The long awaited UCITS V Directive was finally published in the Official Journal on 28 August 2014 and came into force on 17 September 2014. Member states have until 18 March 2016 to fully transpose the new rules into national law.
In September 2014, the European Securities and Markets Authority (ESMA) issued its first consultation on the various pieces of technical advice it must provide to the Commission in delegated acts. This covered its proposed advice on the insolvency protections of UCITS when safekeeping is delegated and on the independence of depositories and managers. The consultation has just closed, on 24 October 2014.
The changes introduced by UCITS V are not as extensive as those under UCITS IV in 2009, although asset mangers will still need to make some changes to the way they conduct their business. Those familiar with AIFMD will recognise many of the proposed changes, although, rather disappointingly, the EU has failed to address some of the uncertainties created by AIFMD in the UCITS V.
The three areas UCITS V covers are:
- Depositary function
We set out below each area of impact and its practical implications.
The UCITS Directive has not been recast on this occasion as it was by UCITS IV. Instead, the new Directive amends existing provisions and the two Directives need to be read together. We have, therefore, prepared a consolidated version of the UCITS Directive for reference showing the changes to the UCITS IV Directive made by UCITS V, which can be accessed here.
AIFMD introduced for the first time a rigorous depositary regime to all full scope authorised investment funds within the remit of AIFMD (AIFs). UCITS have always been required to appoint a depositary (or a trustee for unit trusts) but one of the key elements of UCITS V is to bring the UCITS world into line with – if not beyond – the AIFMD position. UCITS funds are aimed at retail investors and are supposed to offer the highest level of investor protection. It is of concern to the EU Commission that at present the regime governing depositaries of UCITS is not only less stringent than that which applies to AIFs, but also that the UCITS depositary rules are applied unevenly across Europe.
UCITS V then seeks to address these issues by requiring the appointment of a single independent and eligible depositary to each UCITS. There are specific requirements as to who can be appointed as a depositary. The entity must be a national central bank, a credit institution authorised under the Capital Requirements Directive or another legal entity which a regulatory authority approves as a depositary and which can meet certain capital requirements and own funds requirements.
The independence of the depositary from the Manco is currently a broad requirement of the Directive, implemented and added to in different ways in Member States. UCITS V strengthens this requirement, and ESMA’s recent consultation looks at the possible options for this, through restrictions on cross ownership or, essentially, the management of conflict where cross holdings exist.
As per the AIFMD, depositaries will be required to carry out three main functions:
- Cash monitoring.
- Oversight of the UCITS and the manager.
- Safekeeping of the assets of the UCITS.
This is a new obligation for UCITS depositaries and reflects the obligations which have been imposed on AIFMD depositaries. In particular, depositaries are required to ensure any cash movements in a fund are monitored and that cash received from investors for subscriptions is properly booked into cash accounts opened in the name of the fund, the manager or the depositary. The cash monitoring duty is one of the matters which caused most concern for depositaries under AIFMD, as it seemed to replicate functions which are carried out by administrators currently. Much lobbying of ESMA and national regulators has taken place on this issue. The approach of the regulators does, however, still seem to be that cash monitoring must be carried out by the depositary in addition to any monitoring carried out by other service providers.
The second function of the depositary is to carry out oversight of the Fund and to make sure it is operated in accordance with the regulations and its constituent documents. There are five key areas of focus:
- To ensure subscriptions, redemptions and cancellation of units are carried out in accordance with the rules and the scheme documents.
- To ensure the valuation of the fund is carried out in accordance with the rules and the scheme documents.
- To carry out the instructions of the manager unless the depositary believes that the instructions are contrary to the regulations or scheme documents.
- To ensure any consideration is paid to the fund in the required time limits.
- To ensure any income arising on investments is applied in accordance with the regulations and the scheme documents.
In the UK depositaries will already be used to an oversight role which is similar to this as the COLL sourcebook already provides for UCITS depositaries to have oversight of investment and borrowing powers, dealing, valuation and income.
