The European Parliament voted to adopt the UCITS V Directive (“UCITS V”) on 15 April 2014, in advance of Parliamentary elections next month. The final vote followed a period of uncertainty where there was potential for the progress of UCITS V to be thrown off course because of political argument over the scope of the remuneration rules.
UCITS V is aimed at improving the protections afforded to UCITS investors, preventing a repeat of the abuses seen at the time of the Madoff scandal and brings the UCITS framework into alignment with some of the innovations of the Alternative Investment Managers Directive (“AIFMD”). Michel Barnier, Internal Market and Services Commissioner of the European Commission, has emphasised the need to maintain the UCITS framework as a “gold standard for fund regulation globally”.
The key provisions of UCITS V are:
- UCITS management companies will be required to establish remuneration policies that are consistent with sound and effective risk management.
- New rules relating to depositaries concerning liability, delegation and entities eligible to act as depositaries.
- Harmonisation of administrative sanctions.
The issue of remuneration was the major battleground in the negotiation of UCITS V and, for a piece of financial services regulation, it became quite politicised, particularly in March 2013, when the European Parliament’s Economic and Monetary Affairs Committee (ECON) voted to cap bonuses for asset management staff at a 1:1 ratio with their annual salary. Unusually and to the relief of many in the asset management industry, the bonus cap proposal was voted down at the plenary session of the European Parliament.
Consistent with AIFMD, under the final text of UCITS V, UCITS management companies will be required to establish remuneration policies and practices that are consistent with and promote sound and effective risk management. These remuneration policies must not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the UCITS under management and cannot impair compliance with the management company’s duty to act in the best interests of the UCITS.
These remuneration provisions are subject to a proportionality test and UCITS management companies must comply with the remuneration principles set out in UCITS V in a way that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities.
In addition, UCITS V empowers the European Securities and Markets Authority (“ESMA”) to issue guidelines on the scope of staff to be caught under the new remuneration rules and the application of the new remuneration principles for UCITS management companies. These guidelines are intended to add flesh to the bones of the UCITS V remuneration principles and are expected to be largely aligned with ESMA’s Guidelines on Sound Remuneration Policies under AIFMD (the "Guidelines"), which provided guidance on proportionality, which remuneration would be affected and how to identify categories of staff covered by the Guidelines. The guidelines expected to be issued by ESMA in relation to remuneration policies under UCITS V will not be binding, however, financial regulators and market participants will be expected to comply on a ‘comply or explain’ basis. To date under AIFMD and the Guidelines, the sole proponent of explain rather than comply has been Malta.
Under UCITS V, at least 50% of any variable remuneration of UCITS management companies must consist of units of the UCITS concerned. During the negotiations, it had been strongly argued that variable remuneration should be in the form of shares of the management company or its parent company. This position was ultimately rejected as it was argued that this would have led to a situation where fund managers were rewarded for increasing profits of the management company rather than the value of the funds under their management.
Under the final text, at least 40% of variable remuneration will be deferred for at least three years and at least 60% will be deferred for very high bonuses.
Application to delegates
In a late change to the text, UCITS V now includes a recital which states that the new remuneration rules “should apply in a proportionate manner, to any third party which takes investment decisions that affect the risk profile of the UCITS because of functions which have been delegated”.
There is no corresponding provision in the operative parts of UCITS V and there is now a significant question of how effect will be given to this recital. It is most likely that, as was the case with AIFMD, the application of the rules to delegates will be dealt with under guidelines issued by ESMA.
This has been a hot topic under AIFMD, particularly for funds that are advised by US advisers, who are not subject to equivalent remuneration provisions and who find the extraterritorial application of EU regulation troubling.
Close attention will be paid to the consultation process that will precede the issue of any guidelines by ESMA and to the application of the equivalent Guidelines under AIFMD in the period up to the expected implementation of UCITS V in 2016.
There will be a particular focus on how the proportionality rule will be applied by regulators under AIFMD.
