreading.13 It is to be hoped that the Commission will ultimately arrive at a similar position.


Going beyond that would be unnecessarily restrictive and could give rise to inconsistencies given the exposures a UCITS fund can take on even investing in a more restrictively defined range of transferable securities or money market instruments; for example, if it would still be acceptable to invest in the shares of a gold mining company, why prevent a transferable security that is a structured note offering a return linked to the price of gold?


CESR will also consult more generally on where the dividing line falls between transferable securities and derivatives and on the qualifying criteria for holding money market instruments that are not traded on a ''regulated market''.


Collective investment undertakings


UCITS III made it possible for UCITS to invest in UCITS and other funds that meet certain specified criteria. In particular, non-UCITS must be subject to supervision and rules on the protection of unitholders equivalent to those of a UCITS and provide yearly and half-yearly reports. Investment in any one collective investment undertaking is limited to 10 per cent of the assets of the UCITS (or 20 per cent where a home Member State permits) and 25 per cent of the value of the target fund. Holdings of non-UCITS funds must not exceed an aggregate of 30 per cent of the value of the fund.


Collective investment undertakings - areas of uncertainty


A debate has developed over whether closed-ended vehicles such as investment trust companies listed on the London Stock Exchange are caught by the above restrictions on investment in non-UCITS. If so, they would be prohibited, as they do not generally satisfy the conditions for funds that can be acquired by a UCITS; among other things, they are not open-ended.


Such an approach would be manifestly inconsistent with the way the UCITS regime has operated so far, at least in relation to investment in vehicles such as investment trust companies. While there may be legitimate issues regarding some forms of closed ended vehicle, it has always been recognised that shares in listed investment trust companies behave quite differently from interests in open-ended investment funds, being closer to other forms of transferable security. They should therefore continue to fall under the rules for investment in transferable securities, consistent with the approach taken in other directives.


There are also divergences in the way regulators are applying the criteria for investment in open-ended non-UCITS funds. Further guidance may therefore be helpful, perhaps in the form of a Commission recommendation. Alternatively, it could be more fruitful for Member State regulators to maintain a common database of non-UCITS funds that are being permitted for UCITS investment so that they can start to co- ordinate their approach at Level 3. If differences cannot be resolved, there may then be a need for more muscular legislative intervention.


Deposits


UCITS III permits investment in deposits that are repayable on demand and maturing in no more than 12 months. The deposit must be with a credit institution authorised by a Member State or subject to rules considered by the UCITS' home state regulator as equivalent to EU rules. No more than 20 per cent of the fund value can be held in deposits with members of the same group.


Derivatives


UCITS III permits the use of financial derivative instruments (including equivalent cash-settled instruments) for investment purposes, not just efficient portfolio management as before. The derivatives must be dealt on a regulated market or be OTC derivatives.


There are conditions for OTC derivatives to ensure the creditworthiness of counterparties and that they can be readily valued and liquidated at fair value on the initiative of the UCITS. The derivatives' underlying asset class must consist of instruments that can be held directly in a UCITS fund, or financial indices, interest rates, foreign exchange rates or currencies.


Short sales continue to be prohibited


Risk exposure to an OTC derivative counterparty must not exceed 5 per cent of the assets of the UCITS although this may be relaxed to 10 per cent where the counterparty is a credit institution with which the UCITS would be permitted to make deposits. A UCITS may not combine investments in transferable securities, money market instruments and deposits made with, and/or exposures under, OTC derivative transactions with members of the same group in excess of 20 per cent of its assets.
The global exposure of a UCITS to derivatives must not exceed the total net value of its portfolio. UCITS III leaves home state regulators with broad discretion as to how exposure should be calculated and the role of cover. In addition to exposure to the counterparty, the fund also has to consider its exposure to the underlying asset class of derivatives in which it invests; this must not cause the UCITS to exceed the investment limits for direct investment in these categories of asset (outlined above). However, Member States can relax this rule where the fund is investing in an index-based derivative.


Management companies must apply a risk manage- ment process that enables them to monitor and measure at all times the risk of derivatives positions and their contribution to the risk profile of the fund. There must also be a process for accurate and independent valuation of OTC derivatives.


