Yesterday, CESR conducted a public hearing on its proposed Level 2 measures relating to the UCITS management company passport. On 8 July 2009, CESR had published a consultation paper, Ref. CESR/09-624 (CP), in which it had set out its views on the “maximum alignment” between UCITS and MiFID firms. Areas such as

  • organisational requirements, in particular
  • recordkeeping;
  • conflicts of interest management and disclosure;
  • rules of conduct, notably
  • best execution;
  • rules for the depositary; and
  • risk management

are explored in great detail in the CP.

If CESR’s position were to be implemented, then UCITS and their management companies would face a very heavy workload in 2010, the year before Member States are supposed to transpose the requirements of UCITS IV.

While many of the propositions made by CESR make perfect sense – it is surprising that the obvious gap between UCITS and MiFID firms has not been closed earlier – there are a few areas where the CP is either unclear or where the proposals go too far, or are just not necessary to achieve the primary objectives of the UCITS Directive.  

Therefore, UCITS industry participants attended yesterday’s public hearing with some degree of apprehension, and their objective was to help avoid over-regulation of UCITS funds, which are already some of the most heavily regulated products.

General impression

As a general comment, the representatives of the various fund management associations seemed not to be too upset about the prospect of an alignment of UCITS and MiFID. One can only speculate about the reasons, but it appears that many UCITS management companies are already familiar with the requirements under MiFID from their discretionary portfolio management activities. In fact, many commentators said that they were less afraid of a single standard under MiFID and UCITS, but more afraid of being forced to operate under different standards, for MiFID, UCITS and - later - the AIFM Directive.

Notwithstanding this general agreement, industry participants raised a large number of substantive issues, with respect to almost all chapters of the CP.

Organisational requirements

In the interest of investor protection, CESR deems it necessary to impose certain organisational requirements on UCITS and their management companies.

The position in the Consultation Paper

The approach suggested by CESR is to treat the MiFID Level 2 provisions as the primary regulatory model for the regulation of UCITS. For management companies already providing investment services under MiFID, this approach should limit the implementation costs and help to ensure a level playing field in the sector.

There are a few areas in which CESR went beyond the requirements of MiFID, which led to the criticism that CESR was creating a “goldplated” version of MiFID for UCITS. One such area is the exercise of voting rights, which is not a requirement under MiFID for discretionary portfolio managers, but could - on the face of it - be a requirement for UCITS managers under the new Level 2 rules.

Results of the hearing

Several industry participants were critical about the fact that the “copy out” approach adopted by CESR (i.e. that it simply took the MiFID text and declared it applicable to UCITS as well) was not consistently applied. It was argued that an investment services firm, that complies with all the requirements under MiFID should, in principle, be compliant with UCITS, unless there are compelling reasons to apply a stricter standard.

CESR was sympathetic to the plea for consistency between MiFID and UCITS, but one did not get the impression that it will go so far as to confirm that every MiFID-compliant management company will automatically be compliant with the UCITS Directive. Rather, CESR will probably go through its proposal again and try to iron out technical flaws in the Level 2 measures.

As regards exercising voting rights, CESR was visibly surprised that industry participants had read a “duty to exercise voting rights” into its proposal, as this was never CESR’s intention. In all likelihood, this will be clarified in the next legislative step.


The position in the Consultation Paper

UCITS already have to keep very detailed records of their transactions. However, CESR now intends to impose on UCITS the same detailed record-keeping requirements that apply to firms under MiFID, notably with respect to trade information under Annex I of the MiFID Level 2 Regulation.

While some UCITS management companies will have to adapt their systems in order to capture detailed information, it probably makes sense to create a level playing field, not least because many UCITS management companies have shown, in their discretionary portfolio management activities, that they are capable of meeting the MiFID requirements.

But the CP can be interpreted in a manner that goes much further. UCITS management companies shall be required to record:

“the specific identification of the unit holder and the relevant UCITS”.

CESR explains that:

“management companies (shall) record in electronic form the subscription and redemption orders from investors and the relevant terms and conditions immediately after receipt of any such order. In order to ensure a level playing field and proper investor protection, the content of such recording should be harmonised and include a specific identification of the investor and the relevant UCITS, order-related information and indication of relevant subscription or redemption NAV. The procedures put in place by the management company in order to ensure market integrity and avoid malpractice, such as late trading or market timing, should rely on these recordings of subscription and redemption orders.”