The Financial Conduct Authority ("FCA") produced guidance on AIFM remuneration which provides an interesting and helpful analysis of how the principle of proportionality will be applied by regulators and the Irish Central Bank has indicated that it sees “considerable merit in the interpretations which the UK FCA have provided which align the interests of risk-takers and investors and which seek to ensure that the effective management of AIF assets is preserved”.
Among the factors that will need to be taken into consideration by AIFMs are:
- Assets under management
- Scale and complexity of structure:
- whether listed or not
- having additional permissions such as receiving and transmitting orders
- simple structure e.g. internal v external ownership
- use of AIFM passport
- Complexity of strategies:
- use of leverage
- application of group CRD remuneration requirements to delegates
- limiting investment discretion through strict investment guidelines
- Fee structures aligned with investors’ interests
An additional concern for US managers is whether acquiring shares in a UCITS will be practical or feasible. Many UCITS prohibit investment by US persons, so it might be impermissible for US fund managers to hold the shares. If a UCITS changed its constitutional documents to allow US persons to invest, this could result in extra legal and regulatory registration and compliance obligations for the fund and the investment manager, thereby increasing the costs borne by the UCITS. In any event, even if a UCITS changed its constitutional documents to allow US persons to invest, some fund managers might be ineligible to invest based on the fund’s investor criteria and investor criteria imposed by US securities laws. Finally, holding shares of UCITS structured as a corporate vehicle would result in negative tax ramifications for US fund managers who are US taxpayers.
The liability of depositaries will be strengthened under UCITS V; a depositary will be liable for any loss of UCITS assets held “in custody”, corresponding with the liability provisions under AIFMD. In particular, if assets that are held in custody are lost, a depositary is under a restitutionary obligation to replace such assets. A very limited exclusion is available that permits a depositary to exclude liability if it can prove that loss occurred as result of an external event beyond its reasonable control, the consequences of which could not have been avoided despite all reasonable efforts to the contrary.
UCITS V also establishes an overarching duty of care for depositaries and provides that a depositary is liable to the UCITS and its investors for losses suffered by them as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations. UCITS investors are also given a direct right of redress against the depositary, meaning they will not need to rely on the management company to enforce this right.
UCITS V affirms a depositary’s liability for losses caused by its appointed sub-custodians or safekeeping agents by establishing that a depositary shall be liable for loss by a third party to whom the custody function has been delegated.
In contrast to AIFMD, UCITS V prohibits a depositary from discharging or transferring its liability to a sub-custodian. Consequently, there is very limited scope under UCITS V for a depositary to avoid losses of its agents, unless the depositary can establish that the loss falls within the limited exclusion described above.
In relation to the safekeeping of assets in emerging markets, UCITS V establishes a limited exception for liability where the law of the third country requires assets to be held in custody by a local entity and there are no local entities that satisfy the delegation requirements. In such cases, a depositary can discharge its liability if investors are informed of the risks of such delegation and the depositary is instructed by the management company to dedicate safekeeping responsibilities to the local agent.
UCITS V represents a material change to the current standard of liability which requires a depositary to be liable for loss resulting from the depositary’s unjustifiable failure to perform its obligations or its improper performance of them. Industry reaction to the enhanced depositary liability standard has focused on whether the increased responsibilities and standard of liability afforded to depositaries under UCITS V will result in higher depositary fees. Concerns over depositary liability have queried whether this will restrict the choice of depositary, particularly in emerging markets, where only the larger depositaries with extensive in-house sub-custody networks and capital are prepared to operate. Again, the implementation of AIFMD will provide guidance on whether an increase in depositary fees will come to pass.
UCITS V introduces new requirements in relation to the delegation of safekeeping duties by a depositary to sub-custodians. The new requirements generally relate to the operation of sub-custodians and require that sub-custodians: (i) have structures and expertise that are adequate for the safekeeping of the assets that are entrusted to them; (ii) are subject to effective prudential regulation and regulatory supervision; (iii) are subject to an external periodic audit; and (iv) take all necessary steps to ensure that in the event of the sub-custodians’ insolvency that the assets of the UCITS are not available for distribution to creditors. Furthermore, the depositary should not delegate its safekeeping duties unless it can demonstrate that: (i) there is an objective reason for the delegation; (ii) it has exercised due skill and care in the selection and ongoing monitoring of the sub-custodian; and (iii) the delegation is not made with the intention of avoiding the requirements of UCITS V.
