Re: European Commission Green Paper Audit Policy: Lessons from the Crisis

Transcription

1 DG Internal Markets and Services Re: European Commission Green Paper Audit Policy: Lessons from the Crisis The Irish Funds Industry Association ( IFIA ) would like to take this opportunity to comment on the above Green Paper. The IFIA is the representative body for those involved in the international investment fund industry in Ireland, including the administration companies, custodian banks/trustees, fund managers and professional advisors who service international funds in Ireland. With over 10,000 Irish and Non-Irish domiciled funds, including sub-funds, with a Net Asset Value in excess of 1,700 billion, being serviced and administered in Ireland, Ireland is one of the leading international jurisdictions for the domicile and servicing of internationally distributed investment funds and therefore provides a representative view of the international industry including promoters in Europe, Asia and North America. It should be noted that it is common practice in the investment funds industry for the Fund/Fund Sponsor to engage independent regulated third party service providers to undertake certain administrative functions on behalf of the fund, including the valuation of assets of the fund and the calculation of the Net Asset Value (NAV), the maintenance of books and records of the fund and the preparation of financial statements. The industry companies which provide these services invest millions in systems and we believe this independent regulated activity substantially lessens the risk of fraud and error and distinguishes the investment funds industry from other industries. Additionally, it should be noted that investment funds are typically regulated structures and subject to valuation principles and requirements imposed and supervised by Regulators. By way of example appendix A includes the Central Bank of Ireland Guidance Note 1/00 - Valuation of the Assets of Collective Investment Schemes. As the parties responsible for the preparation of the Financial Statements of these investment funds, the industry companies have a keen interest in financial reporting, the standards that govern how accounts are prepared and audited, and have a strong interest in the issues considered in the Green Paper. We would therefore be grateful to be included on any ongoing consultations and to be informed on the status and progress of this initiative. Our comments on the Green Paper are as follows: 1) Framework The focus on Audit Policy, Audit Quality and managing the Audit Expectation Gap is welcomed, particularly in light of recent financial markets turbulence and the need to address systemic risk. However, we are concerned that the response proposed by the Green Paper suggests a broad approach which does not specifically address those Public Interest Entities subject to systemic risk. The proposed approach would lead to broad provisions and rules that would apply to all industries and would result in un-necessary and excessive new requirements, which could potentially add additional costs without adding value. We believe that such a broad approach is not appropriate and would instead suggest that the Commission focus either specifically on new requirements applying to those industries and entities that have the highest systemic risk, or alternatively, ensure that new requirements distinguish between the unique circumstances, issues and risks affecting individual industries. In this context, we believe that the Investment Funds Industry is well served by the existing Audit Framework.

2 Additionally, whilst acknowledging the extent to which Investment Funds may be considered to be Public Interest Entities, we would highlight that there is a significant and fundamental difference between Investment Funds and other Public Interest Entities, e.g. listed multinational corporations, Banks, etc. An investment fund is subject to Regulation (including reporting to Regulators), publishes Offering Documents which contain detailed disclosures with respect to its Investment Strategy, Risk Exposures, etc and reports its performance regularly to investors and Regulators. We would also point out that the responsibilities of auditors are often supplemented by specific rules of the Regulator, including requirements to communicate directly with the Regulator on certain matters and share with the Regulator communications with those charged with governance. It should be noted that Irish Funds operate in a highly controlled and regulated Industry. All Irish Funds are subject to Companies Acts requirements / Unit Trust Acts requirements in addition to UCITS / Non UCITS requirements and have a board of directors with at least two independent non executive directors. In addition, the assets of the Fund are typically held independently by a Depositary that is subject to extensive regulatory requirements and that is required to include a report to the shareholders/unit holders in the annual financial statements. There is significant oversight and interaction with the Central Bank of Ireland and audit firms are required to report to the Central Bank at the end of every audit on certain matters including whether any material internal control weaknesses have been noted and copies of communications with the governing Board. In addition, it should be noted that Irish Funds operate in a control environment where typically the key functions of administration and custody are outsourced. Therefore the books and records and custody records are kept independent from that of the Sponsor which adds a significant level of increased control typically not present in all industries. We believe an Audit Framework that proposes significant amendments to the nature and scope of an audit, that does not recognise the different attributes, issues and expectations of different types of entities, would not be an appropriate framework for Investment Funds and would lead to additional cost and administrative burdens. 2) Audit Scope We would like to highlight that the Investment Funds Industry in the EU is a regulated industry and the stakeholders don t just focus on the annual audit but also on the existence of a strong regulatory framework applying to the Industry. Indeed, it is arguably the case that the primary purpose of an investment funds financial statements is to validate historical performance. Given the volatility of investment performance audited financial statements validate historical performance and are part of the due diligence process, rather than part of the investment decision process. With respect to audit expectations, the historic nature of audited financial information is not considered to be insufficient as the nature of an Investment Fund is such that future performance is dependent on market factors and future market conditions cannot necessarily be expected to behave consistently with forward looking statements, indeed it is common for Investment Fund information for investors and prospective investors to highlight that past performance is no indicator of future performance.

