Finding a Funds Safe Haven
This article was first published in Business & Finance IFSC 25 Year Report in 2012.
When one considers key Irish export services, investment funds may not come in high on the scale. However, this sector is starting to demand more attention as it continues to enjoy sustained growth. Particularly in the last five years, it is quite a significant achievement that this growth has been achieved in the context of extremely challenging markets and a minefield of increased regulation.
As a funds service centre Ireland directly benefits from this growth in a number of ways, employment being one. More than 11,000 people are employed in the fund services industry, across a range of disciplines – lawyers, fund administrators, custody service providers, accountants and auditors, tax advisors, listing advisors, compliance, risk and regulatory consultants. The number of people employed within the sector has grown in net terms in 2010 and in 2011. In terms of the Irish purse, as well as employee income tax, the financial services firms located in Ireland that support this industry will also be subject to Irish tax. Of the funds serviced in Ireland, this breaks down into funds located in Ireland and funds located elsewhere. In both cases these are not subject to Irish tax.
The funds services sector is starting to gain recognition politically and there is a welcome support from government. This is demonstrated in the commitment to facilitate the implementation of various EU legislative initiatives in a manner that will ensure Ireland remains a dynamic and competitive location to domicile funds.
One of the key fund structures that is continuing to grow strongly in Ireland is the undertaking for collective investment in transferable securities (“UCITS”). This is a pan-EU investment fund regime that is fully supported by a range of Irish legislation and regulation. A UCITS is an investment fund that can be sold publicly cross border within the EU based on a very simple notification process. This regime – initially developed for retail investors and dating back to 1985 – now represents more than €5.5 trillion in assets. More than €850 billion of this is from Irish UCITS.
UCITS domiciled in Ireland now represent approximately 15% of all UCITS assets across the EU. This makes Ireland the second largest and fastest growing jurisdiction to locate cross-border UCITS.
Assets in Irish UCITS have grown 64% since the end of 2008. Much of this growth can be attributed to investors seeking a “safe-haven” in turbulent times; a fund structure that ensured some key investor protection measures. Whether the factors that have driven this growth are here for the long term may not be clear, but in any case, it is fair to say that UCITS are now a significant and important sector for the Irish financial services industry.
In that context, it is important that new measures being introduced as a means of enhancing the UCITS regime do exactly that. As is the danger with any increased regulation, it is imperative that the changes introduced increase investor protection, provide for greater transparency and improve cross-border integration. What should be avoided are onerous provisions that demand costly solutions without enhancing the regime to the benefit of investors.
We can consider the two most immediate updates to the UCITS regime in that context – the UCITS IV measures which came into effect on 1 July 2011 and the proposed UCITS V measures currently under consideration.
The broad aim of UCITS IV was to increase cross-border efficiencies and enhance investor protection. One year on, it can be seen to have had limited success in achieving these aims.
The cross-border notification process has greatly improved time and cost efficiencies in registering a UCITS for public sale in another EU member state. However, many EU member states have been slow in putting measures in place to support the new regime so there have been some significant challenges in operating in this space since the regime was introduced. These will inevitably reduce as local regulators in various EU member states gradually get up to speed on this process and, long term, this will improve the process considerably.
The introduction of mechanisms for the pooling of assets has been one of the foremost successes of UCITS IV. Master-feeder structures were introduced, enabling one or more feeder funds to invest at least 85% of their assets in a single master fund (which, in order to avoid opaque cascades of funds, cannot be a feeder itself). UCITS funds (whatever their legal form) established in different EU jurisdictions can now be merged upon the authorisation of the merging fund’s regulator, transferring all assets of the merging UCITS to the receiving UCITS, with the units/shares of the receiving UCITS consequently marketed in the jurisdictions in which the investors in the merging fund are based.
Under UCITS IV, a UCITS management company can now passport its services into another EU member state once it receives the approval of its home regulator – briefly, the home regulator must be satisfied that an adequate administrative structure, risk management plan and financing is in place to manage the foreign UCITS. Within two months of receiving an application from the management company, the home regulator will notify the host regulator. It is not necessary to set up a branch in the host EU member state and no minimum administrative functions are prescribed to take place in the host EU member state. Home conduct of business rules will continue to apply to the management companies’ activities, unless the management company opts to establish a branch in the host EU member state. The Irish Finance Act 2010 provided that the passporting of Irish UCITS management companies would not affect the tax status of non-Irish UCITS under management.
