The European Commission White Paper on the expansion of the internal investment fund market, published on November 16, 2006, heralds far-reaching amendments to the statutory regulatory framework of the European fund industry (1985 UCITS Directive). In this respect it should be noted that around three quarters of European investment funds are covered by the UCITS Directive. The Commission is responding in this White Paper to inefficiencies that have been found in the fund market, specifically with regard to cross-border sales, cost problems caused by inefficient volumes that are less than optimal and length of time for product launch, in the area of fund management and in cross-border fund mergers.
Following up on suggestions from various panels of experts, the White Paper contains proposals for adapting the UCITS Directive, on the basis of which an actual draft amendment is expected to be published in the fall of 2007. This should result in a simplification of European investment fund rules, making them more attractive to investors because of their lower cost and higher returns.
Speeding Up Authorization
The White Paper criticizes administrative obstacles and differences, caused by the lack of precision in the UCITS Directive, in the notification process governing fund authorization in other member states. The White Paper finds fault with the current procedure because it is often too long and drawn out and too costly in the fund’s host member state. The Commission is therefore requiring the process to be made faster, less expensive and simpler, while, at the same time, not reducing effective supervision and investor protection. Amendments to Art. 44 to 47 are therefore being proposed. In future, an electronic process should enable information and documents to be exchanged within three days directly between the supervisory authorities of the participant countries (what is termed a “Regulator-to-Regulator Process”). These amendments are urgently required in order to harmonize the wildly diverging time frames (between one to two weeks and six months) now required in the notification process.
Cross-border fund mergers also are criticized specifically and described as too complex, expensive and time-consuming. As more than half the UCITS funds manage less than 50 million in investments, legal and regulatory merger barriers need to be dismantled and European fund mergers have to be made easier.
As a result, a series of measures is being introduced that serve both to protect the investor and to ensure efficient supervision, such as a warranty that investors have been informed at the outset and are permitted to return their shares at no cost. In addition, the Commission is taking great pains to ensure that cross-border fund mergers are executed in a manner that is tax-effective for investors. In order to be able to keep up on an international level in the competitive fund market, promoting cost-effective structures is urgently required in the specific area of European fund mergers.
Pooling techniques also are running up against the problem of small and inefficient fund structures in Europe. Pooling is the aggregation of assets from different investment funds to obtain volume and liquidity advantages by having the assets managed collectively. This takes the form of “entity pooling,” in which there is a legal transfer of the investments, or “virtual pooling,” in which IT enables investments of several funds to be aggregated in a virtual base pool. The Commission, in its White Paper, is proposing that the UCITS Directive be adapted to allow entity pooling, previously prohibited under control rules, to be used in the future. The Commission also intends to review the virtual pooling technologies to determine whether they comply with supervisory law requirements and to develop corresponding proposals for a regulatory framework for such pooling.
Using Advantages of Scale
The Commission continues to criticize the cost disadvantages to the fund sector caused by the legal obligation to form a management company in the particular country where the fund is sold, without that management company being allowed to offer its services in other countries. A so-called EU Passport for management companies that would enable them, following a one-time authorization, also to act as manager in another member state would cut costs and also lead to advantages in terms of scale and areas of specialization.
The Commission does not, however, feel that the Directive needs to be amended to permit an EU Passport for depositary banks, which currently must be based in the same member state as the associated management companies. However, a simple recommendation to adapt member states’ national laws is not likely to be sufficient, as experience with the simplified prospectus has shown.
Further Refinement of Simplified Prospectus Rules
The Commission’s plan is that consumers will, in future, also have better access to information about their investment funds. To that end, there will be a change in the existing simplified prospectus requirements. Under present rules, in most cases the “simplified” prospectus is too long and complicated, and it takes different forms depending on how the UCITS Directive is implemented in each country. The simplified prospectus provides little assistance to investors in making a well-grounded investment decision because it does not provide the investor with information that is clearly understandable. The White Paper consequently calls for substantial changes to be made to both the form and content of the simplified prospectus. The changes primarily concern information on costs, risks and the expected performance of the relevant investment product. At present, the very diverse national regulations and practices on the form and content of the simplified prospectus illustrate the need for binding harmonized regulations throughout the EU.
Of course, it is debatable whether providing investors with reliable information concerning risk and projected performance of investment funds is even possible.
Non UCITS-Compatible Products
Finally, in addition to a number of other measures, the White Paper states that there are some investment products (such as open-ended property funds) that are not yet covered by the UCITS Directive and therefore are not UCITS-compatible, but that are in great demand by investors at present and are being sold under national regulations. The Commission examined this matter in depth, concluding that because of the potential dilution of investor protector provisions the Commission has no current intention to extend the EU Passport to these products. An independent panel of experts will, however, examine why these products have become increasingly important for the private pension sector.
EU-Wide Private Placements
The Commission has stated it will prepare an “EU-wide private placement regime,” i.e., a system for private placements, for businesses with institutional and other qualified investors. This is intended to enable managers of non-harmonized funds (such as hedge funds and private equity funds) to sell those funds throughout the EU.
It remains to be seen whether all the changes mentioned can be implemented, but in making these proposals the Commission has taken a step in the right direction. To the extent these proposals are implemented they should make the regulatory framework for the European fund sector work better in the global competitive market and enhance the sector’s operation in the internal market. Analysts are proceeding on the assumption that a cut in European funds’ operating costs might lead to a significant increase (up to three percent) in investment returns.