Derivatives - uncertainties


The approach to derivatives has been another area of divergence between Member States. The Commission has already found it necessary to issue a Recommendation on basic principles to take into account in implementing UCITS III with respect to risk management, 14 and further work is being undertaken to assess the current state of implementation and what further guidance may be required.15


Among other things, the Commission recommends that regulators distinguish between ''non-sophisticated UCITS'' using more simple derivatives positions and ''sophisticated UCITS'' in calibrating the risk management methods appropriate to a given fund, the latter effectively needing to use ''Value-at-Risk'' methodologies. It provides clarification on the overall risk exposure to derivatives, which should be limited to 200 per cent of the value of the UCITS allowing for leverage of up to 100 per cent of that value, with cover for all derivatives liabilities being held within the fund at all times.


Exchange traded derivatives should be regarded as free of counterparty risk if they are performed on an exchange where the clearing house is backed by an appropriate performance guarantee and are marked-to-market daily with at least daily margining. Collateral taken from a counterparty under an OTC derivatives transaction can be netted off against the exposure to that counter- party in calculating counterparty spread limits (but not, it appears, the global risk exposure of the fund) as long as it satisfies various conditions set out in the Recommendation.


This means it would be possible for a fund to accumulate a high level of exposure to a single counterparty, which could be reduced to the 20 per cent threshold by taking appropriate collateral; there is a question as to whether, even given the right sort of collateral, the potential for this level of exposure is desirable in a retail fund.


There is also a recommendation that, effectively, the use of derivatives for short selling should be permitted where the underlying asset class of the derivative is highly liquid or the UCITS can settle in cash. However, the UCITS must have the cash or other liquid assets available.16 Otherwise, UCITS are required to hold the underlying where physical delivery is required automatically or at the counterparty's choice.


As with transferable securities, a key area of debate has been over what is permissible as an underlying asset class for derivatives held by UCITS. For example, the UK and Luxembourg authorities have been prepared to flirt with authorising funds that invest in derivatives linked to an index of hedge funds; others have not.


As there are no criteria governing what indices are acceptable for these purposes, Commission clarification would be helpful and this should be covered by the forthcoming eligible assets consultation.17 The Commission intends to rely on the requirement that a derivative must be a ''liquid financial asset'' to clarify what derivatives are eligible, focusing particularly on credit derivatives such as credit default or total return swaps.


It is not clear how this provision will help them since the objective of liquidity is arguably already satisfied by the requirement in Art.19(1)(g) that derivatives should either be traded on a qualifying market or, in the case of OTC derivatives, capable of being sold, liquidated or closed out at any time at fair value at the initiative of the UCITS.18 If it has concerns, the Commission should instead concentrate on the application of the requirements out- lined above on the underlying asset class of derivatives.


On that basis, it is not clear why, depending on their precise structure, credit derivatives should not be permitted and there are good arguments for adopting a liberal approach.


Index tracking


UCITS III facilitates the operation of UCITS aiming to replicate the composition of a particular stock or securities index that is recognised by the authorities of the Member State. Where the index being tracked meets UCITS III criteria, the investment limits for shares and/or debt securities in the same body are increased to 20 per cent with an option for this limit to be increased to 35 per cent in exceptional cases.


The Commission is considering whether to provide guidance on the criteria for establishing which indices should attract exemptive treatment. It also needs to clarify whether the requirement that the UCITS must seek to replicate the composition of the relevant index in order to qualify should more properly be understood as referring to the objective of seeking to replicate the performance of a particular index.


UCITS management companies


UCITS investment powers are not the only part of the UCITS Directive that needs attention. Part of the UCITS III regime for management companies was stillborn and further legislation will probably be needed to sort it out; as Level 2 powers are not available this would require a direct amendment to the Directive. More generally, UCITS III has increased the flexibility available to management companies. Where ambiguities exist over making use of the new flexibility, regulatory and industry co-operation at Level 3 may offer the best prospects for resolution.