Safekeeping of assets
UCITS V follows the approach of the AIFMD and characterises scheme property into two basic kinds: financial instruments and other assets. Financial instruments are those asset classes which are set out in Annex C of MIFID II and break down into listed shares, money market instruments and units or shares in collective investment schemes. Other assets are defined as any asset which is not a financial instrument and would include unlisted shares, certain types of debt and some derivatives. UCITS are not able to invest in property or commodities directly so depositaries will not need to concern themselves with these asset classes.
The relevance of whether an asset is a financial instrument or an other asset relates to the extent of the role that the depositary will have to play in carrying out its safekeeping function. For financial instruments the depositary must take the assets into its safekeeping and segregate the assets in its books. For other assets, the depositary has a verification and record keeping obligation which is a less onerous role. The distinction also has a knock on effect for the liability which the depositary must take and this is discussed below.
In the UK the distinction between financial instruments and other assets will likely be a moot one, as under COLL the depositary is required to take into custody and under its control all the assets of the scheme regardless of how they are classified. The FCA took the same approach under AIFMD for NURS and QIS funds, making use of the latitude given in Recital 33 of the AIFMD, which allows national regulators to adapt local rules to meet “…the specificities of different business models.”
Much was made in the AIFMD of the increased liability regime applying to depositaries – depositaries are subject to a so called “strict liability” regime under AIFMD where they have “lost” a financial instrument. There are, however, opportunities to avoid this liability if the depositary can prove the loss was caused by an “external event” as defined in the AIFMD or if the depositary has contractually discharged its liability to a third party in accordance with the detailed rules in the AIFMD on discharge. There is a lower level of liability for the depositary in relation to other assets.
UCITS V seeks to replicate this regime so that a depositary will be required to return financial instruments of an identical kind if they are “lost” or to give the UCITS the corresponding amount of cash. Again, the depositary is able to avoid liability where it can show there has been an external event. An external event is one which is beyond the depositary’s reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary.
However, unlike in AIFMD, the depositary will be unable to contractually discharge its liability to a third party. In practice, most UK depositaries have not taken the opportunity under AIFMD to discharge liability in any event, save in relation to prime brokers (which cannot be appointed by a UCITS) - and so the inability to discharge is unlikely to be of particular concern. Equally, whilst much was made of the “strict liability” regime and the likely impact on costs and the risk appetite of depositaries, we have not really seen huge increases in costs or depositaries shying away from swathes of markets where they perceive risk. It is likely that they will take much the same approach under UCITS V.
In respect of other assets the depositary will be liable for its negligent or intentional failure to properly fulfil its obligations.
The arrangements with the depositary will need to be reflected in a depositary agreement and it is widely expected that the Level 2 provisions will seek to specify the key elements which will need to be covered in the contract as was the case in AIFMD. It is to be hoped, however, that some of the uncertainty which arose in this respect in AIFMD will be clarified this time round.
Depositaries will be able to delegate so the current depositary delegation model by which depositaries delegate to their network of affiliate and third party custodians in other jurisdictions is likely to stay in place. In what can perhaps be seen as an anti-avoidance move, UCITS V makes it clear that settlement systems and central securities depositaries (CSDs) may be categorised as delegates of the depositary and, hence, the depositary would be responsible for any loss of assets by the CSD if it were held to be its delegate. This is different from the position in AIFMD where CSDs are specifically excluded from the delegates regime.
The existence of a 24 month grandfathering period appears helpful at first sight but only applies in a limited way and where a manager has appointed a depositary who doesn’t meet the eligibility criteria in the Directive as at 18 March 2014. Many UK depositaries are already likely to meet the criteria.
- Depositary agreements which are currently in place in respect of UCITS OEICs are likely to need to be re-papered. As with AIFMD, the depositary community will prepare new template agreements for negotiation.
- UCITS unit trusts will need a depositary agreement for the first time and the existing trust deed is likely to require amendment to give the power for such an agreement to be entered into.
- The disclosure in the prospectus will also need to be updated to reflect the new depositary regime.
In an effort to promote sound and effective risk management and to discourage excessive risk taking, the EU Commission has agreed that managers should be encouraged to take a long term view on investment. This should be reflected in harmonised remuneration policies.
