EUROPE: EU Commission Issue Draft Directive (“UCITS V”)

Tuesday July 3 2012

Overview

Funds-Axis would like to draw your attention to a recent European Commission publication of a Draft Directive on UCITS V. The main areas this draft directive proposes to address are;

• Depository Eligibility, Duties, Responsibilities, Liabilities and Delegation;

• Remuneration Policies; and

• Sanctions relating to UCITS Schemes.

The main impacts of this draft directive will be if implemented as is; the following;

• Increase in fees for investors due to;

• Increased fees charged by depositories to take account of their extra duties and increased liability;

• Increased Vat liability as Depository fees are subject to Vat and if Depository fees increase then as a result the Vat liability suffered by investors into a UCITS scheme will also proportionally increase; and

• Depositories may refuse to enter certain markets due to the increased risk in losing an asset thus making that market inaccessible for investors.

Also with the upcoming Alternative Investment Fund Managers Directive (“AIFMD”), there is a desire at commission level that the approach to Alternative Investment Funds and UCITS Schemes be harmonised and this draft directive is seen as a step towards that harmonisation.

As of yet there is no clear timeline established for the implementation of this directive and it has yet to go through many stages of discussion and agreement prior to coming into legal force. ESMA also has to issue its draft guidance to the commission as of the time this article was written.

As these proposed changes are likely to have a significant impact on depositories, investors and UCITS Schemes, it is recommended by Fund-Axis, that all relevant parties should start reviewing from a strategic point of view their current processes in these areas and draw up a gap analysis as to where they may need to strengthen their controls to mitigate the risks that will arise as a result of the draft directive, if implemented in its current form.

If you wish to discuss the implications of these possible impacts and / or require assistance in planning for UCITS V then please don’t hesitate to contact Fund-Axis on info@funds-axis.com.

Set out below is a high level overview of the impacts of the UCITS V Draft Directive if implemented in its current format.

UCITS V Draft Directive

Depository Overview

One of the main concerns that this draft directive is aimed at is addressing the current divergence that exists amongst member states in terms of depository liability and as a results the differing levels of protection that is afforded to investors in the differing jurisdictions within the European Union. Also, the rules governing depositories have remain unchanged since the introduction of the original UCITS Directive back in 1985. This also is seen by the commission as an area to address due to the changes in other directives that have taken place since that time and as a result impact depositories, e.g. the Eligible Assets Directive and as a result of those changes in other directives the complexity that has grown within UCITS Schemes, e.g. the expansion of assets held outside the direct custody network (Sub-Custodian Network), particularly those outside of the union. This growth of the usage of Sub-Custodian Networks by Depositories in turn has also led to divergence amongst the member states of the European Union with regards to rules governing delegation to the Sub-Custodians and the oversight of same.

Ø  Depository duties

• The principle of a single depositary is confirmed;

• All depositories appointed shall be appointed via a written contract;
• A common approach to the Fiduciary (“oversight”) duties of the depository for both contractual and corporate UCITS schemes, with corporate UCITS schemes now falling under the same oversight regime as contractual UCTIS schemes;

• The depository now must apply similar oversight to cash as it does to other asset types; and

• A clear line being introduced for the depository between its custodial duties relating to assets that can be held within the custody of the depository  and its oversight duties relating to assets that must be held out of the custody network, e.g. Financial Derivative Instruments, (“FDI”)

 Ø  Appointment and Oversight of Sub-Custodians

 The draft directive introduces another common approach but this time in relation to what conditions must be applied by a depository before entrusting assets to a Sub-Custodian. The basics of this common approach are set out below;

• There is a clear reason that can be evidenced that requires the depositary placing the assets in its custody with the Sub-Custodian ;

• Adequate and evidence based due diligence has been carried out over the Sub-Custodian prior to their appointment; and

• The depository must have regular oversight over the Sub-Custodian.

 Ø Depository Eligibility Criteria

The rules surrounding who can become a depositary are proposed to be amended to the following:

• A credit institution; or

• An investment firm subject to strict conditions.

 Ø Depository Liability

The terms surrounding when a depository is liable for the loss of a financial instrument are proposed ot be standardised. Under the new regime if implemented as is, a Depository would be liable to make good a financial instrument that was lost in its case either through restitution of the value or the restitution of an instrument of equivalence. This rule also applies even if the depository has entrusted the asset to a Sub-Custodian and unlike the AIFMD provisions cannot be transferred via contract.

The only exception to this rule would be where the depository could demonstrate that the loss of the instrument that occurred whilst the instrument was in its care was due to an external event that was beyond the ability of the depository to reasonably control.

 Ø Depository Remuneration & Possible Sanctions

The draft directive proposes to introduce policies regarding remuneration specifically to reduce the incentive for senior management and other staff members who exercise control over the UCITS scheme to take undue risks with investors’ capital.

A common approach to sanctions is also proposed within the remit of the draft directive particularly in relation to the publication of sanctions applied and the management of authorisations.