Scope of business


A UCITS management company is a company whose regular business is the management of a UCITS. Until UCITS III, management companies were only permitted to carry on the activity of managing UCITS, but UCITS III extended this to include the Investment Services Directive (''ISD'')19 core service of managing segregated portfolios on a discretionary basis and the non-core services of investment advice and safekeeping and administration of units in collective investment undertakings. This increased flexibility is potentially beneficial although it is not clear why it could not have taken in the full range of ISD services. A further amendment to the UCITS Directive would be needed to achieve this.


The passport


UCITS III also introduced a passport for management companies allowing them to provide their services in other Member States without the need for further authorisation. This is supported by a common prudential regime for management companies (including a somewhat esoteric regulatory capital regime).


In theory, this change should have brought management companies into line with the passport rights enjoyed by credit institutions, investment firms and insurance undertakings, and so it did in relation to ISD activities. However, the failure to amend Arts 3 and 4 of the Directive means that it is still not possible for a UCITS established in contractual form or as a unit trust to appoint a management company outside the state in which the UCITS is established (since the UCITS is deemed to be established and is subject to home state regulation in the jurisdiction in which its management company has its registered office).


In theory, the same does not apply to the management companies of UCITS in corporate form (where the UCITS has a management company and is not self-managing20).


However, there has been controversy between Member States over whether UCITS III was intended to allow a UCITS in one Member State to appoint a man- agement company in another - an outcome which many believed was one of the main objectives of UCITS III. As a result, CESR and the Member State regulators have agreed as a transitional matter that UCITS will continue to be obliged to designate management companies in their home states, so partially frustrating, for the present, the prospect of cross-border administrative rationalisation and the consequent efficiency gains. However, this is likely to be one of the areas covered in the forthcoming UCITS review. Any change will require amendment to the Directive.


Conduct of business rules


As indicated above, management companies can nonetheless carry on ISD activities in reliance on a passport and provide services to UCITS management companies on an outsourced basis. But even here, the position is not straightforward.


In providing ISD services, management companies must comply with the same prudential and non-prudential standards as an ISD firm carrying on the same activities. However, the UCITS III regime applies to the prudential and non- prudential supervision of management company activities applying rules made under the UCITS Directive.


There is therefore a potential mismatch between the two regimes; for example, if a management company is subject to the ISD conduct of business rules regarding its segregated investment management ac- tivities, and the rules made under UCITS III regarding its management of the assets of funds, would the standards in areas such as best execution, aggregation and conflicts of interest be consistent with one an- other? CESR has recognised that work is needed to ensure consistent standards are applied and this is an area where Level 3 co-ordination could prove helpful.


The situation should improve following the introduction of a common conduct of business regime for investment business when the ISD is replaced by MIFID, not least because CESR will have greater control over the content of conduct of business rules made under MIFID. However, it will still be necessary to ensure that Member States are being consistent in the conduct of business rules they apply to management companies for their non-MIFID business.


Outsourcing


In spite of the flaws in the management company passport, it would in theory still be possible for one management company to outsource its management functions to another.21 This could be a means of achieving some of the efficiency gains that fund houses had hoped to derive from the management company passporting regime, particularly those with fund offerings in a range of jurisdictions. In this way management company activities could still be centralised in one management company rather than being carried on separately in each state where the group has a UCITS.


UCITS III sets out the basis on which management companies can outsource management company functions. Among other things, the home state regulator must be notified and there are further requirements to ensure that delegation is made to entities that are qualified and capable of carrying out the delegated functions. The Directive does not permit management companies to transfer their liability to a UCITS and its investors by way of an outsourcing and, in particular, the management company may not delegate its functions to the extent that it becomes what the Directive calls ''a letter box entity''. This last requirement has led to a debate that is, as yet, unresolved and further work is needed to clarify the position.


To what extent can a management company outsource its management company functions?


In resolving this issue, it is important that any restrictions on outsourcing should go no further than is merited to protect investors. The provisions of the Directive should not be used as a cloak for anti-competitive behaviour and the standards applied to outsourcing by management companies should be consistent with those applied to firms under the ISD.