The new provisions apply to senior management, risk takers, control functions and anyone else whose remuneration falls within the same bracket as senior management and risk takers and whose activities have a material impact on the risk profile of the management company or the UCITS which they manage.
The rules broadly replicate, in almost all respects, those which already apply to managers of AIFs under AIFMD.
The majority of the remuneration rules in respect of UCITS managers are set out in new articles 14a and 14b to the UCITS Directive as amended by UCITS V. These will be supplemented by guidelines which will be published by ESMA. In addition, UCITS V amends the Directive by introducing transparency provisions under which disclosure of the remuneration policy of UCITS management companies, and certain details of remuneration paid, must be included in a UCITS’ prospectus, annual report and key investor information.
The key proposals are:
- At least half of the individual’s variable remuneration must be paid in the assets of the UCITS, unless the management of the UCITS accounts for less than half of the total portfolio.
- In addition to this, it has been agreed that a further 40% of the variable remuneration should be deferred for at least three years (or up to 60% in the case of “particularly high” bonuses). ESMA will be required to develop guidelines on who these policies will apply to, in addition to fund managers.
- The variable element should only be paid where it is sustainable in light of the financial situation of the management company as a whole and justified according to the performance of the business unit and the individual concerned.
- There are also new rules on the remuneration process in management companies, including annual reviews, independent of the staff who set remuneration and that the policy is set in line with the business strategy, objectives and values of the company.
- The principles relating to remuneration apply equally to performance fees.
- Firms should apply the rules proportionately to the size and complexity of their business.
Potential issues and practical implications
- Whether or not UCITS V will impact on delegates is currently unclear. Recital (2) of UCITS V states that, ‘remuneration policies and practices should apply... to any third party which takes investment decisions that affect the risk profile of the UCITS because of the functions which have been delegated...’. This statement is not reflected anywhere within the operative provisions of UCITS V but it is anticipated that ESMA will address the ambiguity surrounding this point when it publishes its guidelines.
- Firms will need to carry out a gap analysis against the remuneration policies they have in place currently under existing regulatory requirements (AIFMD for example) to see what changes need to be made. In many cases management companies do not actually have any direct employees so it is potentially unclear how these rules will apply.
- To the extent that any staff member is to receive remuneration by way of units in the UCITS, firms will need to consider if a new share class will need to be issued and what the terms of that share class should be. It is clear that staff will not be able to vote on any shareholder resolutions, however, as they will be associated with the manager.
- Prospectuses, KIIDs and annual reports will need to be amended to include details of the approach to remuneration.
To tackle the current inconsistent approaches to sanctions within the Member States (levels of fines, criteria and use), harmonised administrative sanctions will be introduced under UCITS V. Member States will need to implement these changes and the new rules will apply to those who fail to comply with national UCITS authorisation and reporting rules. For those individuals who breach the rules, the sanctions must include a permanent or temporary ban from fund management, suspension of authorisation, criminal sanctions and a EUR 5 million fine. In addition to this, companies could be fined EUR 5 million, 10% of their annual turnover or alternatively at least twice the amount of the benefit gained from the infringement, where this is determinable. There will also be increased protection for “whistleblowers” who report breaches to ESMA.
The Commission are adamant that the administration sanctions shall be “effective, proportionate and dissuasive”. This, it is hoped, combined with the introduction of transparent segregation and additional safeguards, will result in dramatically increased levels of protection for UCITS investors, in a sector which currently controls almost of third of worldwide fund assets.
In the UK the FCA already have many of the powers which the Directive will provide and are using them vigorously against asset managers. From a UK perspective we do not envisage that there will be too much practical impact from this harmonisation.
It is hoped that the Level 2 regulations and ESMA’s remuneration guidelines will be published early in 2015, followed by, or ideally overlapping with, proposals for local implementation, to allow asset managers and depositaries to put the necessary revised policies and contracts in place for early 2016.
Although Member States have 18 months to transpose the Directive, in light of the many practical implications firms should be starting to work on the proposals now. Those with Luxembourg UCITS will be aware that the CSSF have implemented rules on UCITS depositaries which pre-empt the UCITS V provisions and which are due to come into effect at the end of December 2015.