Addressing issues in respect of over-complicated simplified prospectuses (the document previously furnished to retail investors before sale), enhanced transparency has been brought about by the introduction of the Key Investor Information Document (the “KIID”). The KIID brings the description of the product back to first principles (requiring a plain English description of the investment strategy of the fund is briefly set out) and describes the risk/reward profile of a UCITS for investors. While the KIID has presented logistical challenges to UCITS providers, we have seen little in the way of complaints about it being misrepresentative, unfair or arbitrary in the elements it addresses. It will most certainly be seen as a positive tool for investors. Having such a prescriptive and hard-wired format and disclosing key information (fees, risks, past performance) means the KIID will operate as an excellent means of conducting comparative analysis. This is very much a case of a warts-and-all level playing field. The benefits of this are primarily from an investor perspective, but can also be seen in terms of tangible benefits in enhancing the UCITS brand.
A more recent UCITS IV initiative in Ireland involved a proposal by the Central Bank of Ireland (as the regulator of funds in Ireland) to apply the full scope of the organisational rules applicable to management companies to UCITS that operate a self-managed board model. This position has recently been revisited and there is currently a project ongoing whereby the representatives of the Irish Funds Industry Association (the “IFIA”) are engaging with the Central Bank to develop and agree a set of proposals for self-managed UCITS.
A draft of UCITS V has been unofficially released and reviewed by Maples and Calder. UCITS V will focus primarily on the scope of depositories’ duties, entrenching stricter rules on liability for the loss of assets held in custody and standards expected upon delegation of custodial functions.
As the preparation of the Alternative Investment Fund Managers Directive (the “AIFM Directive”) progressed, pressure mounted for the UCITS sphere to correspondingly address these issues and prevent regulation of more sophisticated/institutional investors stealing a march. Despite increasing focus on the more volatile investments made by ETF funds, the European Commission has dropped the idea of reviewing eligible assets as part of UCITS V.
Depositories considered eligible to act for UCITS funds will be restricted to EU authorised credit institutions or investment firms authorised under the Markets in Financial Instruments Directive ("MiFID") (the AIFM Directive will also be limited further by this because of a cross–reference to UCITS IV; other entities subject to prudential regulation and ongoing supervision will no longer be an eligible category to qualify as depositories for both UCITS and non-UCITS).
As it stands, liability attaches only to depositaries in cases where “unjustifiable failure to perform its obligations or improper performance of them” is demonstrated by a claimant; however ex post UCITS V a presumption of liability will attach upon proof of loss by the UCITS (as distinct from proof of unjustifiable failure to perform), whereupon the depository itself will have to demonstrate on the balance of probabilities that the event of loss was beyond its reasonable control or that it exercised reasonable efforts to prevent a loss. This heightened standard of care extends to the delegation of custodian duties; going forward depositories must exercise due skill, care and diligence not only when appointing a sub-custodian (as per UCITS IV), but also when conducting periodic reviews and ongoing monitoring of those delegated functions.
While the depository always had a duty to ensure that the sale, issue, repurchase, redemption and cancellation of units in a UCITS was carried out in accordance with applicable national rules, industry regulation and constitutional documents, a new oversight function relating to cash will be introduced. This requires that the depository shall properly monitor the cash flows of the UCITS and ensure subscription monies are properly received by the UCITS. In practice this will mean ensuring that monies are lodged to the appropriate account, in the name of the management company/depository. 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.
UCITS IV is to be welcomed in the sense that it has brought about the opportunity to rationalise structures, benefit from economies of scale, reduce bureaucracy and has resulted in increased transparency for investors.
While on a first impression, elements of the proposed UCITS V measures set an ominous tone for depositories, active engagement between regulators and the industry participants can be expected before these measures are finalised and it remains to be seen whether the proposals will be carried through in their current form.
UCITS V represents the next step on the continuing path towards increased EU harmonisation of UCITS and improvement to the regime. The challenge is to ensure that it is implemented in a form that does not result in a disproportionate regulatory burden or bring additional undue costs without enhancing investor protection.