Although CESR will soon be able to influence directly the standards established for ISD services (through Level 2 rules under MIFID), it does not have this power under the UCITS Directive. While the ideal solution might be to amend the UCITS Directive to enable CESR to make Level 2 rules on outsourcing management company activities, this would be too time-consuming. In practice, the most fruitful approach, at least in the short term, is to seek to ensure that regulators adopt similar standards in applying the UCITS III rules on outsourcing.22


UCITS distribution


Further attention must be paid to UCITS distribution to facilitate a genuinely pan-European market. An effective response is likely to need a mixture of legislative intervention, Level 3 regulatory co-operation and industry-led co-ordination. However, even with these changes, truly cross-border distribution may continue to be hampered by the fund distribution models that predominate in some Member States.


In some cases, fund distribution is in the hands of a relatively small number of large financial institutions that naturally tend to favour their own funds. This can operate as a disincentive to market entry. In the absence of anti-competitive behaviour, this is an area where the market must be left to take its course, and it may be that as the move towards more open distribution models gains pace elsewhere these obstacles will diminish.


UCITS registration


UCITS III missed the opportunity to remove a major barrier to market entry for many funds - the UCITS registration regime. Article 46 of the UCITS Directive currently requires a UCITS to register with the regulators of each Member State in which its units will be marketed. The process includes providing the regu- lators with various items of information including details of how the fund will be marketed.


In practice, there are wide variations between Member States in the registration regimes they operate and in the information they require. In some jurisdictions, registering a UCITS can be costly and time-consuming, sometimes taking longer than the two-month maximum in the Directive. Having obtained registration, there is also an ongoing cost in maintaining it. This is a particular problem for funds seeking to operate on a genuinely pan-European basis with multiple registrations.


It is questionable whether there is any compelling reason for keeping the registration regime in its current form. Investors should be adequately protected by the regulation of the product and by the fact that those selling it are also ordinarily regulated under one of the single market directives; it is rare for a UCITS to market itself directly to customers. A simple notification obligation would therefore be more appropriate.23


However, a fundamental change to the registration requirements would mean amending the Directive and hence delay. Amendment should be a longer-term objective, but for the present, attention needs to focus on making the existing arrangements work more effectively and it is encouraging to see that this is one of the areas that CESR has adopted as a target for 2005.


The objective should be to reduce the process and any continuing requirements to the bare minimum and to ensure that they are applied consistently, and with a similar level of efficiency, across all Member States.


The simplified prospectus


Following UCITS III, UCITS can be marketed using a simplified prospectus, which is intended to be ''easily understood by the average investor''. The simplified prospectus must be offered to investors before they conclude a contract. The full prospectus has not been abolished and must be supplied to investors on request. The high-level contents requirements for the simplified prospectus are set out in Sch.C to the Directive and are ''maximum harmonisation'' requirements; Member States are not permitted to require additional information or documents to be added (although individual UCITS may go beyond the con- tents requirements if they wish). Areas covered include details of the investment objectives and policy of the UCITS, expenses born by the investor and the fund, historic performance and a statement about the taxation of the UCITS.


The concept is a good one, but its realisation has been fraught with difficulties. These have thrown the shortcomings of the regime into stark relief, particularly the extent to which it relies on Member State regulators taking a co-ordinated approach to implementation. With such high-level contents requirements, it was inevitable that differences of opinion would emerge between the Member States as to how they should be applied. There have also been problems in developing a consensus as to how the infor- mation should be presented.


As a result, when the UCITS III regime came into effect across Europe in February 2004, there was no agreement on the detailed contents for simplified prospectuses. Firms wishing to launch new UCITS III funds have been confronted with the challenge of how to produce a simplified prospectus when their regulators have not yet passed detailed implementing legislation.24 The situation improved in April 2004 when the Commission issued a Recommendation on the contents of the simplified prospectus.25


 However, because there is no scope for Level 2 legislation in respect of the simplified prospectus, this is no more than it says - a recommendation. On the other hand, while Member States are not obliged to follow it there should be a reasonable level of adherence since it was developed in consultation with the Member State regulators. Additionally, because the Recommendation needs to be implemented and is not directly applicable (unlike Level 2 legislation), funds are currently experiencing further delay.