In some countries, such as Luxembourg and Ireland, the management companies use transfer agents to maintain unit-/shareholder registers. However, in most cases, not the end-investor is not recorded in the shareholder register, but banks, who in turn act as the custodians for their clients, the end-investors.

On the face of it, CESR wants UCITS or their management companies to maintain a register of end-investors (why should it otherwise make reference to investor protection?), which would in theory be possible, but in practice the costs would be significant, with no apparent benefits.

Results of the hearing

As expected, industry participants made clear their views that it is not only pointless for a UCITS management company to record the identity of its unit holders, but that it may be in many cases impossible or at least cumbersome and very expensive.

In many countries, fund units are securitised in bearer form, there is no shareholder register, and thus it would be impossible to trace who owns units of the funds.

Also, it was mentioned that the UCITS management company may be subject to further requirements if it knew the identity of the unit holders, such as know your customer-requirements under the local Anti-Money-Laundering legislation.

While the representatives of CESR did not commit to repeal this proposal, the impression was that they were not completely insensitive to these arguments.

Conflicts of interest management and disclosure

Article 12(1)(b) of the UCITS Directive requires that each management company¸ having regard also to the nature of the UCITS managed, is structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced by conflicts of interest (i) between the management company and its clients; (ii) between one of its clients and another; (iii) between one of its clients and a UCITS; and (iv) between two UCITS.

The management of conflicts of interest is particularly difficult for UCITS and their management companies. Some member states have already extended the provisions under MiFID – which requires investment firms to identify, manage and disclose their conflicts of interest – to UCITS and their management companies, but in other countries, apart from a general statement that UCITS must act in the best interest of their investors, there are no detailed rules.

The position in the Consultation Paper

CESR describes several scenarios – all derived from the MiFID – in which a UCITS could be subject to conflicts of interest. Just like under MiFID, CESR confirms that these conflicts may not only emanate from the UCITS or its management company, but also from group companies.

CESR explains that conflicts arising in the context of managing the UCITS must be distinguished from those conflicts which arise in the context of direct sales. Such conflicts may, for example, arise in cases where management companies have incentives to sell a specific UCITS or where the remuneration of the persons in charge of the sale is linked to the number of units sold.

In our view CESR applies a higher standard to the management of conflicts under UCITS than under MiFID. While under MiFID disclosure of conflicts is the last resort when they cannot be “managed away”, disclosure is at least an option, but this is apparently not so under the proposed Level 2 rules for UCITS:

“(...) considering the stronger separation between ownership and control in the sphere of collective portfolio management activities (where the unit holders cannot undertake their own investment decision) and the lack of sophistication of many UCITS unit holders, disclosure to unit holders may not be the most appropriate investor protection tool in connection with non-neutralised conflicts of interest. Therefore, CESR considers it appropriate to propose an alternative method for the management of non-neutralised conflicts of interest.”

Organisational or administrative arrangements made by the management company to manage the conflicts might not be sufficient to ensure that the risks of damage to the UCITS’ interests will be prevented. In such a case, the senior management of the management company should, according to CESR, take the necessary decisions to ensure fair treatment of the UCITS and relevant unit holders and that, as a consequence, the management company acts in all cases in the best interests of the UCITS and relevant unit holders. Where conflicts arise unexpectedly, they must be resolved in the best interests of investors, and periodic reports must explain and justify the decisions taken by the management company.

On the other hand, as far as direct sales are concerned, the “comply or disclose” method already known from MiFID shall apply.

Results of the hearing

The view expressed above, i.e. that CESR wants to hold UCITS and their management companies to a much higher standard as regards avoidance of conflicts, was confirmed in the hearing.

This has potentially far-reaching consequences. If a UCITS or its management company is legally forced to “manage away” all foreseeable conflicts, so that they always act in the best interests of the investors, then this may have repercussions on the choice of depositaries (will UCITS management companies still be allowed to use affiliates as depositaries?), the selection of investments (can fund managers still purchase Structured Financial Instruments - SFI - or OTC derivatives designed by their affiliates?), etc.

On the other hand, the duty to act in the best interests of the investor has been part of the UCITS Directive for many years, and so far, no regulator has taken a tough approach regarding this topic, probably fearing regulatory arbitrage.

