BaFin, the German financial regulator, has recently begun to review performance fee calculation clauses in fund documents filed by non-German UCITS for marketing in Germany in a more systematic manner. In a number of instances, BaFin has objected if the performance fee is not calculated according to the principles applied by BaFin to domestic funds. UCITS that are registered, or intend to register, to be marketed in Germany should therefore review their performance fee calculation methodologies. However, it is not clear whether BaFin has the authority to review fund documents previously approved by the competent authorities of the relevant UCITS' home Member State (as hereafter defined). On a European level, ESMA is engaged in a consultation on draft guidelines on UCITS performance fees, and will consider the feedback it receives in Q4 2019 with a view to finalising the guidelines for publication afterwards.
BaFin’s Review of Non-German UCITS Fund Documents
The current UCITS disclosure regime has been established for many years, based on home Member State control with a maximum harmonisation regime. The single-license approach of the UCITS marketing passport allows a UCITS that has been authorised in one EU Member State (UCITS home Member State) to market its units within other EU Member States (UCITS host Member States), after having submitted a notification letter to the competent authorities of its home Member State. The passporting regime is predicated on UCITS host Member States permitting UCITS to market their units in that host Member State upon notification, and not imposing any additional requirements or administrative procedures on the UCITS.
The supervisory responsibilities are allocated between the authorities in the home and host Member States to ensure the proper functioning of the passporting framework. Only the authorities of a UCITS home Member State have the power to take action against a UCITS if it infringes any law, regulation or administrative provision, or any regulation laid down in that UCITS’ governing documents or in the instruments of incorporation of the UCITS. The authorities of the UCITS host Member State may take action against the UCITS only if it infringes the laws, regulations and administrative provisions in force in that Member State which fall outside the scope of the UCITS Directive1 (i.e., which infringe local statutory provisions of the EU entity in which the UCITS is being marketed).
BaFin, in a number of instances, has objected to performance fee clauses contained in fund documents of Non-German UCITS that notified BaFin of their intention to carry out cross-border marketing in Germany, based on BaFin’s administrative practice. According to this practice, a performance fee may be charged only when:
- The outperformance exceeds the performance of the UCITS’ benchmark at the end of a crystallisation period, and
- Any underperformances during the last five years (or since inception of the fund, if it has been in existence for less than five years) are considered and carried forward as negative contributions.
The crystallisation period should be at least twelve months and, for transparency, the performance fee must be subject to a cap. These requirements correspond to sample clauses that BaFin has published in relation to general fee and performance fee provisions of open-end retail funds (with which German UCITS funds comply in practice, even though such provisions are not legally binding2).
For German UCITS, BaFin recognises three different models of performance fee calculation methodology:
- Performance-based remuneration with a benchmark. A performance-based remuneration that refers to a benchmark can be applied only if the fund’s investment policy contains a specific investment focus and the fund invests at least 51% of its assets in assets corresponding to that investment focus (e.g., an equity fund must invest at least 51% of its assets in equities).In this model, any performance fee is based on the amount of the performance that exceeds the performance of the benchmark at the end of a crystallisation period. The performance fee must be capped. It may not exceed the average net asset value during the crystallisation period, calculated from the values at the end of each month. A performance fee cannot be paid if the performance at the end of a crystallisation period falls below the performance of the benchmark. BaFin also requires that any underperformance must be carried over into the next crystallisation period. For the annual calculation of the fee, any underperformance for the five (or, if the fund is less than five years old, all) preceding periods must be taken into account.
- Performance-based remuneration with increases in value. Where a fund does not have a specific focus in its investment policy, or where no suitable benchmark is available, the following methodology may be applied: the performance fee is calculated based on the percentage of: (i) the value that a fund share or unit at the end of a crystallisation period exceeds (ii) the highest value of the share or unit at the end of five prior crystallisation periods (high water mark). Again, the fee may not exceed the average net asset value. A hurdle rate, which must be exceeded to pay any performance fee, can be included.
- Performance-based remuneration with increases in value and cash investment as a benchmark. As an alternative to the above method with increases in value and where a fund does not have a specific focus in its investment policy or where no suitable benchmark is available, the following methodology may be applied: the performance fee is calculated based on the amount (i) the performance of a fund share or unit at the end of a crystallisation period is in excess of (ii) the income from a money market investment used as a benchmark in the crystallisation period. As in the previous examples, a cap must be applied.
BaFin’s principles and sample clauses are based on IOSCO Principles (with the spirit of which BaFin's guidance intends to comply). According to the IOSCO principles, performance-based remuneration clauses should comply with the principle of equal treatment of investors. This means more specifically that:
- A performance-based remuneration clause should match the goals of the fund and not create an incentive for the fund’s management company to take excessive risks in the hope of being able to trigger the payment of a performance fee.
- The calculation of the performance-related remuneration should be verifiable and not susceptible to manipulation. It is important to disclose to investors how the performance of investments is calculated, what benchmark is used (if any), and how the calculation formula is presented.