Member States were to report on their first experiences of seeking to apply the Recommendation by February 28, 2005, and a consultation exercise was recently undertaken by the ESC on the state of implementation. Initial indications are that implementation of this Recommendation (and the associated Recommendation on risk management and derivatives) is patchy.


If so, it is not encouraging for those who think that the current defects in the UCITS regime can be ironed out by regulatory co-ordination rather than revised legislation. In the longer run, there may be arguments for bringing prescription of con- tents requirements fully within the ambit of the Lamfalussy regime so that it can be addressed by way of Level 2 measures.


Other rules applicable to marketing UCITS


Finally, even if the path to introducing the simplified prospectus had been smoother, there are further potential obstacles to a truly harmonised UCITS mar- keting regime. One is Art.44 of the Directive. This is a general provision requiring a UCITS that is marketing in another Member State to comply with any laws, regulations and administrative provisions of that State not falling within the scope of the Directive and any advertising rules it imposes.


UCITS III did nothing to change this and it remains as a further potential impediment to a harmonised marketing regime; Member States are still able to apply a further layer of requirements on funds marketing in their jurisdiction. UCITS promoters must therefore continue to spend time and money understanding the marketing rules of each Member State in which they wish to market.


There are also significant areas of uncertainty as to how the marketing regime established under the UCITS Directive will tie in with the distribution and advisory regime contemplated by directives such as the ISD/MIFID (which regulates a range of investment firms' activities in relation to units in funds), the E-Commerce Directive (which applies a carve-out to UCITS marketing rules made under Art.44)26 and the Distance Selling Directive.27 CESR intends to publish guidelines on this during 2006.


However, as the Commission is already able to apply Level 2 measures under MIFID, one approach at least to harmonising UCITS with MIFID in this area would be to enable it to make Level 2 legislation covering UCITS marketing arrangements throughout the European Union, so helping to ensure consistency and flexibility. This would doubtless be a time-consuming process, so in the short term the best hope is for CESR to seek to ensure consistency in this area using a mixture of Level 2 and Level 3 powers where it is currently able to do so under the terms of the relevant directives, and otherwise to seek a consistent approach on a voluntary basis.


UCITS depositaries


UCITS III left the existing rules for depositaries largely intact. While it may not be at the top of the list of priorities, there is a question as to whether the regime needs updating. The Directive would probably need amending to achieve this.


Depositaries form the third key element in the UCITS regime, along with the funds themselves and management companies. Their role is an important one - safekeeping the assets of a fund and overseeing the fund's operation to ensure that it is carried on in accordance with its constitution and any applicable laws. However, the Directive provides little detail on the duties of depositaries, how they should be discharged or the criteria a firm should satisfy before it is permitted to act as a depositary. There is no passporting regime for depositaries; Arts 8 and 15 of the Directive currently require a depositary to have its registered office or a branch in the same Member State as the fund appointing it, meaning that the depositary is subject to local supervision.


This has led to a fragmentation of depositary provision. There may have been policy reasons for this approach when the Directive was first introduced, related to ensuring that the regulator of a UCITS could supervise the operation of the fund as a whole. However, as the market has developed, the lack of a passport for depositaries looks increasingly like an anomaly.


One change to consider is therefore the introduction of a passport for depositaries allowing them to provide their services cross-border. Custodians are, after all, already able to rely on an ISD passport to provide safekeeping and administration services under the ISD - which is half of the job of a depositary.


Allowing for the consolidation of depositary services could provide another means of driving cost out of the system, facilitating fund mergers and enhancing consistency of operation across borders (since depositaries operating cross- border should have a strong incentive to identify inconsistencies of operation and practice and to press for their removal). As with management companies, it would be necessary to apply common prudential standards to establish a workable passporting regime, perhaps by borrowing parts of that established for custodians under the ISD. However, a tighter depositary regime would be consistent with the current emphasis on corporate governance and any cost needs to be weighed against potential advantages.


The Commission has identified the regime for depositaries as needing more general harmonisation.28 It is currently examining the scope for regulatory convergence in the areas of prudential standards, the treatment of conflicts of interest, the legal nature of the duties of a depositary, and investor transparency by means of greater co-operation between national regulators. There are various reasons why convergence may be desirable such as enhancing investor confidence in acquiring units in passporting funds.