3 Investors in Investment Funds, particularly Institutional Investors, see audited historical financial statements as valuable as it provides information with respect to the Fund, in accordance with accounting requirements that are very comprehensive. It is not uncommon for investors and prospective investors to obtain and review audited financial statements as part of their initial and ongoing due diligence and monitoring of their investments in Funds. Furthermore, we would like to point out that, to the extent not met by statutory audit requirements, there are additional options available whereby audit and assurance services can be provided. We would note in particular the extent to which service providers to the Investment Funds Industry, such as third party Administration Companies, Custodians etc, produce reports detailing their processes and controls and where such service providers have engaged auditors to audit and report on these processes and controls. An example of this is the SAS 70 report. Such a report is common place and is often requested by investors and prospective investors as additional information, providing them with enhanced assurance. Although SAS 70 is based on a US Auditing Standard, it has become somewhat of a global standard and an equivalent International Standard on Auditing will shortly be implemented. In summary, we believe that the current Audit Framework is sufficient to meet the needs of the Investment Funds Industry s key stakeholders and that the EU s focus on how the Audit Process can learn from the recent crisis should focus on those entities that contain systemic risk. We do not believe this should include Regulated Funds, particularly as Regulators have and are already responding to the financial crisis with new regulations, such as the Alternative Investment Fund Managers Directive and further proposed increased regulation of Depositaries (UCITS V). 3) Audit Independence Rules We acknowledge the importance of Auditor Independence rules but believe that present Independence Rules and Regulations are sufficient and that efforts to enhance these would only lead to reduced choice over selection of service providers. 4) Competition and Choice of Auditor We note that a number of suggestions have been made which are designed to improve competition and choice, including mandatory auditor rotation, establishing service time limits, joint auditors or requiring that auditors be appointed by Regulators. We support the development of a competitive market place, where Investment Funds have a wide choice of potential service providers. However, we believe that there is currently a dynamic market place and note the ongoing presence in the market of non-big 4 accounting firms acting as auditors and service providers to Investment Funds in Ireland. Additionally, given the Investment Funds Industry is a global industry, Investment Funds often have cross jurisdictional activities which require their auditors to have the capability to address a variety of issues in multiple countries, such as accounting rules, taxes, regulations etc. Furthermore, it is noted that Investment Fund s often select separate audit firms for their Funds than for their own Investment Manager s corporate audits and that Fund families often look to appoint different auditors to groups of Funds.

4 We believe that market forces should drive competition between audit firms and the growth and development of service offerings. We are concerned that some of the current proposals would have the effect of limiting choice and increasing costs by mandating changes of auditor or joint audits whilst potentially impacting on service quality. In terms of auditor rotation we are concerned that the empirical evidence of independent research in this area highlights the fact that the risk of fraud and error is at its greatest in the year following mandatory rotation of a Firm. We are concerned that a forced rotation of an audit Firm will add risk and costs that are not appropriate or required for the environment in which Funds operate. It should also be noted that many Irish Funds are set up for a defined period of time and a mandatory rotation in the context of such funds could be even more disruptive and costly. We are also concerned with International studies which have demonstrated a positive correlation between rotation and increasing market concentration in practice. Irish Funds operate in a highly competitive audit market with a number of audit firms, in addition to the Big Four, actively offering their services. There is significant transparency in the market place in terms of the levels of fees being charged and the decisions to appoint are generally made by the Fund Sponsor in conjunction with the board of directors, typically after a due diligence process and after a number of quotes from different Firms have been obtained. As previously noted, in a significant number of cases, this is not the same Firm that is responsible of the audit of the Corporate Sponsor entity. 5) Audit Regulation We support proposals which would lead to EU wide audit regulation and greater transparency. In summary, whilst we remain broadly supportive of the focus on improving the Audit Process and learning from the crisis, we would encourage the Commission to focus on the extent to which Regulatory developments are already addressing these issues. We agree that entities which pose systemic risk do need to be considered and we would welcome enhancements for such entities, including Banks and Custodians but feel the current Audit Framework serves the Industry well and would not benefit from many of the proposals, if applied in full to all Public Interest Entities without consideration of relevance, impact, cost, or whether they represent the best approach for serving the interests of Investors and other stakeholders. We would be happy to discuss these comments further and to provide comments on any further or updated proposals. Yours sincerely, Gary Palmer Chief Executive