Bearing in mind the quasi strict liability imposed on depositaries for the loss of sub-custodians and the prescriptive requirements as to delegation, it is expected that depositaries will enhance their due diligence and ongoing monitoring requirements of sub-custodians, seek to establish relationships with only those sub-custodians that have superior credit ratings and require indemnities from sub-custodians to cover loss of assets, particularly where enhanced custody risks are perceived. The pricing of safekeeping services is likely to change and in particular the rate cards that depositaries currently use for pricing custodial fees in different markets are likely to be replaced with a matrix pricing structure. Fees will take into account a myriad of factors, including, the types of assets, the settlement systems used, the markets assets are traded on, the credit rating of the sub-custodian, the depositary’s relationship with the sub-custodian and overall assessment of risk in the delegation of safekeeping duties.
Other depositary provisions
A depositary is subject to asset verification and cash monitoring obligations that are similar to AIFMD. In relation to assets that are not held in custody, such as derivatives, a depositary is required to verify ownership of such assets and to provide a comprehensive inventory of all the UCITS’ assets to the UCITS management company on a regular basis.
UCITS V also requires a depositary to ensure that the UCITS’ cash flows are properly monitored, that all payments made by or on behalf of investors upon the subscription of shares have been received and that all cash of the UCITS is booked in UCITS’ cash accounts.
Reuse of assets held in custody
UCITS V provides the assets held by a depositary may only be reused where the reuse: (e.g. for securities lending) (i) is executed for the account of the UCITS, when carrying out the instructions of the management company on behalf of the UCITS; (ii) the reuse is for the benefit of the UCITS and its unitholders; and (iii) the transaction is covered by high quality and liquid collateral received by the UCITS under a title transfer arrangement. The market value of the collateral at all times has to amount to at least the market value of the reused assets plus a premium.
The entities eligible to act as depositaries will be limited to: (i) credit institutions; (ii) national central banks; and (iii) other legal entities that satisfy the CRD capital adequacy requirements and who are subject to prudential regulation and satisfy certain conditions as set out in UCITS V. The inclusion of this third category, i.e. entities which are adequately supervised and capitalised, allows entities which currently provide depositary services (that are not classified as banks or credit institutions) to act as depositaries for UCITS.
UCITS V sets out the conditions under which administrative sanctions will apply for infringements of the Directive and the maximum penalties that should apply, which are at least €5 million or 10% of the annual turnover for corporations and at least €5 million for individuals.
Member States may apply criminal sanctions instead of the proposed administrative sanctions.
Sanctions will generally be published on the website of a Member State’s competent authorities. This publication will include the type and nature of the breach and the identity of the persons responsible. However, where the publication of the identity of a corporate entity or the personal data of an individual is considered to be disproportionate by the competent authority, the sanction may be published anonymously, delayed, or not published at all. The competent authorities will carry out a case-by-case assessment in such an event.
UCITS V also contains provisions encouraging whistle-blowing, requiring Member States to implement mechanisms to encourage reporting of potential or actual breaches of national laws transposing UCITS V, including secure communication channels for the reporting of such breaches. ESMA will also be required to establish secure communication channels for reporting, allowing individuals who have previously reported a breach to their national regulators to report it to ESMA where this issue has been ignored. This is a significant development as it is the first time such provisions have appeared in EU financial services legislation.
The adoption of UCITS V will now pass to the Council for its formal approval and the final Directive is expected to be published in the EU Official Journal before the end of June 2014.
Member States will have 18 months to transpose UCITS V into national law, meaning that the Directive is likely to come into force before the end of December 2015. There will be no transitional period. The depositaries of UCITS appointed prior to the transposition date that do not meet the eligibility criteria will be given an additional 24 month transitional period in order to meet these criteria.