However, as a Commission press release points out, it is also a prerequisite to funds being prepared to appoint depositaries in other Member States29; while it is clear that no decisions have been taken, the impression is that this may be a warm-up exercise for the introduction of full passporting rights. As indicated above, this would make sense, but would also require further legislation unless it could be based on the existing arrangements for providing depositary services through a branch.


Cross-border fund mergers


It is essential for the future of the industry that investment funds are managed more efficiently. Smaller funds have higher relative costs. As indicated in the introduction to this article, the economics are simple: increase the size of the fund and the relative cost to investors should be reduced. The challenge is to find a way of achieving this. One of the main means is to merge small, uneconomic funds into larger funds. 30


Most Member States have a domestic regime that allows for fund mergers. However, for the European industry to reap the full economies of size there needs to be a way of doing the same thing between jurisdictions. At present, cross-border mergers are hampered because existing merger regimes (and the concessionary tax treatment that goes with them) only contemplate domestic mergers.


Consequently, cross-border mergers, where they are possible at all, are likely to be time-consuming and costly. It would be possible to facilitate fund mergers were Member States to cooperate by removing the obstacles; in particular, they could reduce the level of shareholder consent re- quired to approve a merger31 (in some cases currently as high as 100 per cent), harmonise the circumstances in which mergers will obtain regulatory approval, and ensure that fund mergers are tax-neutral whether or not they are domestic or take place cross-border.
However, given the national interests involved and the prospects for effective regulatory co-operation in such a complex area, the most effective solution in the long run may be the introduction of new European legislation allow-ng for cross-border mergers. Either way, there seems little justification for continuing with the present situation; if UCITS funds are genuinely harmonised there should be no investor protection concerns about merging a UCITS in one state with a UCITS in another.


An alternative to full mergers would be the use of ''pooled'' management- effectively taking a number of similar funds and managing them together either by using information technology to manage them as if they were one pool of assets (sometimes referred to as ''virtual pooling'') or actually pooling the funds using a master-feeder structure.


Various Member States permit arrangements such as this on a domestic basis, but they can be difficult to achieve cross-border. It would be open to individual Member States to take steps to facilitate cross-border pooling arrangements and this could, perhaps, provide a short-cut to some of the benefits of a merger without the need for a European merger regime. However, even with pooling, European legislation may be needed to establish a co-ordinated pan-European approach.


UCITS funds infrastructure


This is another area where harmonisation could bring important efficiency gains, but here the best chances of success lie in enhanced co-ordination within the industry. The prime example of where this is already happening, but not the only one,32 is the area of transaction processing. Cross-border funds processing within Europe is highly fragmented, in stark contrast to the United States. Much of it remains manual and bilateral in nature with differing communication and operational standards being applied. This results in higher transaction costs and increased operational risk. With the possibility that transaction volumes could double in the next three to four years, this is a concern.33


Both could be significantly reduced were standard settlement processes to be adopted throughout the European Union. Unchanged, the existing situation is likely to fetter the development of a single funds market. In response, the European Fund and Asset Management Association (''EFAMA'', formerly ''FEFSI''), in association with various industry participants, has been making a promising contribution in the effort to establish common standards. It is seeking to identify obstacles to more efficient settlement and to make recommendations on how they can be re- solved. This is not an area where it is reasonable to expect instant solutions.


However, progress has been made in the form of a proposed ''fund processing passport'' which, if commonly adopted, could provide a harmonised statement of all of the information that would ordinarily be needed to facilitate funds processing.34


EFAMA has also made a range of recommendations with a view to greater standardisation of the transaction and settlement process covering the basis for electronic order processing, the adoption of standard data for account opening, the process of order acknowledgment and confirmation and settlement standards.35 The process of standardisation in these areas will be essential to laying the golden egg of ''straight through processing'' for investment funds.


Europe-wide endorsement of these recommendations is currently being sought together with some significant institutions that are prepared to adopt them to lead the market forward. While the task is considerable, there is scope for cautious optimism that this initiative will produce results precisely because it is drawing in a wide range of industry participants and is market driven, in an area where the market can be left to do its work without undue political involvement.