Rules of conduct

The position in the Consultation Paper

CESR wishes to impose relatively vague general requirements on the selection of investments by management companies, which should not create real additional burdens. However, it also wants management companies to record the reasons for their investment decisions, and records for each and every investment shall include:

“forecasts and perform analyses concerning its contribution to the UCITS’ portfolio composition, liquidity and risk and reward profile. These analyses should be supported by reliable, updated and meaningful information, both in quantitative and qualitative terms.”

While there might be portfolio managers which – together with the risk management department – establish and maintain such records, presumably for most UCITS management companies these requirements will cause huge additional costs, for a doubtful benefit.

Even more stringent due diligence and documentation requirements will apply for the investment into complex investments, such as SFIs.

As regards direct sales – which are increasingly rare these days – the UCITS management company shall as a minimum conduct an appropriateness test, unless the client takes the initiative for an execution-only transaction.

The CP is not quite clear on how CESR wishes to deal with inducements paid by the UCITS management company. If a direct sale takes place, CESR wants the management company to inform end-investors about any inducements being paid – although in practice inducements are not necessary and not paid in the case of direct sales.

Outside the area of direct sales, it is clear that the management company or a third party manager to which the portfolio management is delegated must inform the UCITS of any inducements received. This is a sensible provision for third party managers who might for instance receive payment for order flow. But for the management company it would be pointless to disclose to the UCITS of which it is itself the manager that it received or paid inducements.

Possibly, this requirement could make sense if the investors were also informed about inducements paid or received by the management company, in the prospectus or otherwise. Indeed, the following statement could be interpreted as imposing a requirement on UCITS management companies to disclose to the end-investors all inducements paid, including retrocession fees:

“Ex-ante information to the UCITS should be understood as covering also their unit holders. The ex-ante information to the unit holders should be provided in any appropriate and durable medium (e.g. UCITS’ website, UCITS’ prospectus etc). However, since arrangements involving inducements may also be set up after the initial offering of the fund, unit holders may become affected by such arrangements at a time when they have already purchased the units/shares of the relevant UCITS. Therefore, in practice, disclosures towards current unit holders may only be done ex post, possibly on a periodic basis (for example in the periodic reports).”

Results of the hearing

In the hearing, it became clear that - just like under MiFID - the issue of inducements was highly controversial. To start with the bad news:  

In the CP, CESR wanted to impose an obligation on UCITS management companies to disclose, to the end investor, all inducements paid to third parties, including retrocession fees. CESR expected resistance from UCITS managers, but thought that this approach was consistent with MiFID.

However, during the hearing, industry participants made it clear that the payment of retrocession fees by the UCITS management company is a necessary precondition for getting the funds sold, in a way a “proper fee” that must be paid, and should thus be exempted from the disclosure requirements.

While the CESR representatives showed some sympathy for this argument, it is difficult to predict whether CESR will follow this reasoning, or whether it will insist that UCITS management companies disclose - in their prospectuses, or otherwise - their price models.

On the positive side, CESR will probably rethink its position on the requirement to keep detailed records on the reasons and due diligence for each and every investment decision.

Best execution

Best execution - a tale of two cities

Imagine two cities: in one city, professionals who manage other peoples’ money need to observe very strict rules regarding the selection of the markets where they buy or sell securities. The need to choose these markets by first establishing clear written criteria as to what feature of a market is most important for their clients, in terms of speed, reliability, costs, etc. Then they must - on the basis of a very large amount of expensive data - determine in a transparent manner which market or markets best meet the previously identified needs of their clients. If they do not have sufficient resources to undertake this time-consuming exercise, they can delegate such activity to expensive service providers, but retain full responsibility if the service provider does a bad job.

But that is not enough: once the market where a financial instrument will be bought has been identified, they must, again in great detail, assess which intermediaries they will use to obtain the best result for their clients. The money managers in this city are then required to inform all of their clients in writing about their intended course of action and seek their consent - and one year later, they need to go through this whole exercise again, taking into account market developments.

In the neighbouring city, there are also money managers at work, and they deal with much larger sums of money. However, no one forces them to study markets or intermediaries in a careful, diligent and structured manner. In fact, most often these money managers simply use their custodians or affiliated entities for the execution of their orders. They can change their minds on a whim and do not have to tell their clients anything about their past or future action.

