In this briefing note we consider the EU Undertakings for Collective Investment in Transferable Securities (UCITS) V Directive (2014/91/EU) (UCITS V), which amends the existing UCITS IV regime. The European Commission’s purpose in introducing another UCITS Directive was twofold:
- to strengthen and clarify the UCITS regime, particularly in light of the fraud perpetrated by Bernard Madoff and the Lehman Brothers default, which revealed material discrepancies in depositary duties and liabilities across Member States; and
- alignment of the UCITS regime with the EU Alternative Investment Fund Managers Directive (AIFMD), thereby helping to harmonise and streamline EU funds regulation.
Where are we now?
On 28 August 2014, the text of UCITS V was published in the Official Journal of the EU (OJ).
UCITS V comes into force 20 days after publication in the OJ, i.e. on 17 September 2014. Member States must then transpose it into national law by 18 March 2016 (18 months from publication in the OJ).
What is the purpose of UCITS V?
UCITS V focuses on three areas:
- the depositary: changes to, and clarification of, UCITS depositary eligibility criteria, oversight, cash monitoring and safekeeping duties, delegation and liability provisions;
- remuneration: the introduction of rules on remuneration policies for staff whose professional activities have a material impact on the risk profiles of the UCITS they manage; and
- sanctions: harmonisation of the minimum administrative sanctions available to Member State competent authorities for violations of the main investor protection safeguards.
UCITS V clarifies that a UCITS may only appoint a single depositary to which all assets must be entrusted. The depositary must be appointed by way of a written contract. Further detail on the content of the depositary contract is expected from the European Commission by way of delegated act during the course of 2014 – 2015.
Under UCITS IV, Member States have discretion as to the institutions deemed eligible to act as UCITS depositaries, provided that they are subject to prudential regulation and on-going supervision. By contrast, but in line with the AIFMD, UCITS V will require depositaries to be either:
- a credit institution authorised in accordance with the Capital Requirements Directive IV (CRD IV);
- a national central bank; or
- another legal entity authorised by a Member State competent authority under UCITS V, subject to capital adequacy and own funds requirements equivalent to those under the Capital Requirements Regulation and CRD IV, respectively (along with certain other prudential regulation and on-going supervision requirements).
UCITS V brings in prescribed depositary oversight duties, which include ensuring that the:
- sale, issue, re-purchase, redemption and cancellation of units of the UCITS are carried out in accordance with applicable national laws and fund rules;
- value of the units of the UCITS is calculated in accordance with applicable national laws and fund rules; and
- income of the UCITS is applied in accordance with applicable national laws and fund rules.
In addition to oversight duties, the depositary will have a cash monitoring role similar to that prescribed for depositaries under the AIFMD. The depositary will need to ensure that cash flows are properly monitored and, in particular, that all payments made by or on behalf of the investors (upon the subscription of units of the UCITS) are received, and that all cash of the UCITS is booked in cash accounts opened in the name of the UCITS.
There is also a requirement concerning the segregation of the UCITS’ assets from the assets of the depositary, so that any financial instruments on the depositary’s book held for the UCITS can be distinguished from the depositary’s own assets and can be identified at all times as belonging to the UCITS.
In relation to the safekeeping of financial instruments, UCITS V distinguishes between:
- financial instruments that can be held in custody by the depositary; and
- record-keeping and ownership verification requirements relating to assets that are not physically held.
In relation to the former:
- the depositary has to hold in custody all financial instruments that can be registered in a financial instruments account opened in the depositary’s books and all those financial instruments that can be physically delivered to the depositary;
- the depositary must ensure that those financial instruments are registered in its books within segregated accounts, opened in the name of the UCITS or its management company, and are clearly identified as belonging to the UCITS at all times;
- the reuse of assets held in custody by the depositary or its delegate is restricted and only permitted if certain criteria are satisfied; and
- in the event of its insolvency, securities held by the depositary or its delegate for the UCITS shall be unavailable for distribution to creditors of the depositary.
In relation to assets that are not physically held:
- the depositary has to verify the ownership of such assets by the UCITS or the management company acting on behalf of the UCITS, and has to maintain up-to-date records of those assets for which it is satisfied that the UCITS or the management company holds ownership; and
- ownership verification should be based on information and documentation provided by the UCITS or the management company and, where available, on external evidence.
Delegation of safekeeping duties
UCITS V aligns the requirements regarding delegation of custody with the AIFMD. A depositary will therefore only be permitted to delegate in respect of safekeeping duties where:
- there is an objective reason and not simply with the intention of avoiding the requirements of UCITS V;
- it exercises all due skill, care and diligence in selecting and appointing a delegate;
- it conducts periodic reviews and on-going monitoring of the delegate; and
- it complies with certain requirements, including ensuring that its structure and expertise is in line with the nature and complexity of the assets received in custody, segregation obligations and ensuring that, in the event of its insolvency, the assets held in custody are unavailable for distribution to creditors.
Note that where local law requires that certain financial instruments are held in custody by a local entity and none satisfy the delegation requirements, the depositary may still appoint a local entity, subject to compliance with certain pre-investment disclosures (presumably to be contained in the prospectus) and on express instruction from the UCITS or the management company.
We are still waiting for further detail from the European Commission in respect of the conditions for performing the abovementioned depositary duties. Further alignment with the AIFMD is expected at this level.