- In principle, the performance fee should be annualised (i.e., paid by reference to a one-year performance period). In addition, any benchmark used should be verifiable and published by an independent party.
Background and Consequences of BaFin’s Administrative Practice on Performance Fees
When “suggesting” the use of sample performance fee clauses, BaFin refers to various general principles of the German Capital Investment Act (Kapitalanlagegesetzbuch, or KAGB). According to these principles, a German management company (Kapitalverwaltungsgesellschaft, or KVG) must act in the interests of investors as well as the funds it manages, and must avoid harming investors through the imposition of inappropriate costs and fees. However, these general principles of German law do not per se allow the application of restrictions to non-German UCITS (in particular, with regard to limiting the amount of performance fees).
Impact of BaFin’s Administrative Practice on Non-German UCITS
The requirements to consider and to apply sample cost clauses relating to performance fees were initially applied by BaFin only to domestic UCITS. Such sample clauses are used by BaFin for the approval of fund rules or their amendments in accordance with the statutory provisions of the German Investment Code. Non-German UCITS, which are or seek to be marketed in Germany, historically did not need to comply with the requirements of the sample clauses. However, BaFin’s administrative practices suggest that this approach is changing.
In several instances, BaFin has objected to the language and calculation methods used in performance fee clauses applied by non-German UCITS that notified BaFin of their intention to carry out marketing in Germany. BaFin’s administrative practice of extending its jurisdiction to review performance fee clauses contained in fund documents of non-German UCITS is questionable, as the above-mentioned German statutory provisions that apply to German funds do not entitle BaFin to intervene or review the contents of fund documents of non-German UCITS that already have been reviewed and approved by the funds’ home Member State regulators.
As discussed above, the UCITS Directive clearly states that only the authorities of the UCITS home Member State have the power to take action against that UCITS if it infringes any law, regulation or administrative provision or regulation laid down in the fund rules or in the instruments of incorporation of the relevant investment company. The authorities of the UCITS host Member State may only take action against that UCITS if it infringes the laws, regulations and administrative provisions in force in that Member State that fall outside the scope of the UCITS Directive or the requirements set out in Articles 92 and 94.
The UCITS Directive further provides3 for a procedure that applies in case of a violation of provisions by UCITS. In the event the competent authorities of a UCITS host Member State have grounds to believe that a UCITS whose units or shares are marketed in that Member State is in breach of provisions of the UCITS Directive, these authorities shall refer those findings to the competent authorities of the UCITS home Member State, which shall take appropriate measures.
In the case of these cross-border situations, BaFin as the competent host Member State authority may report any violations of the UCITS Directive to the competent authority of the UCITS home Member State. However, if the UCITS persists in acting against the interests of German investors, despite the measures taken by the competent authorities of the UCITS home Member State (or if such measures prove to be inadequate or the UCITS home Member State fails to act within a reasonable timeframe), BaFin may:
- After informing the competent authorities of the UCITS home Member State, take all appropriate measures in order to protect investors, including preventing the UCITS from carrying out any further marketing of its units within the territory of the UCITS host Member State; or
- If necessary, refer the matter to the European Securities and Markets Authority (ESMA), which may act in accordance with the powers conferred on it under Article 19 of Regulation (EU) No 1095/2010.
Further, if the authorities of the UCITS home Member State do not take appropriate measures, BaFin may prohibit marketing of the non-German UCITS in Germany and/or request support from ESMA in accordance with the UCITS Directive4.
On 16 July 2019, ESMA published a consultation paper entitled “Guidelines on performance fees in UCITS”. Comments on the consultation paper may be provided until 31 October 2019. The consultation paper results from a mapping exercise among the EU’s national competent authorities that ESMA performed in 2018. This exercise showed a lack of convergence as to how different Member States deal with performance-based fee models; this lack of consistency creates the risk of regulatory arbitrage and may lead to a lack of harmonised rules and approaches in respect of investor protection among Member States.
ESMA’s proposed Guidelines aim to harmonise (inter alia): (i) general principles on calculating performance fees; (ii) consistency between the performance fee model and the fund’s investment objectives; (iii) the frequency with which any performance fee should be payable; and (iv) disclosure of performance fee models.
Similar to BaFin’s approach, according to ESMA’s consultation paper, performance fee calculation methods should include: (i) a reference indicator to measure the relative performance of the fund (e.g., a benchmark, high water mark or hurdle rate); (ii) a crystallisation period where any performance fee is accrued; (iii) a crystallisation date on which the performance fee crystallises; (iv) a performance fee period; (v) a performance fee rate; (vi) a performance fee methodology; and (vii) a computation frequency.
It remains to be seen how coordinated and systematic BaFin’s review of performance fee clauses of non-German UCITS will be. The legal basis for BaFin’s review seems questionable. Further, given the ongoing ESMA consultation, an approach from BaFin that differs from the approach taken by other UCITS host Member States would be disruptive to the harmonised UCITS framework. In the meantime, non-German UCITS that are registered or intend to register to be marketed in Germany should carefully review their methodologies for performance fee calculation in light of BaFin’s administrative practices.