You have guessed it: the first “city” is MiFID; the second “city” is UCITS.

Obviously, the above description is an exaggeration: most European jurisdictions require their fund management companies - either by law or through SRO rules of conduct - to have written principles about how they execute trades. But experience shows that the MiFID rules are much more detailed than the rules imposed on fund managers. This sometimes leads to absurd consequences: suppose an institutional client asks a Luxembourg-based investment manager to act as a manager for a managed account. In this case, the whole set of obligations under MiFID applies. If such an investment manager suggests that the investor establish a Special Investment Fund (SIF) instead and manage the assets therein, then no MiFID rules apply - even though the work done by the investment manager and the conflicts under which he operates regarding choice of brokers and counterparties are identical.

The position in the Consultation Paper

If CESR’s position is implemented – and we have no doubt that it will – then the managers of UCITS will be subject to the same stringent requirements as discretionary portfolio managers. In practice, the requirements will in fact be even stricter, as discretionary managers can in many cases rely on instructions from their clients as regards best execution, but this is of course not a possibility where monies of thousands of investors are managed within one fund.

CESR also made it clear that best execution concerns regarding both the choice of the execution venue, and also the choice of the executing broker or counterparty.

Fortunately, CESR recognises that UCITS management companies shall have the right to apply a wide range of criteria when it comes to choosing the venue or broker – and that the price alone shall not be the decisive criterion.

Results of the hearing


Is it allowed to draw the conclusion that industry participants think - rightly or wrongly - that they already practice best execution, and take the view - rightly - that the new rules for UCITS derived from the MiFID make sense, benefit investors and are long overdue?

Rules for the depositary

Position in the Consultation Paper

CESR’s mandate in this area is limited. It has been asked to propose minimum requirements to be followed by a UCITS management company when it uses a depositary in another member state.

CESR fulfilled this mandate by proposing a range of rather detailed clauses that must be included in a depositary bank agreement for cross-border situations. Mandatory clauses include rules on using sub-custodians, information flows, confidentiality, even the right of the UCITS to conduct on-site visits. Going actually beyond its mandate, CESR proposed the same requirements should also apply in a purely domestic set-up, where the UCITS management company uses a depositary in the same country.

Results of the hearing

The representative of a fund management association criticised CESR for not taking into account the fact that in many countries, depositaries fulfil functions - such as the valuation of assets - that in other countries are fulfilled by the UCITS management company or the fund administrator.

CESR recognised this point and promised, where necessary, to amend its proposal accordingly.

CESR also stressed that it was aware of the controversy triggered by the use of sub-custodians, and the fact that the CP considers the use of sub-custodians as a delegation of functions. It stressed, however, that this issue needs to be discussed in a wider context, taking into account UCITS and the AIFM Directive.

Talking to industry participants, one got the impression that the representatives of UCITS management companies are fully aware that - even though the UCITS framework was too weak to prevent the Madoff-scandal affecting European retail investors - it would be pointless to impose a heavy liability on depositaries, as they would then make their services much more expensive - to the detriment of investors.

Risk management

Position in the Consultation Paper

The CP is already the second detailed paper issued by CESR on risk management measures to be implemented by UCITS, following the CESR Risk Management Principles for UCITS published on 27 February 2009. Apparently, the regulators in at least a few countries are not content with the state of risk management measures presently taken by UCITS management companies.

In our view, the measures proposed by CESR by and large make sense, and do not impose too much of an additional burden on at least the large UCITS management companies.

Results of the hearing

This view seems to be shared by participants at the hearing, as they made only very few comments on the rather detailed provisions in the CP.

By way of exception, some commentators thought that the rules on the valuation of OTC derivatives were not very practicable. In particular, they demanded clarification as to what CESR meant by “other types of financial instruments which expose the UCITS to valuation risks equivalent to those of OTC derivatives”. During the meeting, CESR was at a loss to explain this, and promised to provide clarification at the next stage of the process.


If you wish to know what the future holds for UCITS management companies, the CP in its present form gives you quite a precise idea. Yes, some of the more controversial points will once more be considered, but by and large, the final Level 2 legislation will bear large similarities with the CP. This is bad news insofar as these new rules will cause additional costs - at sometimes doubtful benefit - but good news as UCITS management companies will have sufficient time to adjust to the new regime.