The liability regime under UCITS IV sets out that a depositary is liable for:
- unjustifiable failure to perform its obligations; or
- improper performance of its obligations.
This liability regime has resulted in disparities between Member States, with different levels of investor protection depending on the domicile of the UCITS scheme. Consequently, under UCITS V, the depositary will be liable to the UCITS and its unit holders for:
- loss by the depositary or its delegate of financial instruments held in custody. In this regard, the depositary will also need to ensure the return of a financial instrument of an identical type or the corresponding amount without undue delay; and
- all other losses suffered as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations.
In respect of paragraph 4.13(a) above, the depositary can only discharge itself from liability if it can prove that the loss arose as a result of so-called force majeure (an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary).
Delegation of safekeeping duties does not absolve the depositary from liability and, unlike the depositary regime under the AIFMD, UCITS V does not allow the depositary to exclude or limit its liability by agreement. Indeed, any agreement that purports to do so will be void. Note also that unit holders may invoke the liability of the depositary directly or indirectly through the management company.
The financial crisis exposed the dangers of reliance on performance based remuneration policies by fund managers, which were seen to encourage excessive risk taking. Consistent with the approach adopted under the AIFMD, management companies will be obliged to implement remuneration policies that are consistent with and promote sound and effective risk management, discourage risk taking that is inconsistent with the risk profiles and fund rules of the UCITS managed and do not impair compliance with the management company’s duty to act in the best interests of the UCITS.
Remuneration policies will need to cover fixed and variable components of salaries anddiscretionary pension benefits. These policies will apply to senior management, risk takers, control functions, employees receiving total remuneration that falls within the remuneration bracket of senior management and risk takers whose professional activities have a material impact on the risk profile of the management companies or of the UCITS they manage. In addition, policies should apply, in a proportionate manner, to any delegate which takes investment decisions that affect the risk profile of the UCITS.
Two particularly important remuneration requirements are:
- subject to the legal structure of the UCITS and its fund rules, a substantial portion, and in any event, at least 50% of any variable remuneration, should consist of units of the UCITS concerned, equivalent ownership interests or share linked instruments or equivalent non-cash instruments with equally effective incentives as any of the instruments referred to in this point (unless the management of UCITS accounts for less than 50% of the total portfolio managed by the management company); and
- a substantial portion (at least 40%) of the variable remuneration component should be deferred over an appropriate period (at least 3 years).
The European Securities and Markets Authority (ESMA) has been tasked within the issuance of remuneration guidelines, which will consider the application of proportionality principles, along with those persons to whom the remuneration policies should apply. ESMA will work with the European Banking Authority in developing the guidelines and they are expected to be aligned, to the extent possible, with those produced for the AIFMD, whilst ensuring consistency with requirements developed for other sectors of financial services, in particular credit institutions and investment firms.
Following an analysis of national rules on sanctions for breaches of the UCITS IV regime by the European Commission, which revealed significant discrepancies between Member States’ regimes, UCITS V sets out an exhaustive list of circumstances which require sanctions. These include breaches of the main investor protection safeguards, including those relating to authorisation and organisation requirements, and non-compliance with cross-border marketing notifications (which will mean that the UCITS marketing passport will be the only route to access cross-border capital). Certain criteria will be taken into account when determining the appropriate sanction to be applied, including the gravity and the duration of the breach.
Interestingly, UCITS V also includes a requirement for Member State competent authorities and management companies to establish whistle-blowing mechanisms, including protection for whistle-blowers who report breaches committed by the UCITS to their competent authority.
The European Commission has indicated in its UCITS V impact statement that it will carry out an economic evaluation in 2019 (three years after the implementation of UCITS V) to determine whether the new rules have increased investor protection, enhanced transparency on remuneration and bolstered investor confidence in the UCITS brand.
To date, Member State competent authorities have not indicated specific timelines for the transposition of UCITS V. However, we are aware that:
- the UK Financial Conduct Authority’s Business Plan for 2014/2015 indicated that UK transposition of UCITS V would take place throughout 2015;
- the German Capital Investment Act already includes some gold plating with respect to the alignment between the AIFMD and UCITS V, e.g. in relation to the liability of the depositary for loss of financial instruments held in custody;
- although the Dutch Ministry of Finance has not yet released a timetable for implementation, in practice, it usually manages to meet implementation deadlines; and
- the French Autorité des Marchés Financiers has not yet published anything in relation to UCITS V implementation.
What should firms be doing now?
Asset managers, custodians and depositary banks will need to understand the new requirements of UCITS V and evaluate its impact on their business. They will need to assess compliance with the regulatory provisions by examining their existing structure, identifying any gaps and developing a roadmap to achieve compliance, particularly in light of the new sanctions regime. A watching brief should be kept as further developments arise.
More specifically, depositary banks will need to analyse the impact of the new safekeeping, delegation and liability requirements. Under the AIFMD, we have seen that the new liability provisions will cause depositaries to review their sub-custody networks and determine if changes are needed to initial and on-going due diligence processes. We believe this will also be the case for the implementation of UCITS V. Asset managers will need to pay particular attention to the new remuneration requirements. A review of the fund prospectus and related documentation may also be required to take into account the remuneration requirements and applicable disclosures on delegation of safekeeping.