5 APPENDIX A Guidance Note 1/00 - Valuation of the Assets of Collective Investment Schemes

6 2010 Guidance Note 1/00 Guidance Note 1/00 Valuation of the Assets of Collective Investment Schemes October

7 Contents 1. Methods of valuation 2 a. Securities which are listed or traded on a 3 regulated market b. Securities which are listed or traded on a regulated market where the market price is unrepresentative or not available and unlisted securities 3 c. Collective investment schemes 4 d. Cash (in hand or deposit) 4 e. Exchange traded futures and options 4 contracts, including index futures f. Over-the-counter derivative contracts 4 g. Forward foreign exchange and interest rate 5 swap contracts Notes i. Additional provisions for specific asset 6 ii. Adjustments 6 iii. Amortised cost 6 iv. Dual pricing 7 v. Consistency 7 vi. Dealing 7 2. Frequency of Valuation & Dealing Arrangements 8 3. Responsibility 8 a. Management company, directors, general partner 8 b. Trustee 9 1

8 Guidance Note 1/00 Valuation of the Assets of Collective Investment Schemes Paragraph 2 of non-ucits Notice NU 8 provides: The assets of a collective investment scheme, including any techniques or instruments used for the purposes of efficient portfolio management (Ref. NU 16), will be valued by a method clearly defined in the trust deed, deed of constitution, articles of association or partnership agreement and approved by the Central Bank. The method of valuation used will be disclosed in the prospectus. Paragraph 2 of UCITS Notice UCITS 5, provides: Unless otherwise provided for in the trust deed, the deed of constitution or the articles of association, the value of the assets of a UCITS shall be based, in the case of securities traded on a stock exchange or on a regulated market, on the last known stock exchange or market quotation unless such quotation is not representative. For securities not so quoted and for securities which are so quoted but for which the latest quotation is not representative, the value shall be based on probable realisation value which must be estimated with care and in good faith. Financial derivative instruments will be valued by a method clearly defined in the trust deed, the deed of constitution or the articles of association. The Central Bank of Ireland [ the Central Bank ] reviews valuation provisions contained in the trust deed, deed of constitution, articles of association or partnership agreement during its assessment of an application. This note provides guidance on the Central Bank s application and interpretation of the above conditions. As a fundamental principle, valuation methodologies and the pricing of units must strive to promote fair treatment of incoming, existing and outgoing investors in collective investment schemes ( CIS ). 1. METHODS OF VALUATION Valuation policy will be established by the management company, investment company or general partner. A CIS is required to ensure that the valuation rules provided are clear and unambiguous. While a CIS is not required to follow a particular set of valuation rules, valuation policies should fall within the parameters set out below. Other valuation policies may be permitted provided that an acceptable rationale is provided to the Central Bank, the methodology is clearly disclosed and it is not in conflict with relevant legislation or the principles outlined herein. 2

9 Assets may be valued in accordance with the following guidelines: a) Securities which are listed or traded on a regulated market: Valuation should be the closing or last known market price. The CIS may determine that this shall be the closing bid, last bid, last traded, closing midmarket or latest mid-market price. 1 Where a security is listed on several exchanges, the relevant market shall be the one which constitutes the main market, or the one which the manager/directors/general partner determines provides the fairest criteria in a value for the security. Securities listed or traded on a regulated market, but acquired or traded at a premium or at a discount outside or off the relevant market may be valued taking into account the level of premium or discount at the date of the valuation. The trustee must ensure that the adoption of such a procedure is justifiable in the context of establishing the probable realisation value of the security. b) Securities which are listed or traded on a regulated market where the market price is unrepresentative or not available and unlisted securities: The value of the security is its probable realisation value which must be estimated with care and in good faith. The security may be valued by the manager, directors or general partner, or valued by a competent person 2 appointed by the manager, directors or general partner and approved for the purpose by the trustee, or valued by any other means provided that the value is approved by the trustee. Matrix pricing (i.e. valuing securities by reference to the valuation of other securities which are considered comparable in rating, yield, due date and other characteristics) may be an appropriate method of valuation for fixed 1 2 It may be more appropriate to use an offer price or offer quotation in certain circumstances (e.g. to value a short position or in the context of a dual pricing CIS (see Note (iv) below). Where the competent person is a related party to the CIS, the prospectus should disclose the possible conflict of interests which may arise (e.g. valuation provided by an investment adviser; the advisers fee will increase as the value of the CIS increases) 3