Conclusion


Considerable progress has been made, but few would pretend that Europe yet has the funds regime it needs.


The report of the Commission on the UCITS regime later this year is therefore an important opportunity to take stock and to develop a consensus about what a single funds market should look like and how best to achieve it. The industry and not just its regulators and trade associations needs to engage fully in the debate; whether agreed objectives are realised through legislation, or regulatory or industry cross-border co-operation, consensus offers the best prospect for achieving the common goal. No single party controls all the solutions.


Further legislation will be needed, among other things, to clarify the rules on eligible assets, to strengthen the management company regime and to facilitate cross-border fund mergers. And the Lamfalussy approach probably needs to be applied to more areas of the Directive.


However, legislation cannot resolve everything. Even with the greater flexibility permitted by Lamfalussy, laws and regulations have to be drafted, understood, applied and overseen. This can be time-consuming and expensive and so, where it is possible to achieve common objectives by making the existing regime work or by stimulating the industry to come up with its own solutions, this is likely to be preferable.


Where legislation is unavoidable, it should focus on identifiable objectives and go no further than is necessary in achieving them; there is a need for effective prioritisation and cost benefit analysis with full consideration of the implications. From this perspective it seems highly questionable whether the idea of a new ''European asset management directive'' favoured by some really hits the mark; it appears to place form over substance and risks creating a situation where all legislative change in the area of asset management is delayed as a result of the need to move at the pace of the most controversial elements.


And what of that name ''UCITS''? What does it mean to anyone outside a group of hard-core fund management enthusiasts? It is also misleading now that UCITS are no longer restricted to investing in transferable securities. Along with all of the other changes, perhaps now is the time to do away with the misnomer.


