Draft UCITS V Directive Released - Initial Assessment of Key Elements
A draft of the UCITS V Directive1 has been unofficially released. This is a further revision to the regime for Undertakings for Collective Investment in Transferable Securities (“UCITS”) and is aimed specifically at enhancing certain measures within the UCITS framework, particularly in relation to investor protection.
Below is a high level initial assessment of the key elements addressed in the UCITS V Directive, according to the draft released.
The UCITS regime was only recently updated, pursuant to Directive 2009/65/EC (the “UCITS IV Directive”) and various supporting directives and regulations (collectively “UCITS IV”). UCITS IV introduced a range of new measures to the regime with the broad aims of: (i) increasing EU cross-border efficiencies; and (ii) improving investor disclosure.
However, UCITS IV was initiated prior to the 2008 financial crisis – an event that marked a significant political driver in European financial services regulation. The most notable result of this, to date, being the initiative to regulate alternative investment fund managers and the introduction of the Alternative Investment Fund Managers Directive (2011/61/EU) (the “AIFM Directive”).
The stated aim of the European Commission with UCITS V is to effectively bring the UCITS regime into line with the AIFM Directive and introduce a range of corresponding measures that, to date in a UCITS context, had been regulated in less prescriptive terms.
The draft UCITS V Directive covers three key elements, namely:
1.) Depositary role (covering eligibility criteria, liability, delegation and oversight function relating to cash);
2.) Manager remuneration; and
3.) Regulatory sanctions.
These three key elements are considered below. See also Appendix I for a summary analysis and consideration of the correlation with the AIFM Directive.
1. Depositary Role
1.1 Depositary eligibility criteria
To date, the UCITS rules have given a certain degree of discretion to the EU member states in relation to the types of entities that can act as a depositary. As a result, there is some divergence across the EU in terms of the eligibility criteria being applied and the types of entities performing the function. The draft UCITS V Directive proposes to prescribe that only two categories of entities will be eligible to act as a depositary to a UCITS, namely: (i) EU authorised credit institutions2; or (ii) investment firms (authorised under the MiFID3 regime to provide safekeeping and administration of financial instruments for the account of clients and subject to adequate capital requirements). Article 23, paragraph 2 of the UCITS IV Directive will be amended to reflect this.
This proposed new depositary eligibility criteria for UCITS is aligned with the corresponding provisions in the AIFM Directive. However, it should be noted that the draft UCITS V Directive does not carry the third category of eligible entity as contained in the AIFM Directive which covers other entities subject to prudential regulation and ongoing supervision. The fact that the provision in the AIFM Directive directly cross-referred to the UCITS IV Directive that is being amended means that the draft UCITS V Directive will restrict the scope of eligible depositaries for both UCITS and for non-UCITS.
The draft UCITS V Directive provides for a two-year grandfathering period for UCITS that, at the point this new requirements come into effect, engage a non-compliant depositary.
1.2 Depositary liability
The current standard of care for UCITS depositaries is that they shall be liable for any losses suffered due to the depositary’s “unjustifiable failure to perform its obligations or improper performance of them.”
The draft UCITS V Directive proposes to align the liability of a depositary with the higher standard of liability of a depositary under the AIFM Directive. Accordingly, the provisions of Article 21 of the AIFM Directive are proposed to be replicated in a revised Article 24 of the UCITS IV Directive. This is a word-for-word replication of certain sections of Article 21 of the AIFM Directive, although specific provisions4, regarding liability where a sub-custodian is appointed, are not carried over in the draft UCITS V Directive.
The new liability standard will mean that the depositary of a UCITS shall be liable:
- for any losses suffered by the UCITS or its investors unless “it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary”; and
- “for all other losses suffered by [the UCITS or its investors] as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations”
Note, in relation to the first point above, the burden of proof regarding an external event beyond its reasonable control will be on the depositary.
In the event of the depositary being liable for losses relating to assets held in custody, the depositary will be required to return identical assets to the UCITS without undue delay. The draft UCITS V Directive, as is the case with the AIFM Directive, acknowledges that certain financial assets cannot be held in custody and so this obligation will only apply for certain types of assets.
Depositaries will remain liable for the loss of assets, even where part or all of its safekeeping tasks have been delegated to a third party. This provision is unchanged from the current UCITS regime.
The draft UCITS V Directive aims to give the same rights to all UCITS investors, allowing them to sue depositaries, either directly or indirectly through the management company, depending on the legal nature of the relationship between the depositary, the management company and the investors.
It has never been completely clear whether the current standard of care for UCITS depositaries corresponds to a standard of negligence or whether it could be interpreted as a stricter standard of care. The proposed revised standard of care under the draft UCITS V Directive is certainly a stricter standard than negligence.
1.3 Depositary delegation
The draft UCITS V Directive provides that the safekeeping functions can be delegated by the single depositary to third parties, subject to certain conditions. Among these conditions is a requirement that the depositary: “has exercised all due skill, care and diligence in the selection and the appointment of any third party to whom it wants to delegate parts of its tasks, and keeps exercising all due skill, care and diligence in the periodic review and ongoing monitoring of any third party to whom it has delegated parts of its tasks and of the arrangements of the third party in respect of the matters delegated to it.”