10 income securities, where reliable market quotations are not available. Provision may be made for matrix pricing provided the securities used in the matrix are comparable to the securities being valued. Matrix pricing must not ignore a reliable market quotation. The matrix methodology will be compiled by the manager, directors, general partner or competent person, as outlined above. c) Collective investment schemes: Valuation is based on the latest bid price or latest net asset value, as published by the collective investment scheme. Use of a mid or offer price is acceptable if consistent with valuation policy, i.e. the other assets held by a CIS should be valued on the same basis. Use of market prices may be appropriate where the collective investment scheme in which the investment is made is listed on a regulated market, in accordance with (a) above. d) Cash (in hand or deposit): Value is the nominal/face value plus accrued interest e) Exchange traded futures and options contracts, including index futures: Valuation is based on the settlement price as determined by the market in question. If a settlement price is not available they may be valued in accordance with (b) above. f) Over-the-counter derivative contracts: The Central Bank s Notices, both UCITS (UCITS 10) and non-ucits (NU 16, NU 20, NU 21), require that the counterparty to an over-the-counter ( OTC ) derivative contract must be prepared to value the contract and to close out the transaction at the request of the CIS, at fair value 3. A CIS may choose to value an OTC derivative using either the counterparty valuation or an alternative valuation, such as a valuation calculated by the CIS or by an independent pricing vendor provided the CIS or other party has 3 For the purposes of this paragraph, the reference to fair value shall be understood as a reference to the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction. 4

11 adequate human and technical means to perform the valuation. A UCITS must value an OTC derivative on a daily basis; non-ucits must value on a weekly basis 4. Where a CIS will value an OTC derivative using an alternative valuation: the Central Bank expects that the CIS will follow international best practice and adhere to the principles on valuation of OTC instruments established by bodies such as IOSCO and AIMA; the alternative valuation is that provided by a competent person appointed by the manager, directors or general partner and approved for the purpose by the trustee, or a valuation by any other means provided that the value is approved by the trustee; and the alternative valuation must be reconciled to the counterparty valuation on a monthly basis. Where significant differences arise these must be promptly investigated and explained. Where a CIS will value an OTC derivative using the counterparty valuation: the valuation must be approved or verified by a party who is approved for the purpose by the trustee and who is independent of the counterparty 5 ; the independent verification must be carried out at least weekly in the case of UCITS and at least monthly in the case of non-ucits. 6 g) Forward foreign exchange and interest rate swap contracts: Valuation of these OTC derivative contracts can be in accordance with the preceding paragraph or, alternatively, by reference to freely available market quotations. If the latter is used, there is no requirement to have such prices independently verified or reconciled to the counterparty valuation. 4 The Central Bank will permit closed-ended CIS and/or PIF and QIF CIS to value OTC derivatives on a monthly basis. 5 An independent party can include the CIS. It can also include a party related to the OTC counterparty provided that the related party constitutes an independent unit within the counterparty's group, which does not rely on the same pricing models employed by the counterparty. In this case, the relationship between the parties, and the attendant risks, must be disclosed in the prospectus. In the case of UCITS and retail non-ucits, where the independent party is related to the OTC counterparty and the risk exposure to the counterparty may be reduced through the provision of collateral, the position must also be subject to verification by an unrelated party to the counterparty, on a six monthly basis. 6 A CIS which is permitted to value OTC derivatives on a monthly basis (see footnote 4) must carry out the independent verification procedure at least on a quarterly basis. 5