Notes:
1. Directive 85/611 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities [1985] O.J. L375/03, referred to in this article as ''the Directive'' or ''the UCITS Directive''.
2. Figure stated as at June 30, 2004. FEFSI Statistical Release number 18, September 2004.
3. F. Heinemann, ''The benefits of creating an integrated EU market for investment funds'' in ''The Incomplete European Market for Financial Services'', P. Cecchini, F. Heinemann and M. Jopp, eds (Springer, 2003).
4. The report will be made under Art.2 of Directive 2001/108,which requires the European Commission to report to the European Parliament and the Council on, among other things, how to improve the single market for UCITS, the scope of UCITS investment powers and how UCITS are structured.
5. CESR's guidelines for supervisors regarding the transitional provisions of the amending UCITS Directives (2001/ 107 and 2001/108). The fact that the regulators of the Member States have managed to reach some consensus as to a practical approach in resolving the ambiguities in the drafting of the Directive does at least suggest that effective Level 3 co- ordination is not an entirely unrealistic aspiration (see ''UCITS and the Lamfalussy regime'' below).
6. Directive 88/220 [1988] O.J. L100/31 and Directive 95/26 [1995] O.J. L168/07.
7. Directive 2001/108 [2002] O.J. L41/35.
8. Directive 2001/107 [2002] O.J. L41/20.
9. The ''Lamfalussy Extension Directive'': Directive 2005/01 [2005] O.J. L79/09 amending Council Directives 73/239, 85/ 611, 91/675, 92/49 and 93/6 and Directives 94/19, 98/78, 2000/12, 2001/34, 2002/83 and 2002/87 in order to establish a new organisational structure for financial services committees.
10. Directive 2004/39 on markets in financial instruments amending Directives 85/611, 93/6 and 2000/12 and repealing Directive 93/22 [2004] O.J. L145/01.
11. The CESR mandate for the Expert Group on Investment Management (June 2004) indicates that they are intending to consider how to deal with this issue, although it is not entirely clear which of the possible approaches they are likely to adopt. The Report of the Asset Management Expert Group of May 2004 on the Financial Services Action Plan suggested that there is scope for both approaches operating in tandem. One advantage of a common private placement exemption is that it works on the basis of removing regulation whereas a new class of authorised funds would mean more rules to comply with.
12. It covers shares in companies and securities equivalent to shares, bonds and other forms of securitised debt, and negotiable securities carrying the right to acquire transferable securities (such as warrants).
14. Commission Recommendation 2004/383/EC of April 27, 2004 on the use of financial derivative instruments for undertakings of collective investment in transferable securities [2004] O.J. 144/33.
15. Member States have responded to a questionnaire from the ESC on the subject and the responses are currently being collated. Member States were to report on their first experi- ences of seeking to apply the Recommendation by February 28, 2005.
16. The Recommendation takes the approach that instru-ments should be considered as ''liquid'' where they can be converted into cash in no more than seven business days at a price closely corresponding to the current valuation of the asset in its own market.
17. The issue is not mentioned in the Commission mandate to CESR, possibly because the Commission Recommendation 2004/383/EC suggests that regulators should have regard to the same criteria as those that apply in deciding whether a tracker fund can benefit from the exemptive treatment in Art.22a of the Directive described below. However, it is questionable whether this is sufficient because it does not directly deal with the question of asset classes, albeit that the criteria in Art.22a concern a ''stock or debt securities index''.
18. As mentioned above, the Commission Recommendation indicates that derivatives should be considered as liquid if they can be converted into cash in no more than seven days at a price closely corresponding to their current valuation.
19. Directive 93/22 on investment services in the securities field [1993] O.J. L141/27. The ISD will shortly be replaced by MIFID. However, because that has not yet happened, this article continues to refer to the ISD.
20. It is not necessary for a UCITS in corporate form to appoint a management company to run the UCITS. Instead, the company can run itself.
21. Outsourcing in relation to ISD activities is also possible.
22. A further area of uncertainty in the UCITS III management company regime is the requirement that where a management company, ''entrusts a third party with the marketing of the units in a host member state'' it must go through the same
notification procedure as it would if it were going to provide the service itself cross border (Art.6b(5)). The precise purpose of this requirement remains unclear, but on one approach it could lead to regulatory duplication since it appears to suggest that a separate notification is required each time a distributor is appointed even though the UCITS it will be distributing is already authorised and in most cases the distributor will also be regulated to carry on the activity concerned. The recent transitional guidance from CESR does not seem to resolve the point although, in practice, it is not clear that Member State regulators are taking a particularly firm line in applying the provision.
23. As the Asset Management Expert Group recognises in its report, The Financial Services Action Plan: Progress and Prospects (May 2004).
24. This was aggravated further by confusion over whether pre-UCITS III funds also needed a simplified prospectus.
25. Commission Recommendation 2004/384 of April 27, 2004 on some contents of the simplified prospectus.
26. Directive 2000/31 [2000] O.J. L178/01 on certain legal aspects of information society services. In particular, see Art.3(3).
27. Directive 97/7 [1997] O.J. L144/19 on the protection of consumers in respect of distance contracts.
28. Communication from the Commission to the Council and to the European Parliament, ''Regulation of UCITS depositaries in Member States: review and possible developments'', COM(2004)207. The Communication is a response to the request of the Council in Art.2(1) of Directive 2001/108 that it should report on the application of the UCITS Directive with ''proposals for amendment where appropriate'', the report to cover among other things, the functions of depositaries.
29. Commission Press Release IP/04/430.
30. As indicated above, greater administrative centralisation and outsourcing at management company or depositary level also provides opportunities to reduce cost.
31. This would probably need to be combined with free redemption arrangements subject to tax relief.to anyone outside a group of hard-core fund management enthusiasts? It is also misleading now that UCITS are no longer restricted to investing in transferable securities. Along with all of the other changes, per-
haps now is the time to do away with the misnomer.
32. Another is industry-wide consideration of performance reporting by the European Fund Categorisation Forum. Note also the work of the UK Investment Management Association.
33. European Fund and Asset Management Association, ''Standardisation of Funds Processing in Europe: Order and Settlement'', February 9, 2005.
34. European Fund and Asset Management Association, ''A Pan-European Fund Processing Passport'', February 9, 2005.
35. ''Standardisation of Funds Processing'', n.33 above.


This article first appeared in the Journal of International Banking Law and Regulation, Issue 6, 2005.

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