In addition, the depositary must ensure that the delegate safekeeping agent meets a range of specific conditions while it continues to carry out safekeeping functions on the depositary’s behalf. These are new conditions that were not previously contained in the UCITS IV Directive.
These provisions, contained in Article 1(3) (c) of the draft UCITS V Directive (inserting new provisions into Article 22 of the UCITS IV Directive), replicate certain sections of Article 21, paragraph 11 of the AIFM Directive. Notably, one additional condition applying to a delegate safekeeping agent is contained in the draft UCITS V Directive as follows:
“in the event of the insolvency of the third party, securities held by the third party for UCITS are unavailable for distribution among or realisation for the benefit of creditors of the third party.”
The draft UCITS V Directive envisages that the prospectus for a UCITS must contain a description of any safekeeping functions delegated by the depositary, identification of the delegate and any conflicts of interest that may arise from such a delegation. This provision5 corresponds with an investor disclosure requirement contained in Article 23, paragraph 1(f) of the AIFM Directive. However, in the AIFM Directive, it is only stipulated that this information must be provided to investors, not that it must be contained in the prospectus.
This prospectus disclosure requirement could present significant practical and operational challenges.
1.4 Depositary oversight function relating to cash
The UCITS regime already provides for oversight functions that must be discharged by the depositary and cannot be delegated to a third party. These include ensuring that the sale, issue, repurchase, redemption and cancellation of units in a UCITS are carried out in accordance with applicable national rules and the fund rules or instruments of incorporation.
The draft UCITS V Directive6 introduces a depositary oversight function relating to cash that is not present in the current UCITS regime. This requires that the depositary shall properly monitor the cash flows of the UCITS and ensure subscription monies are properly received by the UCITS. Additionally, the depositary shall ensure that all cash is properly booked in accounts opened in the name of the UCITS, in the name of the management company of the UCITS acting on its behalf or in the name of the depositary acting on its behalf. Where assets are held in the name of the depositary acting on the UCITS behalf, they must be held in an account separate to that of its own cash.
This replicates a cash monitoring obligation on depositaries contained in Article 21 paragraph 7 of the AIFM Directive.
2. Manager Remuneration
The draft UCITS V Directive proposes to introduce a requirement that UCITS management companies put in place remuneration policies and practices for senior management and persons whose professional activities have a material impact on the risk profile of the management company or the UCITS. Such policies and practices must be consistent with and promote sound and effective risk management and discourage disproportionate risk-taking by the UCITS.
The remuneration policy requirements7 directly replicate the corresponding provisions in the AIFM Directive.
The requirements in the draft UCITS V Directive will be supplemented by ESMA guidelines on sound remuneration policies.
Certain disclosure will be required to be made in the UCITS annual report in relation to fixed and variable remuneration paid by the management company / self-managed UCITS to its staff.
A point to note is that the draft UCITS V Directive does not stipulate that the remuneration requirements will apply to delegates carrying out investment management functions. Also, it expressly refers to the requirements applying to self-managed UCITS directly8. Therefore, for cases where a self-managed UCITS or UCITS management company does not itself receive an asset based fee, these remuneration obligations may not be applicable.
3. Regulatory Sanctions
The draft UCITS V Directive requires that EU Member States empower their competent authorities with wide-ranging investigative powers and administrative sanctions covering a range of breaches of regulatory functions.
These measures expand on the broad principles contained in Chapter XII of the UCITS IV Directive. While these provisions are in line with the sentiments in the AIFM Directive in relation to enhancing the powers of national competent authorities, the provisions are not corresponding.
By now, the key elements considered above are all quite familiar in an AIFM Directive context. The draft UCITS V Directive proposes to mark the introduction of corresponding measures in a UCITS context. To that end, it will effectively level the playing field between non-UCITS European funds (under the AIFM Directive) and UCITS and avoid a situation where sophisticated investor funds are subject to a more onerous regulatory regime than retail investor funds. Nevertheless, the changes that existing UCITS will need to make in order to comply with the new measures will present the industry with significant challenges. It is also concerning that, as highlighted above, in some cases the measures contained in the draft UCITS V Directive go further again that the AIFMD Directive.
With the draft UCITS V Directive expected to be formally published in the second quarter of 2012, national implementation could be required by mid-2014. However, it is quite possible that certain EU Member States may fast-track national implementation of UCITS V so that it coincides with the implementation deadline for the AIFM Directive of 22 July 2013.
For a copy of the Appendix, please find the attached PDF.
1Proposal for a Directive of the European Parliament and of the Council amending Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) in respect of depositary functions, remuneration policies and sanctions.
2A credit institution authorised in accordance with Directive 2006/48/EC.
3Markets in Financial Instruments Directive (2004/39/EC).
4Paragraphs 13 and 14 of Article 21 of the AIFM Directive.
5Article 1(18) of the draft UCITS V Directive (amending Annex I of the UCITS IV Directive).
6Article 1(3) (c) of the draft UCITS V Directive (inserting a new Article 22 paragraph 4 of the UCITS IV Directive).
7To be inserted into the UCITS IV Directive as a new Annex IIa.
8Article 1(7) of the draft UCITS V Directive amending Article 30 of the UCITS IV Directive.