12 Notes: (i) Additional provision for specific asset: A trust deed, deed of constitution, articles of association or partnership agreement may provide that, notwithstanding the detailed valuation rules, valuation of a specific asset may be carried out under an alternative method of valuation if the manager, directors or general partner deem it necessary. The alternative method of valuation must be approved by the trustee and the rationale/methodologies used should be clearly documented. (ii) Adjustments The value of an asset may be adjusted by the directors, manager or general partner where such an adjustment is considered necessary to reflect the fair value in the context of currency, marketability, dealing costs and/or such other considerations which are deemed relevant. The rationale for adjusting the value must be clearly documented. (iii) Amortised cost: A CIS which is a money market fund is permitted to provide for the use of amortised cost as an alternative method of valuation in accordance with Guidance Note 1/08. It is recognised that there are non-money market CIS which have investments in money market instruments. Where it is not the intention or objective to apply amortised cost valuation to the portfolio as a whole, money market instruments within such portfolios may be valued on an amortised basis provided that the money market instruments have a residual maturity of less than three months and have no specific sensitivity to market parameters, including credit risk. In the case of non-ucits CIS, amortised cost may also be applied to money market instruments with a residual maturity not exceeding six months, where these instruments have no specific sensitivity to market parameters, including credit risk. 6

13 (iv) Dual pricing: A trust deed, deed of constitution, articles of association or partnership agreement may provide for the calculation of a separate bid and offer price on its units, i.e. dual pricing. The valuation procedures utilised in calculating both the bid and the offer price should be clearly disclosed as previously outlined. (v) Consistency: A CIS may provide for valuation of its assets on a mid-market basis, a bid basis or, in the case of dual pricing, on a bid and offer basis. It can also provide for valuations on an offer basis where total subscriptions on a dealing day exceed total redemption requests, or for a switch from mid-market to bid basis when total redemption requests, on a dealing day, exceed total subscriptions. Valuation policies, including provisions which allow for a switch from a midmarket to a bid or offer basis, must be applied on a consistent basis throughout the life of the CIS. Whatever basis is chosen, there must also be consistency in the policies adopted throughout the various categories of assets. Accordingly, if a switch to valuation on an offer basis is provided for in one category (because of subscriptions exceeding redemptions) then the other categories must contain the same provision. There may be some exceptions to this principle because an offer quote is not available. (vi) Dealing in the units of a CIS should be carried out at forward prices i.e. the Net Asset Value next computed after receipt of subscription and redemption requests. 7

14 2. FREQUENCY OF VALUATION & DEALING ARRANGEMENTS Frequency of valuation must be consistent with dealing arrangements. The minimum frequency at which dealing days must be provided is as follows: UCITS: Twice per month at regular intervals Non-UCITS retail schemes: Monthly Professional /Qualifying investor schemes: Quarterly In the case of closed-ended schemes valuations must be carried out on a monthly basis except for: Venture or development capital schemes (NU14); and property schemes (NU18) in which cases valuation on a half-yearly basis is permitted. Qualifying investor schemes where valuation may be carried out on an annual basis. 3. RESPONSIBILITY a) Management company, directors, general partner: Ultimate responsibility for valuations rests with the management company/ directors/general partner. The management company/directors/general partner should ensure that securities prices and currency rates are up to date and are provided from a reputable source. The reliability of the source of prices and rates should be kept under constant review. Systems and procedures should be in place to: verify uncertain prices and rates; ensure that investment restrictions are not breached; ensure that dividends, expenses and taxes are properly accounted for; provide movement thresholds at which price movements are reviewed; query prices which appear stale, i.e. little or no movement over time; provide for the valuation policy in relation to unlisted or illiquid securities; provide for the valuation policy in relation to OTC derivatives. Full and detailed records, particularly in the case of unlisted or illiquid securities and OTC derivatives,, should be maintained where they can be reviewed. The 8

15 management company, directors or general partner should pay particular attention to and closely monitor valuations provided by parties in respect of illiquid or unlisted securities and OTC derivatives to ensure that they remain competent for this purpose. Reconciliation of cash, debtors and creditors should take place at a frequency which reflects the frequency of the valuation. b) Trustee The Central Bank s Notices [UCITS 4 and NU 7] require the trustee to ensure that the value of units is calculated in accordance with the Regulations and/or the trust deed, deed of constitution, articles of association or partnership agreement, as appropriate. The trustee should ensure that the valuation methodologies provided for in the constitutional documentation are adhered to and the operations of the management company/investment company/general partner are properly controlled. A detailed initial review of the overall valuation procedures should be carried out and these should be subject to subsequent periodic review by the trustee. The frequency of the periodic review should depend on the type of CIS and the degree of satisfaction with the initial review. Careful attention should be given to procedures adopted in the case of illiquid or unlisted securities and OTC derivatives. Financial Institutions and Funds Authorisation Central Bank of Ireland October

16 T F FIFApolicy@centralbank.ie Bosca OP 559, Sráid an Dáma, Baile Átha Cliath 2, Éire PO. Box No 559, Dame Street, Dublin 2, Ireland 10